Friends,

At Mackey Advisors™ we are always looking for ways to keep our clients educated on what we do and why we do it. I have included this latest piece for your enjoyment.

Thanks,

Andy Pulsfort


Investing Luck vs. Skill

Periodically, we hear about this or that person who called the market top, who predicted a major downturn--or, sometimes, a mutual fund manager who managed to beat the market by some astronomical amount. Last year was no exception: for example, the Encompass Fund was up 122.05% in 2009 according to Morningstar--which, of course, means that its investors would have doubled their money if they'd invested at the start of the year and held on for the next 12 months. The Birmiwal Oasis Fund was up 102.94% last year.

These people are geniuses, right?

Usually not. The simple law of averages says that somebody, somewhere, will have a streak of correct predictions or hold, for a year, maybe two, stocks that dramatically outperform the markets. Certain unsavory people who hung out at race tracks knew how to make money at this game; they would go around the track telling some people that Horse A was going to win the next race, others that Horse B was a shoo-in, and still others to put their money on Horses C, D and E.

Then, if horse D won the race, the unsavory tout would go back to the people for whom he had "correctly" predicted the outcome, and offer to give them more "inside tips" for a generous fee.

To see how the normal patterns of luck can bring about even the most extraordinary results, imagine that instead of managing investment portfolios, we were talking about people who flipped coins in a huge nationwide contest. On Day One of the contest, 300 million people flip their coins, and those whose coin comes up tails are out of the contest. By the law of averages, 150 million (or so) people will be able to play the game on Day Two, and after they flip, the number of contestants will have shrunk to 75 million.

Then come Day Three (37.5 million left), Day Four (18.75 million), Day Five (9.4 million)--and by the end of three weeks, the amateurs have been weeded out, and there are only 144 people left. In newspaper accounts, these are all described as remarkable coin flippers who somehow managed to throw a coin in the air and have it land on heads 21 consecutive times. This is exactly what would be predicted by the law of averages, but now, suddenly, reporters in each city are interviewing their local champion, asking about their "winning techniques." And, of course, the local champions are starting to believe in their own remarkable coin-flipping skills, telling their friends and the press about their wrist movements and the preferred height of the coin toss.

The next day, only 72 of these highly-skilled coin flippers are left, and the following day, just 36, and as the number diminishes, as the number of consecutive flips goes up, the media attention becomes frenzied. Eighteen, then nine, then four finalists are flown to Hollywood for the nationally-televised coin flipping face-off, and all America believes in the skills that allowed these remarkable people to consistently cause a coin to land with the head of the coin facing up.

Finally, two flips later (maybe three), there is a winner--and who can seriously believe that this person managed to get a coin to land on heads 29 or 30 consecutive times without a tremendous amount of coin-flipping skill?

When one or two of the 8,000 mutual funds break dramatically from the pack in any one year, this is no more than what the law of averages would predict. Yet investors flock into these funds, believing in their stellar investment skill. The next time these winning managers confidently flip the coin, it just as likely turns up tails, the performance falls back into the pack, and experts call it "mean reversion," which just means that the luck ran out and the statistics caught up with the process. Investors put their money in too late to catch the first remarkable flip, but just in time to catch the fall, the return to normalcy. It is the oldest trap in the book, and it sucks away millions, perhaps billions, from consumer retirement portfolios.

There ARE excellent fund managers, but you rarely see them break from the pack, and if they do, they will be the first to tell you that there was as much luck as skill involved. Sometimes, a great manager will experience a terrible year, for the same reasons. Investing is a game where you take the luck that is offered you, and inevitably you give something back when the luck runs out. Those investors who are diligent and careful and humble in the face of this reality, who don't chase the hot coin flipper right after a great run, will usually win more often than they lose--because, unlike a casino, the odds in the investment markets have, over most historical periods, tended to favor the patient investor. The markets go up more than they go down, and so you can have more than your share of coin flips going your way with no more skill than the patience to stay invested.

Advisory services offered through Mackey Advisors, LLC, a registered investment advisor.

Welcome to the Blog

Today I thought it might be fun to take one last look at the holiday newsletter. Stay tuned for much more news you can use in 2010.

“Suddenly it's Christmas,
Right after Hallowe'en.
Forget about Thanksgiving;
It's just a buffet in between.
There's lights and tinsel in the windows;
They're stocking up the shelves;
Santa's slaving at the North Pole
In his sweatshop full of elves.” – Loudon Wainwright III

It’s the holidays again everyone. I bet I’m not the only one who was completely unprepared. These days if you don’t have at least a few gifts bought by Halloween you are a slacker. I wouldn’t let that get you down. Everyone is a winner this holiday season. We bid adieu to 2009 on ground that is much more stable then the year past. Companies are spending money, housing sales and prices are up, manufacturing reports are improving, banks are making money, and it’s not such a wallet killer to leave the tree on all day if you wish.

Remember that the most important gift Americans will have given this year is the spirit of goodwill and hard work. It has taken us to a better place with many necessary lessons learned along the way. With an unemployment rate still peaking, chances are you know a household that may need a little holiday cheer this year. Whatever holiday your family or theirs celebrates, do your share to make life easier and smiles brighter. Seriously, how many shirts and sweaters do we all really need anyway?

In last year’s letter my encouragement was if you were buying a gift for someone and out of ideas, you should buy stock. Here is what your $50.00 gift of stock would be worth today if you had:

Dow Jones $61.08 up 22.16%
S&P 500 $63.33 up 26.66%
NASDAQ $70.32 up 40.64%
Emerging Markets $84.00 up 67.99%

Now that is my kind of a holiday gift. I bet not many people have gifts from last year that are worth more today. In a year of little inflation, your gift of stock in an incredibly cheap market would have made someone quite happy. This can work wonders with children and teenagers too. Financial education is missing in today’s curriculum, so whether it’s stock or cash a gift like this could be an exciting way to teach good financial practices.

As a financial news junkie, my favorite piece of news is the Christmas Price Index released each year by The PNC Financial Services Group. I like a company that can have some fun and these guys have been at it for 26 years. This year the cost of giving someone “The Twelve Days of Christmas” grew by only 1.8% to $21,465.56. What a deal! Can you imagine all those birds, rings, ladies, and lords for such a price? Clearly inflation has been working in our favor as we climb back to solid financial footing. If you’ve got time to waste, click here, for loads of Christmassy financial fun!

The year could have been a lot less rosy than it turned out to be. Be thankful this year, and if you aren’t ready for a spending free-for-all, you are not alone. Give a gift that will keep giving and mean something special to someone. Help out a struggling family, donate time to a food shelter, make a contribution to that grandchild’s college fun, and of course, I’m not changing course: give stock. Each year we have the opportunity to make someone happy with a holiday gift, make your gift the one that will always make someone happy.

Something that won’t break, something that won’t shrink, something that will be a part of that special person or cause for years to come. Happy Holidays to you and yours.

by Andy Pulsfort