The Intelligent Investor: Chapter 9

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Graham believes funds are useful overall. They promote savings and investment and protect against mistakes (through diversification and professional management). Those that invest in mutual funds are likely to do better than those that make stock purchases directly (on average), even though mutual funds tend to do no better than the market as a whole and have higher fees.

Graham suggests the reason funds do no better than the market is because funds have such a large amount of capital invested that what happens to the market must necessarily happen to the funds, so don’t expect funds, on average, to do appreciably better or worse than the market. Like individual investors, individual funds may do better or worse in different years, but in the aggregate they will match the market.

Graham cautions against using past performance as an indicator of future success. In many cases, abnormally successful funds are successful because they took inordinate risk which is not sustainable.

Zweig points out several more reasons you CANNOT use past performance as an indication of future performance and thus a reason to buy the stock:

• Migrating Managers - Top fund managers are snatched away by rival funds, or leave to start their own funds. New managers may not be as talented.
• Not Scalable - Top performance catches the attention of the market, which pours money into the fund. It is easier to earn high returns with $1 million invested than with $1 billion invested.
• Unsustainable Strategy - Past success may have been derived from risky strategies that are not sustainable
• Rising Expenses - It becomes more expensive to trade in very large blocks than in smaller ones. Trading costs rise as the larger trades affect the market price.
• Herding - After a really successful run, the managers become scared of a loss, so they begin tracking each other, holding the same large companies in the same proportion, to ensure returns don’t deviate by a large amount from other funds.

Lesson: Don’t expect (or seek) above-average returns from funds. Their value is derived from the diversification benefits and professional management.

An intelligent investor should purchase index funds. These beat the funds over the long term, have the same diversification benefits, and have low costs.