Beating the Odds?

PAUL SOLMAN: It was big financial news.

PAUL KANGAS: (Nightly Business Report) Fidelity closes its flagship mutual fund to new investors.

PAUL SOLMAN: As of September 30th, the Magellan Fund is shut to those not already in it. Fidelity, the mutual fund giant, manages more than $1/2 trillion. You buy shares in any of its 246 mutual funds. They then buy shares in lots of companies. The Magellan Fund was launched in the 1960's to explore the world looking for good firms to invest in, hence the name Magellan. In 1977, a 30-year-old named Peter Lynch took over and began betting on U.S. firms, often those whose wares he could sample: KFC, Dunkin Donuts, the list goes on. Enough of these bets paid off so that money invested with Magellan grew much faster than the rapidly rising stock market as a whole.

ANNOUNCER: There is an eye that doesn't rest--

PAUL SOLMAN: By 1987 Fidelity was touting Magellan on TV. It was the company's most widely held mutual fund.

ANNOUNCER: Over 600,000 of your neighbors put their trust in Fidelity Magellan and prospered with the decade's top performing equity fund.

PAUL SOLMAN: The fund that Peter Lynch built now has some 4 million accounts. As Magellan has grown so has the industry. Today some $4 trillion are invested in mutual funds, which appeal to people because they've made investing more convenient and by spreading your money over more companies, less risky. But when Magellan and others began to consistently beat the market, performance became the name of the game, Magellan's modest manager a superstar.

LOUIS RUKEYSER: (Wall Street Week) Peter, what did you do that the other fellows didn't do?

PETER LYNCH, Vice President, Fidelity Management & Research Co.: (1982) Well, I'm not sure what the other people were doing, but what I've tried to do is I've worked as hard as I could. I've visited over 200 companies every year.

PAUL SOLMAN: Peter Lynch became a guru, writing how-to books like One Up On Wall Street in 1989, which helped inspire the public to get rich quick by beating the market. Now, you may be as surprised as we were when we first learned that chasing the hottest mutual funds is basically an exercise in futility, so says the economics profession, and so it has said for decades. To most economists the things that you're liable to read in Lynch's bible, they ain't necessarily so. Sixteen years before Lynch's bestseller Princeton's Burton Malkiel had warned in his own good book, A Random Walk Down Wall Street, that just about all the investment industry's claims should be taken with a shaker of salt. The professor's first sobering fact: that the highly paid pros do not as a group beat the market at all.

BURTON MALKIEL, Princeton University: Mutual funds have generally under-performed the market as defined by one of the broad market indices, such as the Standard & Poor's 500. And they have under-performed the market over the past five years, ten years, twenty-five years, and over any period you would like to measure.

PAUL SOLMAN: Now, this flies in the face of almost everything we're bombarded with about mutual funds and their dazzling returns. Yes, most funds have risen a lot in recent years, and, thus, delivered seemingly super performance, but, say economists, if instead you'd invested in a so-called "index" fund like the S&P 500, which simply buys shares in the 500 biggest companies in proportion to their size, your investment would have performed even better. And pretty much everyone in the know knows this, says Jason Zweig, who covers the mutual fund industry for Money Magazine.

JASON ZWEIG, Money Magazine: It's not a secret among people in the money management business. I find when I interview fund managers that they're all willing to accept the proposition that over time most fund managers will under-perform the average by the amount of the expenses they charge, but they all generally believe that they won't be among those people.

PAUL SOLMAN: As Zweig suggests, the reason for this failure to beat the market is expenses, attracting investors, servicing them, doing research on companies, buying and selling stocks and paying commissions. Add it all up and you can see why the average fund manager does almost 2 percent a worse than the market as a whole, which over the lifetime of a pension account can cost you hundreds of thousands of dollars. But what about Magellan? Counting all its expenses it beat the market, remember, year after year with Peter Lynch at the helm. The economist's response:

BURTON MALKIEL: Now, Peter was a very smart guy, and the smartest thing I think he did was he knew when it was time to quit.

PAUL SOLMAN: That is, says Malkiel, Lynch quit while he was ahead, resigning from Magellan with a stellar record. As to how he achieved that record, well, says Professor Malkiel, given the thousands of money pros out there picking stocks, a few would have to come up big winners by the laws of probability alone.

BURTON MALKIEL: Suppose you've got a thousand people in the room flipping coins, seeing whether if they flip them 10 times there was any chance they could get 10 heads in a row. Now, in fact, if the coins are fair, the chances of getting 10 heads in a row is minuscule. It's almost zero. But if there are a thousand people in the room, there will be one or two who flip ten heads in a row. And, indeed, the number of people who have out-performed like Peter Lynch are no more than you would expect by chance.

