The financial media is pleased to report that the best performing mutual fund of the decade is Ken Heebner’s CGM Focus fund.

Through the end of January, 2010, the mutual fund annualized 18.03%, easily outpacing the S&P 500’s annualized return of -0.55%.

Did you miss these returns? Not to worry, because the typical investor in the CGM Focus mutual fund also missed out on the returns. Unfortunately, there is a big difference between investment returns and investor returns.

The financial media always focuses on investment returns. In other words, what did a specific investment return? In this case, the media focuses on the great track record the CGM Focus mutual fund had over the last decade.

Of course, the media rarely focuses on investor returns. In other words, how did the typical investor perform in the same investment? Luckily, Morningstar calculates dollar-weighted returns, which represents the returns real investors receive based on buying and selling.

Here are the 10-year annualized results through the end of January, 2010:

• CGM Focus: 18.03%
• Typical CGM Focus Investor’s return: -13.73%

How can this be? How did investors lose money in the best performing stock fund of the decade?

Simple. Poor investor behavior.

Most investors make buy and sell decisions based on past performance. As the financial media was happy to point out, CGM Focus returned 80% in 2007.

Believing this trend would continue, investors poured a whopping $2.6 billion into the fund in 2008.

Then, in horror, investors watched as the fund tanked -48.2%. Disappointed with the results, investors yanked more than $750 million out of the fund.

The typical CGM Focus investor missed all the gains in 2007 and captured all the losses of 2008.

Don’t fall victim to poor investor behavior and media hype. Understand there is a difference between investment returns and investor returns.

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There is a difference between luck and skill and knowing when you are just lucky and when you are successful due to skill is of paramount importance as an investor.

For instance, let’s say you correctly called the flip of a coin five times in a row. What are the odds that you will correctly call the next flip?

Correctly calling five flips in a row might be considered a “hot streak” and lead you to believe that chances are high you can correctly call the next flip. Well, assuming it is a fair flip, there is, of course, only a 50/50 chance that you will be correct because flipping a coin is a game of known probability. The fact is the coin flip has no memory of your hot streak.

And, just like a coin flip, an investor who is on a “hot streak” may simply be lucky.

With millions of investors, odds are that some of them will make winning investments numerous times in a row.

If these winning investors were, in reality, just lucky, but they think they were actually skillful, then that is when the situation turns problematic. The lucky investor may start to think they are infallible and get stubborn when the market turns against them.

Eventually, when the lucky streak ends, it will likely mean serious losses for the investor.

The best antidote we know of to the danger of confusing luck and skill is to remain humble. When our investment strategy performs well, we are very thankful. When it doesn’t perform well, we accept this as part of the market cycle.

The investment business has an uncanny way of turning hubris into painful losses. We think humility is a safer route.

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Investors are driven by the fear of losing and losing out.

Last winter, as the financial markets were seemingly in a free fall, panic and fear reigned. There was a sense that the worldwide financial system could collapse and that the problem was bigger than the government’s ability to solve it. This fear of losing spurred more selling and it became a vicious cycle – until it stopped.

Today, it’s a completely different picture.

The banking system is back from the brink. Liquidity is improving. The S&P 500 index is up about 50% from its March low. And, the economy is showing definite signs of coming back to life.

Ironically, fear is also returning to the markets. However, it is not the fear of losing money; rather, it is the fear of losing out from making a big killing as the markets recover.

Both types of fear have the ability to dramatically move the markets.

To state the obvious, humans are emotional. For example, we’re emotional about relationships, about work, about politics, about religion, about food, and, of course, about money.

As humans oscillate between the fear of losing money and the fear of missing out on making it, we tend to drive the financial markets much lower and much higher than “reason” might dictate.

The tricky question facing investors right now is, “Will the fear of missing out on a big rally drive this market even higher as investors who have been on the sideline decide they have to get in?”

Back in the late 1990s, the technology-led stock market bubble took stock prices to an unprecedented level that was far higher than justified by “fundamentals.” Could history be repeating itself?

Interestingly, as of last Friday, the S&P 500 index was 22% lower than it was 10 years ago.

For the bulls, this suggests the market still has lots of room to run higher and is in no danger of being in bubble territory.

For the bears, they point to a near 50% rise and say it’s time for a breather.

Ultimately, you should strive to take the emotions out of investing. Your investments should be a means to an end as defined by your personal financial plan.

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Sunk costs and mental accounting can be hazardous to your wealth.

