Secrets of Success: Constant failure is success for investment gurus

Suppose you were a racehorse owner. Would you be wise to rehire a jockey who fell off your prize gelding at the fifth fence? Does a golfer such as Bernhard Langer become a bad player just because he has a year when he has difficulty getting near the hole with his putts?

In most fields of sport, periodic failure is accepted as part of the daily currency of being a sportsman. You can start again the next day with an equal chance of success. Yet in the investment world, risk of loss is rarely forgiven by those who experience it, even when they have explicitly sanctioned a high-risk strategy. Comebacks by those who were responsible are therefore rare.

The Names who were victims of scandal and fraud at Lloyd's of London 20 years ago had only themselves to blame for participating in a market which explicitly gave them both unlimited liability and access to a market, which by its choice, and their active connivance, was more or less unregulated.

That combination of hidden risks gave them limited practical redress when under-writers posing as gentlemen turned out to be crooks. There are many examples of where those who presided over spectacular losses were unlucky or incompetent, rather than criminally motivated. They too have mostly been treated as pariahs.

You have to admire the gall of the speculator Victor Neiderhoffer, a celebrated hedge fund manager of the 1980s and early 1990s, in trying to tell us in a book how we as investors should conduct ourselves. By his admission, Mr Neiderhoffer ended his career as an investor of other people's money as a failure, wiped out only months after being named one of the investors of the year. His Global Systems funds fell in 1997. He has written his first book explaining how he made the journey from academic to what he says was an investor with the "best record in the investment world". For years, Mr Neiderhoffer worked with the legendary George Soros. His performance was good and his fund attracted scores of investors, many of them market participants of long experience.

Yet the end came with brutal suddenness. Mr Neiderhoffer had bet a huge proportion of his fund on an unsuccessful punt on the direction of the Thai bhat. Combined with a dramatic fall in the US stock market, this loss of value triggered a spate of margin calls (like most hedge fund traders, Mr Neiderhoffer was in effect investing with borrowed money to increase his returns) and the fund was unable to stay in business. With the loss of the fund went nearly all of Mr Neiderhoffer's family money, leaving him scratching for a living at 55, with six children and two wives to support. Many of his best friends, he says, were also his clients, and deserted him in droves.

It is hard to think of someone who is less likely to be listened to today as an authority on investment. Yet I found his book, co-written with a former Bloomberg journalist, Laurel Kenner, full of interesting insights. He knows the way the investment markets work, and many of his observations seem valid, despite being written by someone whose own fund, after years of success, ended in such dismal failure.

One of the many points Mr Neiderhoffer makes is that most investors are astonishingly gullible and naïve about whom they choose to place their money with. He declares, with pardonable exaggeration: "Almost anything disseminated about buying stocks is promotional, and most of the advice is completely untested." Many of the studies on which investors seize for support of their chosen investment methods are based on random or accidental correlations, rather than causal relationships.

This may be one reason why those who pioneer such studies often fail to make a successful transition to practical fund managers, a case in point being James O'Shaughnessy, whose book What Works on Wall Street was a big success a few years ago. It presented a telling quantity of data in support of certain stock selection criteria that had worked well in the past. Alas, these criteria, notes Mr Neiderhoffer, failed to provide a bankable method of managing money when Mr O'Shaughnessy set up a firm to do just that.

It is easy to accuse Mr Neiderhoffer of being consumed with getting even for his brush with misfortune. Yet his strictures are entertaining even where they are overstated. He says there is almost no proven correlation over time between the price-earnings ratio of the market and its subsequent performance; indeed, if anything, the correlation is negative.

He also refers to research at London Business School which appears to confirm something I have long suspected, that most investors are driven by an insatiable need to have rational explanations for whichever strategy they are pursuing. It doesn't matter if the explanations are right or wrong: the most important thing is to avoid the frightening conclusion that nobody really knows. He quotes Dr Brett Steenbarger as saying: "Investors focus on earnings numbers for the same reason dying people focus on the afterlife. In the face of uncertainty, people have a need for understanding and control. They will latch on to an explanation rather than go without one." Yet following rules based on earnings ratios, or any constant relationship of that kind, usually produces subnormal results.

Most investors find it impossible to come to terms with the practical consequences of the notion that most (not all) movements in security prices are random over anything but the long term. He also has an entertaining dig at Alan Abelson, the veteran columnist on Barron's, the American stock market weekly, saying he was consistently gloomy about the stock market almost the entire way through the bull market of the 1990s. He is correct to point out that, in stock market punditry, it is easy to sustain a career by being repeatedly wrong, and to do so without loss of prestige or influence.

davisbiz@aol.com

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