Finding Peter Lynch

Both Jonathan Clements and Hersh Shefrin say it’s tough looking for the next Lynch. Clement said it in 1990 in an article in Wall Street Journal, while Hersh says it loud in his book on behavioral finance. They are both true, finding a 13-year stellar growth record with the underlying fund growing from $ 20 million to $ 13 billion is a textbook case study, rare.

Though they both say the same thing Clement is pointing to a high skill, but Shefrin on the other hand says it was also luck and not the simple investing approach which Lynch followed. There is another aspect that they disagree on, past performance. The ex-Wall Street Journal columnist does not discredit past performance as an indicator of future performance but the behavior guru says past performance is difficult to evaluate.

The subject of the past is widely debated between people who live ”there” and believe in it to drive the future, and people who say the past is meaningless, the future is always different. The non-believers forget that life is ruled by law and not by accident and action and reaction are part of life’s mystery or misery. If the past is such an important driver for the evolution of a society, how can the past lag behind? Future builds on the past and so does performance, positive or negative. The famous quote of Jean Baptiste Alphonse Karr “The more things change, the more things remain the same” summarizes how we cannot break away from the two ends of time. So if we keep revisiting the past, how can the future be so different from the past and how can past stellar performance not be delivered again. If randomness was the future, why do options traders keep waiting for the black swan from 1987?

Cyclicality is another thing that behavioralists miss. Teaching masses how emotionally flawed they are is one thing and telling them how economic cycles change and force us to adapt is another thing. We as a group of humans can learn how error-prone we are but we still need to understand how changing asset cycles force us to change our thinking. Emotional maturity is just a step in the right direction.

There is a host of literature written about understanding and identifying a professional. The process becomes tricky when prices are falling and belief levels are less in institutions and professionals who run them. Just like individuals, the majority of professionals tend to be overconfident about their skills. The institutionalization of the professionals intensifies the incompetency further. Hersh illustrates the ‘games’ institutions play to mask failure. Merging loss-making funds can have multiple aims like showing the winners, masking the risk and failure.

Benchmarking an industry-wide practice is more of a performance masking than a performance illustrating the technique. Michael Jensen (1968) who studied performance from 1945-1964 found that past year winners don’t repeat. He said that a fund could only be expected to return more than the market if it held a portfolio that featured more systematic risk than the market. What Jensen did was to take the raw return to a fund and subtract out a portion that reflected the compensation for taking the risk. He called this residual “alpha” and it is called “Jensen’s alpha”. In effect, Jensen found that all mutual fund alphas were indistinguishable from zero. This is one reason, why the skyline has very few positive return histograms standing if you compare funds locally or globally. The majority of them fall and rise together. Grinblatt, Titman, and Rauss Wermers (1995) find that about 77 percent of mutual funds use momentum strategies, meaning that they purchase stocks that have recently gone up. There is a clear herding behavior concerning stocks that have recently gone up. They move in to buy past winners at the same time but don’t herd when it comes to selling past losers.

The past performance indicator for future success is not the fair coin flip catch up, but fading rationality as overconfidence enters. It’s tough to stand alone with a performance less than the benchmark. It’s tough to resist a big city glitter for a small city bland shine. It’s tough to be conservative when risk-taking is the norm. It’s tough to stand against peer group pressure. We have lived with peer group pressure from the day we were born, competing with siblings, competing at school. It’s is this which makes us herd and not stand alone as a fund manager or investor happy with single-digit portfolio returns in a double-digit market or be a fund manager more focused on risk control than on return increase. The time ahead will change this, as a new genre of individuals emerges, new professionals, creating new institutions.

The human mind may be full of biases, but it has amazing willpower and determination to stand alone, sometimes foolishly. Daniel Kahneman’s famous words regarding the great mystery of finance ” Why do people believe they can do the impossible? And why do other people believe them?” is more about how we are constructed to dream the impossible, dreaming to become Peter Lynch and not just finding him.

We don’t think the Lynch record is unassailable, human brightness is limitless, a double-edged sword, determination to succeed versus spending time hiding evidence and failure. This reminds me of a Bill Naughton short story I read in school titled ?seventeen oranges’. Clem Jones’s (the delivery boy at docks) love for oranges puts him in trouble when Pongo the policeman decides to punish him. There was no escape, locked in the hut, and with the oranges on the table, Clem had to think of a fast solution before Pongo brought a witness. The inner voice ’Oh, my god! What can I do? Eat the oranges. Eat the evidence. No time to eat, you have to swallow the pips too.’