Imagine you just arrived at a theater and as you reach into your pocket to pull out the $10 ticket you purchased in advance, you discover that it’s missing. Would you fork over another $10 to see the movie?

Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the theater, you discover you lost a $10 bill. Would you still buy a movie ticket?

In these two scenarios, you effectively lost $10, but here’s where it gets interesting. Psychologists Amos Tversky and Daniel Kahneman of Princeton University conducted the above study in 1984.

They discovered that only 46% of the study participants in scenario one said they would spend another $10 to buy another movie ticket. However, a whopping 88% of the subjects in scenario two said they would still spend $10 to buy a theater ticket.

Here’s what happened.

More than half of the subjects in scenario one created a “mental account” for the theater ticket. They equated the $10 they spent on buying the ticket in advance with the additional $10 they would have to spend to replace that ticket and concluded that the theater ticket actually would cost them $20. Paying $20 for a $10 ticket was a non-starter for 54% of the study participants.

Conversely, in scenario two, 88% of the study participants did not create a “mental account” that equated the $10 theater ticket with the $10 bill they lost on the way to the theater.

But, as you can see, in both scenarios, the study participants still lost $10.

So, are humans completely irrational?

Sort of. The participants who lost the theater ticket succumbed to the “sunk cost” trap. They let the price they paid for the lost ticket affect their decision to buy a new ticket even though the two are technically unrelated.

Investors frequently do the same thing.

They buy a security, watch it go down, and then tell themselves, “as soon as it gets back to breakeven, I’ll sell it.”

But, the fact is, a losing security is a sunk cost and there should be no commingled “mental accounting.” Instead, each investment decision should stand on its own and be made based on the most current information.

Remember, you don’t have to recoup a loss in the same way that you generated it. Sometimes it’s best to take a loss and move on to a more promising investment.

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“Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.” –Jesse Livermore

Jesse Livermore is a famous early 20^th century trader and speculator who was immortalized in the 1923 book, Reminiscences of a Stock Operator by Edwin Lefevre.

Many consider Livermore one of the greatest traders and speculators who ever lived.

Now, we’re not mentioning Livermore because we think aggressively trading and speculating in your account is the way to go. Instead, we want to highlight the above quote from Livermore and discuss its relevance to today.

“Wall Street never changes.”

From the standpoint that Wall Street is all about making money, that statement is true. It was as true in “The Roaring 20s” during Livermore’s lifetime as it was during the internet bubble of the late 1990s.

“The pockets change, the suckers change, the stocks change.”

Wow, that statement is spot on.

Wall Street continues to come out with new products that they think the public will buy even if they make little economic sense. Do you remember all those shaky limited partnerships from the 1980s? How about the dot-com IPOs of companies that had little revenue and no profits? And more recently, we had newfangled mortgages that let you buy a house with no money down or skip payments or just pay the interest only, among other options.

“But Wall Street never changes, because human nature never changes.”

This is the key quote.

In particular, as humans, our emotions have a tendency to get the best of us. In good times, we tend to get greedy and make decisions that under normal circumstances would be too risky for us.

In scary times, we tend to panic and “get out at all costs.” We like to keep up with our neighbors so we behave in a herd-like fashion. We extrapolate the most recent trends and expect that they will continue indefinitely. All these tendencies have the ability to work against us and preclude us from reaching financial security.

The “smart” people on Wall Street understand our human frailties and, unfortunately, some of them use it to their advantage. Don’t allow this to happen to you. Work with an advisor you trust.

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In a battle of the sexes, finance professors Brad Barber and Terrance Odean crunched the trading data on over 35,000 households from a large discount brokerage firm.

They built upon psychological research, which indicates that in the area of finance, men tend to be more overconfident than women. Additional research shows that overconfident investors tend to trade more often than less confident investors.

Armed with this data, Barber and Odean went to work.

They hypothesized that men traded more frequently than women and that this excessive trading hurt their performance more than it hurt the performance of women.

Here’s what they found in a 2001 study published in The Quarterly Journal of Economics:

1. Men overall traded stocks 45% more frequently than women.
2. Single men traded stocks 67% more frequently than single women.
3. Women overall earned annual risk-adjusted returns that were 1.0% greater than men.
4. Single women earned annual risk-adjusted returns that were 1.4% greater than single men.

So yes, based on this study, women are more successful investors than men because they earn a higher annual return.

An interesting sub-point from the study is the out-performance by women was solely due to their lower trading frequency. Women were no better than men at security selection; instead, their advantage came from making fewer trades.

Let the bragging begin!

