SOURCE: Disciplined Growth Investors

Disciplined Growth Investors

September 05, 2013 05:00 ET

Disciplined Growth Investors: Index-Hugging and the Quest for Mediocrity

Benjamin Graham and the Power of Growth Stocks: 15th in a Series

MINNEAPOLIS, MN--(Marketwired - Sep 5, 2013) - "Worldly wisdom teaches that it is better for reputations to fail conventionally than succeed unconventionally."
-- John Maynard Keynes

Most portfolio managers on Wall Street would rather mirror the market averages using a conventional strategy than step outside the mainstream to pursue a superior return, according to author Frederick K. Martin of Disciplined Growth Investors.

"Institutions often settle for mediocrity because that's what they think will help them retain clients," writes Martin in his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill).

"Index-hugging," the practice of managing a portfolio in such a way that it closely follows the ups and downs of market, has become common practice on Wall Street -- and with good reason. It helps ensure job security.

"As long as the institution's investment performance is in line with the general market trends," says Martin, "it can justify its performance to its customers -- whether their portfolios are moving up or moving down. If the stock market is down 20 percent and their portfolio is down 20 percent, the institutions can rationalize their own failings by pointing out that their performance is in line with the market average."

But a portfolio manager who steps outside the norm -- even if he or she has beaten the averages over the long-term -- can face the heat from both their clients and their company when their approach results in the occasional and inevitable periods of underperformance inherent in a long-term-oriented approach.

"In this business, if you're going to split from the herd, you had better be right," says Martin, "If you're different and right, you're a hero. If you're different and wrong, you're a loser and a stiff."

The focus on short-term performance emanates from Wall Street, where portfolio managers are graded every three months at the end of each quarter. Results are published and distributed to clients and often posted on financial web sites and in business publications.

If you're one of the lucky ones who outperform your peers, you get a pat on the back. But if you have a quarter when you fall near the bottom of the pack, the outrage can be deafening -- past performance notwithstanding. "Clients will want to know what you're doing, why you're doing it, and why it's not working," says Martin.

This trend is not new to the investment business. Nearly a century ago famed British economist John Maynard Keynes discussed the investment world's propensity for mediocrity: "It is the long term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputations to fail conventionally than succeed unconventionally."

More recently Seth Klarman discussed this overemphasis on short term results in his book, "Margin of Safety: Risk Averse Investing Strategies for the Thoughtful Investor": "Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals. There are a number of reasons for this. Among them are performance pressures, the compensation structure of Wall Street, the frenzied atmosphere of the financial markets. As a result, investors frequently become enmeshed in a short-term performance derby whereby temporary price fluctuations become the dominant focus."

Bucking that short-term mentality can be a challenge for both investment managers and individual investors. The pressure to continually tinker with your portfolio -- at the expense of pursuing a disciplined long-term approach -- comes from forces well beyond Wall Street.

"Spouses can put the pressure on when your investments don't appear to be working out," writes Martin. "And relatives, who are often the source of bad marital advice, can be as bad or worse when it comes to their investment advice. How many fathers have told their children that investing in stocks is gambling? Or that the stock market is rigged against the individual investor?"

That's why it's important to have the courage of your convictions in order to stay true to your long-term strategy -- to resist the short-term mentality of the masses. As Rudyard Kipling wrote, "If you can keep your head when all about you are losing theirs . . . ...yours is the Earth and everything that's in it."

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