Child's Play'Follow the Leader' should have nothing to do with your investments.
We all remember (perhaps not fondly) playing "Follow the Leader" when we were children. I distinctly recall looking — and feeling — a little foolish as I flapped my arms and made other random gestures while trying to follow the "leader" — another child we all had to mimic. Invariably, unable (unwilling?) to conform, I was soon out of the game. But all the other kids loved the game, and most of them vied to be the next leader.
It's a game for children, for sure. But perhaps its popularity explains why so many adults continue to play it today — not with other kids, but with their investments. They look to certain investment managers — people the media have anointed as leaders — and then invest in whatever that "leader" is pitching, mimicking his or her moves.
While the game might have been fun for children, it's not fun for adults. Don't play it — or you might suffer far more serious consequences than looking a bit silly. Bill Gross and Bill Miller serve as two recent examples that illustrate the dangers of "following the leader."
- Bill Gross for years has been manager of the Pimco Total Return Fund, the world's largest bond mutual fund. Last year was the fund's worst since at least 1995, the earliest year for which Bloomberg has rankings for the fund. It was among the bottom 30% of all funds in 2011, Bloomberg reported.
- Bill Miller was famous for beating the S&P 500 Stock Index every year for 15 consecutive years through 2005, as manager of Legg Mason Value Trust — an unprecedented record. But in the past six years, Miller has beaten the index only once, generating results that have been so bad that the fund now has only $2.6 billion in assets, down from $20 billion in 2006, and Legg Mason has replaced him with a different manager.
What happened to these "leaders"? Well, Gross stumbled when he made a big bet in the beginning of 2011: He expected that inflation would rise, forcing the Federal Reserve to increase interest rates. That, in turn, would cause bonds to lose money. So Gross dumped his bond holdings.
Turns out that this was precisely the wrong move at precisely the wrong time. Instead of rising, interest rates fell. And worries about Greece sent investors scurrying to the safety of U.S. Treasuries. The result: Instead of falling in value, Treasuries soared, becoming last year's best-performing asset class, with a 9.8% gain — the highest return for bonds since 2008, according to Bank of America Merrill Lynch Indexes. Gross missed the rally entirely — and so did the people who owned shares of his fund. Small wonder that his fund suffered $5 billion in client redemptions last year — its first year of net withdrawals since 1993, according to Morningstar.
Bill Miller fared no better last year. He's known for taking big bets (successes include early gambles on Dell Computer and America Online), and Morningstar named him fund manager of the decade for his performance in the 1990s. But more recently, Miller's bets failed; Bloomberg cited the example of Eastman Kodak, which Miller started buying in 2000. By 2005, his fund owned 25% of the company. He sold the shares last year for a $551 million loss.
Did luck play a role in Gross' and Miller's many successes (and failures)? Bradford Cornell, a professor at California Institute of Technology, says it did. "Most of the annual variation in (fund) performance is due to luck, not skill," he says. "Annual rankings of fund performance provide almost no information regarding management skill," he noted in his 2008 analysis of more than 1,000 equity mutual funds.
We don't believe you should follow "leaders" who make a living by betting your money on their hunches. It's your family that suffers the consequences if they are wrong — but they get paid no matter which way the bet goes.
So instead of big bets, we recommend that you make lots of little ones. Sure, own bonds. But instead of picking a bond fund merely because it is managed by a famous person, choose one that gives you access to the entire marketplace of bonds. Likewise, don't invest in stocks that are selected by one person. Instead, own a basket of as many stocks as you can buy. You don't have to follow the leader. Instead, use broad diversification to help lower your risks — and help you avoid making the wrong bet at the wrong time.
"Follow the Leader" is a game for children. Let's leave it to them.