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“Whoever manages my money better beat the S&P 500! What’s your strategy? What’s your performance? Jim Cramer says buy Lehman Brothers. What do you think of Lehman Brothers? Should I buy gold? ”

A prospective client asked these questions during a meeting last year. When I attempted to discuss goals, he directly focused on investments and described the classic investors mistakes he made over the last decade including:

• Buying technology and growth stocks in 1999 and holding to the end of 2002 realizing a huge loss.
• Buying bonds in 2003, just in time for the bond market to decline. (Yes, bonds can and do decline.)
• Buying a property to fix up and flip in 2006. Still holds the property at a loss and cannot sell as the mortgage is higher than the home’s value.

He planned to retire in a few years and wanted advice but didn’t want to talk about goals. He only wanted to focus on investments and strategy.

After a decade of making mistakes, this investor is still looking for the secret to maximize investment returns. But the reality is this: The more you search for investing secrets, the worse your returns will be!

Now, suppose in 1999 he:

• Identified his goals
• Designed a plan with a real financial planner focused on these goals
• Understood the portfolio was a tool, a means to an end.

First, a financial planner would have helped avoid the classic investor mistakes he made.

Second, a financial planner would have designed a diversified portfolio based on his goals. A portfolio designed with an end in mind!

Last, a financial planner would continually monitor the plan, adjusting goals and/or the portfolio allocation based on the plan. In other words, benchmarking the portfolio against the plan, not an arbitrary index.

The time has come to stop searching for the next “hot” investment or guru who can provide market beating returns.

It’s time to define life goals and design a plan with a financial planner toward achieving these goals.

It’s time to meet with a financial planner on a regular basis to benchmark your portfolio against the plan and adjust as required.

It’s time to understand a portfolio is not the end. A portfolio is a means to an end.

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The financial media is back at it.

A recent article in the Financial Times announced that “Anyone who started saving 40 years ago…has found that stocks have performed no better than bonds.”

The article also contains a graph that proudly displays over a 20-year span, from 1929-1949, bonds beat stocks.

Further, the article continues with opinions that stock investing is dead and gives examples of real investors damaged by this market. (We can’t dispute this last part, as many have been damaged by this down market. However, the article tells us nothing about the planning or investment strategy these people followed.)

Of course, the article offers no solutions.

First, let’s examine the claims.

Looking back at the data from February, 1969 through February, 2009, Long-Term Government bonds annualized 8.65% while the S&P 500 annualized 8.44%.

From January, 1929 through December, 1949, Long-Term Government bonds annualized 4.02% while the S&P 500 annualized 3.80%.

And there it is.

The data that proves bonds beat stocks over long periods of time.

Of course, it would have been nice if the Financial Times (or anyone, for that matter) told us in 1969 or 1929 this would happen. No one did.

And, who in the real world does this data apply to?

It only applies to those who invested all their money in stocks on the exact date in 1969 or 1929, and had to withdraw their entire sum in February, 2009 or December, 1949.  That is an unlikely scenario.

But that is beside the point. The real point is, anyone can make a case for anything using hindsight and data mining.

For instance, take the 1929 through 1949 period. How are the returns affected by simply moving the time period forward one year, from 1930 through 1950, and fully diversifying* the equity portfolio?

• Long-Term Bonds annualized return: 3.86%
• Fully diversified equity portfolio: 9.39%

And, what if we move the time period back one year in the 1969-2009 scenario, to 1968-2008?

• Long-Term Bonds annualized return: 8.34%
• Fully diversified equity portfolio: 11.10%

Simply moving the time period makes a big difference!

For you, the reader, these articles are pointless and will do nothing but scare you into inappropriate behavior.

The best move to make is to develop a financial plan with a trusted advisor, and implement the plan with a portfolio specifically targeted for your personal goals. Then, meet regularly with your advisor and adjust the plan and portfolio as needed.

And leave these articles to those who believe everything they read.

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* Diversified Portfolio:

Rebalance: Per 12 Months
Fama/French US Small Value Index (ex utilities): 25%
Fama/French US Large Value Index (ex utilities): 25%
Fama/French US Large Growth Index (ex utilities): 25%
Fama/French US Small Growth Index (ex utilities): 25%
Currency: USD

The occurrence of “market watching” unleashes during a robust bear or bull market. The practice of investors checking the stock market’s daily swings has spread faster than the Pinot Noir fad.

Frequent overused phrases in the media include, “The Market is up big!” or “The Market plunged.”

