Money manager Lou Simpson recently talked about the negative correlation between the number of people making an investment decision and the results. He noted that if a lot of people are involved, the tendency is for the least competent person to effectively make the decision when a consensus is required.
Think of it as a dark reflection of the notion that two heads are better than one. It stuck in my mind after it was offered as an aside during an interview at the Kellogg School of Management at Northwestern University, where Mr. Simpson is a senior fellow and adjunct professor. Long-time Berkshire Hathaway shareholders will know of his sterling reputation as an investor, which he developed while working for Warren Buffett as Geico's chief investment officer.
While Mr. Simpson's observation applies directly to investment and pension fund committees, it has a much wider impact. It's something that might be happening right now. After all, two people have to agree on the advice that appears in these pages before it can be acted on – both the reader and author. One of them is, at least when it comes to some things, slightly less competent than the other.
To see the issue in action, it helps to think about its applicability to stock screens and ranking methods. For instance, I looked at the performance of a portfolio composed of 10 stocks with generous dividend yields and monstrous momentum a few weeks ago.
I fully expect that the approach will be of interest to only a fraction of my readers. Those who like it may pick through the portfolio as a sort of menu. They might chose a few stocks to buy while avoiding the others. An even smaller number of people will be inclined to follow the approach faithfully.
I hope that those who pick and choose will prove the adage that two heads are better than one, but I fear the results might conform to Mr. Simpson's upside-down version of the saying. Indeed, evidence from a modest, and admittedly limited, experiment indicates the latter is more likely than the former.
The experiment was conducted unintentionally by money manager Joel Greenblatt who published The Little Book that Beats the Market. He advocated the use of a value-plus-quality "magic" formula when picking stocks.
Due to reader demand, Mr. Greenblatt set up brokerage accounts for investors to follow the method. They could choose between professionally managed accounts that would do all of the work for them or they could go for self-managed accounts where they could buy and sell from the list of magic-formula stocks when they pleased.
The self-managed accounts did pretty well, with gains of 59 per cent (after expenses) over the following two years. Unfortunately, they trailed the market slightly because the S&P 500 climbed 63 per cent over the same period. The investors who opted for the professionally managed accounts that diligently followed the magic formula gained 84 per cent (after expenses).
The self-directed investors underperformed both the strategy and the market despite picking from the list of stocks in the magic-formula portfolio. As Mr. Greenblatt wrote, "on average the people who 'self-managed' their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!"
Typically, they underperformed by avoiding cheap stocks with notable warts that went on to be big winners. Many also bailed out after a short period of poor performance and stayed in cash. Others bought more after a short period of good performance. Over all, their market-timing efforts hurt their results.
On the other hand, the top performing self-directed accounts didn't do much of anything. They simply bought a bunch of stocks when they opened their accounts and then sat on them. Score one for the buy-and-holders.
Nonetheless, it's sobering to think that a value-enhancing strategy might turn into a value-destroying one in practice when it's passed on to someone else. Of course, it's also important to face the possibility that the strategy in question might not have been a value-enhancing one to begin with. Such is the risk of following the ramblings of an old fool like me.
Norman Rothery, PhD, CFA, is the founder of www.StingyInvestor.com