Chasing Returns

Now with Buffet-heavy Add On.

Since the deadline for TAG 401(k) enrollment looms (the deadline is next week), here's another dollop of investment advice, this one about the folly of chasing overheated returns ....

Please note the word "chasing," as in "trying to overtake," which is essentially what chasing entails: the train -- some hot investment or fund -- is barreling along the track, and the hopeful investor is racing along behind trying to jump aboard.

The problem is, most investors buy into the hot mutual fund (or stock) around the time it's starting to cool off.

One quick example: In Money Magazine's 2010 Investor's Guide, the top ranked fund for 2009 was Oceanstone Fund..

The little darling returned 246.1% in 2009. For the three years spanning 2007 to 2009, the fund was also number one, earning 56.7% for the period.

But before you go piling onto this big-time bonanza, here's a few things you should know:

1) Oceanstone is small, with only four million dollars in assets. (This might explain part of the reason it's performing well -- the sucker has a small asset base and is therefore nimble.)

2) Oceanstone has only been up and running since November 2006, so it's got a short track record.

And here's the other thing: as investors read Money Magazine, they'll look at the rankings and jump on the gravy train, unaware that as investors sign up the fund will inevitably become much larger and less able to ride hot investments.

(This is what happened to Fidelity's Magellan Fund under Peter Lynch. Magellan took off like a rocket when it was small, well-managed and able to turn on an investment dime. But its success caused it to become huge, and Magellan became, for all intents and purposes, little more than a high-cost index fund.)

Warren Buffet, who's managed to make a few dollars as a professional stock picker, has offered this advice to small, part time investors:

... "The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you'll be buying into a wonderful industry, which in effect is all of American industry ... If you have 2% a year of your funds being eaten up by fees, you're going to have a hard time matching an index fund ..."

But I'll go a step or two further. You should get into a low-cost asset allocation fund (I've linked t0 three examples -- only one of which contains pure index funds) and feed it month by month over a period of twenty or thirty years.

Do it that way, and you won't have to worry about rebalancing, because the fund will rebalance for you. And you won't have to worry about a steady drip-drip of brokerage costs, because you won't have any.

The only thing you'll have to worry about, after several decades of dribbling in your investment dollars this way, is how you're going to spend whole lot of money.

Add On: Since Warren Buffet published snippets of investing wisdom in his Berkshire Hathaway letter yesterday, we quote (via The Wall Street Journal) some highlights:

Stay liquid. "We will never become dependent on the kindness of strangers," he wrote. "We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses."

Buy when everyone else is selling. "We've put a lot of money to work during the chaos of the last two years. It's been an ideal period for investors: A climate of fear is their best friend ... Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble."

Don't buy when everyone else is buying. "Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance," Mr. Buffett wrote. The obvious corollary is to be patient. You can only buy when everyone else is selling if you have held your fire when everyone was buying.

Value, value, value. "In the end, what counts in investing is what you pay for a business-through the purchase of a small piece of it in the stock market-and what that business earns in the succeeding decade or two."

Don't get suckered by big growth stories. Mr. Buffett reminded investors that he and Berkshire Vice Chairman Charlie Munger "avoid businesses whose futures we can't evaluate, no matter how exciting their products may be."

Most investors who bet on the auto industry in 1910, planes in 1930 or TV makers in 1950 ended up losing their shirts, even though the products really did change the world. "Dramatic growth" doesn't always lead to high profit margins and returns on capital. China, anyone?

Understand what you own. "Investors who buy and sell based upon media or analyst commentary are not for us," Mr. Buffett wrote.

"We want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it's one that follows policies with which they concur."

Defense beats offense. "Though we have lagged the S&P in some years that were positive for the market, we have consistently done better than the S&P in the eleven years during which it delivered negative results. In other words, our defense has been better than our offense, and that's likely to continue."

All timely advice from Mr. Buffett for turbulent times.

The only thing that I'll add here is the simplest way to be a Buffet-like contrarian is to have an asset allocation between stocks and bonds (say, 50%-50%) and to re-balance the mix to that percentage every twelve or eighteen months. This will force you, over time, to sell high and buy low.

To do it any other way is difficult. Because very few mortals -- Mr. Buffet is clearly one of that small band -- have the ability and discipline to fold a hot hand.