These market commentary one-liners pop up with increasing frequency at gas stations, soccer fields, grocery stores and permeate everyday life.

But watching the stock market creates bad habits.

Let’s face it-people do not make financial decisions based on what the market does today. Market watching is as productive as staring at a thermometer and shouting numbers in degrees Fahrenheit as the temperature rises and falls by fractions of a degree.

Friends don’t let friends watch the market. A better use of your time is:

1. Determine which of your investments are tax efficient. Most investors have tax deferred accounts (such as IRAs) and taxable accounts (such as joint accounts). Position tax-efficient investments in taxable accounts and  tax-inefficient holdings in IRA accounts.
2. Verify beneficiaries on IRA, 401(k), or any Trust accounts are up to date.
3. Consider refinancing your home. Currently, 30-year fixed rates are below 5%.
4. Have you fully harvested any unrealized losses in your taxable accounts?  These losses have an intrinsic worth as they offset future capital gains and even provide an annual $3,000 tax deduction from normal income each year until fully exhausted.
5. What is the potential estate tax liability if you pass away?  Does your potential estate have the liquidity to pay those taxes or would your heirs have to sell real estate, heirlooms, or even borrow money to meet those tax obligations?
6. What is the deductible on your homeowner’s insurance policy?  It may be too low. If the deductible is $1,000 and you experience a $1,500 loss is it worth filing a claim to collect that $500 and potentially hurt your insurability?  Raising the deductible to $2,500 or higher could lower the premium.

I look forward to a day when investors behave rationally-when they don’t know what the stock market “did” that day. I’m not naive enough to expect good investor behavior, but at least we can take a time out from market watching and focus on areas of our financial lives over which we have control.

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In investing, it’s natural to seek out clues that we’ve made the right choices, right off the bat.

We check the prices of our investments every few minutes, though they’ve barely had time to move in any direction. And, if we find, by some chance, that the price has gone down, we start asking questions right away:

• Should I have bought that stock?
• Did I buy the right fund?
• Is this portfolio manager my best choice?

Unfortunately, these questions don’t address the most important aspects of effective investing. What we should be asking is if our portfolio is properly aligned toward our overall, long-term goals.

Granted, the financial services industry, along with the financial media, is happy to oblige your thirst for instant feedback.

With a few clicks of your mouse, you can learn how the value of your portfolio has changed over increments as tiny — and ultimately irrelevant — as ten minutes.

You could check out five different analysts’ opinions of what your stock will do this morning – and then get the word from six more telling you what the market will do next week. You can find seven different ratings on the mutual fund manager of your fund of choice.

And if you’re tech-savvy, you can set your BlackBerry to scroll price updates on all your portfolio positions all day long — so you’re always up to the minute on “how much you have.”

Is this flood of financial information really telling me anything?

The reality is that none of this intensive monitoring indicates to us whether or not we’ve made the right choices, in terms of our long-term investment goals. If anything, all the rapid input can be a distraction, and can lead to serious investing mistakes.

The temptation is natural: you know that you’re investing towards financial goals that span decades, but you find yourself seeking positive reinforcement five minutes after you’ve put your money in!

Still, if you’re doing anything beyond reviewing your quarterly statements, there’s a significant likelihood that that the feedback you’re receiving will lead to poor investment choices.

The proper way to decide if you’ve made solid decisions is to focus on portfolio analytics — not individual positions.

Ask yourself…

1. How do portfolio positions correlate with each other? In other words, when one positions “zigs”  – does another one “zag”?
2. What is the impact of each position on the volatility of the total portfolio? Will adding one increase the volatility of your portfolio, while keeping the same return? Or can you increase your returns while reducing the volatility?
3. How tax-efficient is the portfolio? What are the total expenses?
4. Is the portfolio thoroughly optimized to harness the most risk-adjusted return?

Of course, the answers to these questions are much less readily available than the kind of noise the financial outlets provide us with – and that’s where problems start.

The current (and temporary) bear market encourages buzz from “doom and gloom” sellers, and creates a focus on loss of wealth. The irony is — even with all the debate about market dilemmas – wealth loss occurs mostly as the result of investor behavior.

This might seem like an oversimplification. However, given a long-term perspective, the markets have historically risen. So if markets are rising, how else could people be losing wealth?

That’s right – they’re making bad decisions based on insufficient data.

Your success as a resilient investor depends mainly on your behavior and the structure of your portfolio, not on moves based on short-term feedback — or worse yet, what shows up on the cover of Money Magazine!

photo credit: epicharmus

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