43. Year of the Yo-Yo

An interesting article in the New Yorker last week discusses the financial performance of 2011. I agreed with some of James Surowiecki's points, but I think he's missing a couple of important observations. First, the writer makes the correct assertion that 2011, a year with wild swings, ended up where it started, more or less: the S&P 500 down 0.03%. Per Surowiecki, this tepid performance will send many investors with long-term horizons looking somewhere else to park their money: what's the point of investing in a market that, after making your fortunes climb and fall like a republican primary candidate, ends up more or less at the same point? A market with high-volatility is good for nothing except heart burn.

Well, not exactly. Even a market that does 0% over the long run can be a source for profits, exactly because of the volatility. True, if you invest $100 in 2001, and 10 years later you sell them after the S&P 500 did exactly 0%, you'll get 0% appreciation of your money. But passive index investing is not just about invest-and-forget. An important part of it is about rebalancing: a smart investor, either through consistent, periodical investments ($10 a year over 10 years instead a lump sum of $100) or through annual rebalancing, can rip benefits even in a volatile market. In fact, the more volatile  the market is, the bigger your benefit is. Volatility is the investor's best friend, as long as you believe in a positive long-term trend and have the stomach and discipline to keep your plan. The writer says that "while crazy volatility may be great for traders (who live for the chance to make two per cent a day), it’s lousy for the rest of us." It doesn't have to be.

However, volatility is not everyone's friend. I have to admit I gleefully read Surowiecki's description of hedge-fund woes:

You might think that volatility would allow people with superior information and market sense to get ahead. But last year money managers did a very poor job of playing the market. According to estimates made by Goldman Sachs, as of the last week in December 72% of core large-cap mutual funds had underperformed their market indexes. The average stock-market mutual fund was down almost three per cent for the year. And hedge-fund managers, who are supposed to thrive on volatility, did even worse, with hedge funds that focus on stocks falling more than 7%. Strikingly, some of the biggest flops came from superstars: Bruce Berkowitz, whom Morningstar named one of the money managers of the past decade, saw his flagship fund fall more than 30%; the hedge-fund manager John Paulson, whose bet against mortgage-backed securities a few years ago has been called “the greatest trade ever,” saw one of his funds drop nearly 50%.

So much for these geniuses. -50% in one year! Makes you happy about your -.03% return, doesn't it?

Is it time we stopped believing that the lucky hedge-fund/mutual fund manager from last year has some divine knowledge, and if we just trust him with our money (and 5% annual fees) we can get a few crumbs from his multi-billion table?

As my friend Danny says, people often try to hang out with the wealthy, hoping that some money from the rich will rub off on them. Why they don't realize is that it's the other way round: these financiers became rich by rubbing other people's money off on them. But far from Surowiecki's advice, "the only way to win the game is simply not to play", I believe that you can play it smart and simple, and win this game. Good luck!