PAUL SOLMAN: Now, Peter Lynch may have been more than just lucky, an inevitable product of statistics. There's plenty of evidence he was very smart and very skilled. But to most economists it really doesn't matter. And here comes their second critique of beating the market; that it's almost impossible to find a Peter Lynch before he racks up the great record no matter how he does it.

This reminded us of yet another book. In Where's Waldo? this goofy guy right here is hidden somewhere in each crowd scene, and your job is to identify him. You believe he's there, just like the book says, but he's mighty tough to distinguish from everyone else. It's even tougher if you're searching for the next Peter Lynch. Most money managers look alike, were trained alike, thus, the Waldos or Lynches among them who will out-perform the others are almost impossible to find beforehand. I pressed the point with Professor Malkiel.

PAUL SOLMAN: If I had latched onto Peter Lynch early, I would be wealthier than I am now and proud as a peacock.

BURTON MALKIEL: Absolutely. If you had known in advance that he would be the top performing manager, you would have been better off. There will, undoubtedly, be someone who's starting to manage a portfolio now out of the thousands of equity mutual funds who will beat the market and beat the market by a substantial amount. But you don't know who it is, and I don't know who it is.

PAUL SOLMAN: Now, if it's tough to pick the right manager, it's tougher still to pick the right fund, since managers come and go. Even at Magellan you were betting on four different stock pickers in the 1990's alone. But, according to Peter Lynch, they still beat the market.

PETER LYNCH: I mean, the Magellan Fund has beat the market. I stopped running Magellan a little over seven years ago. If you put $10,000 in the day I left, you'd have $31,000 today. I mean, it's more than tripled. It's beaten the market and it's beaten the average fund.

PAUL SOLMAN: Indeed, Magellan did beat the market in the past decade but only by the thinnest of hairs: Under Morris Smith, the subject of such close scrutiny that he quit within two years and moved abroad; Jeffrey Vinik, who made a few highly publicized bad bets; and now Bob Stansky, Magellan is up a bracing 253 percent in the decade, including sales fees. But the market as a whole, as measured by the S&P 500, is also up, 251 percent. Now, this is still a great record, considering the average fund under-performs by that 2 percent a year.

But given Magellan's huge growth--the $60 billion--critics say it now has to buy shares in more and more companies, so it's tougher and tougher to make unusual bets and beat the market as a whole. That may be one reason, say critics, that Magellan has closed itself to new investors. This is where Jason Zweig works. Money loves to tout the hottest, best performing funds, which in turn advertise loud and long in its pages. But Zweig sounds a last note of caution. When we investors try to beat the market, we tend to buy into funds when they're hot, sell when they cool off. We know the first rule of investing: Buy low, sell high. But, says Zweig, we actually do the opposite.

JASON ZWEIG, Money Magazine: People are consistently buying high, selling low, locking in losses in a fund that is making money. The fund makes money from the beginning of the calendar year till the end, but if people aren't in it consistently for the whole period, they can easily lose money. And in 1996 we found several funds that earned over 20 percent a year, in theory, but whose typical customer actually lost more than 20 percent of his or her money in the fund.

PAUL SOLMAN: Because--

JASON ZWEIG: Because they didn't buy and hold; they traded. They got in and they got out too fast. They got out at the bottom, and they locked in the loss in a money-making fund.

PAUL SOLMAN: You mean, so when the fund started going down, they started selling their share of the fund.

JASON ZWEIG: Panicked. They panicked.

PAUL SOLMAN: Given his magazine's obsession with hot stocks, Zweig seemed almost embarrassed to offer his only real advice.

JASON ZWEIG: Certainly, everything you need to know about investing in mutual funds you could put on the head of a pin and have quite a few millimeters left over. Basic truths are control your expenses, pay attention to your taxes, keep your portfolio turnover low, and stay put. In fact, you can actually boil it all down to one rule, which is minimize your costs and maximize your patience, simply buy and hold and do nothing. You'll beat 99 percent of all of the investors in the country, professional and retail.

PAUL SOLMAN: So, in our collective zeal to get better than average returns we tend to ignore what economists have long known, that it's almost impossible to pick winners before they win; that funds as a whole under-perform; that many investors are in and out at precisely the wrong times. Remember then that trying to beat the market, even through mutual funds, is something of a gamble. But, of course, a lot of people like to gamble, including, as it happens, Burton Malkiel, who frequents Las Vegas and plays an occasional hunch on Wall Street, even though most of his money is in index funds.

BURTON MALKIEL: I certainly would respect anyone who would want to take some part of their money and basically gamble because it's fun to do, and we all have a little bit of hope springs eternal. It's hard to tell people that Santa Claus really doesn't exist.

PAUL SOLMAN: And it's hard to tell people that when it comes to beating the market, there's no such thing as a sure thing.