“Can’t you see what is happening? Potter isn’t selling, Potter is buying and all because we are panicking and he isn’t.” – George Bailey (Jimmy Stewart), It’s a Wonderful Life.

This is one of my favorite quotes from one of my favorite Christmas movies. George Bailey and his new bride are on the way out of town for their honeymoon when they see a run on the bank. They give up their honeymoon budget to save the Bailey Building and Loan during the depression.

Fear and Greed: these are the emotions of the marketplace. Fear gripped the nation during the Great Depression and the runs on the bank that were illustrated in the classic film were commonplace. Franklin D. Roosevelt, in his first inaugural address on March 4, 1933, uttered these famous words, “So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning unjustified terror which paralyzes needed efforts to convert retreat into advance.” I would guess that most of you recognize that quote. I would also guess that most of you did not know that this was given in a speech in 1933, long before the onset of World War II, and FDR was not talking about facing Nazis or the Japanese. Later in the same speech he goes on to say, “In such a spirit on my part and on yours, we face our common difficulties. They concern, thank God, only material things.”

FDR was talking about economic fear. He was talking about the kind of fear we see today on Wall Street. Irrational, short-sighted fear. There is of course a difference between now and then. Now, we are just a few short months from all-time record highs on Wall Street, then we were suffering through the worst bear market of all time. Now we have 5% unemployment which is incredibly low on historic basis, then unemployment was rampant. Now we have had just a few mortgage companies go out of business, then more than 4000 banks went under in the first two months of 1933 alone. In other words, they actually had cause for fear; we do not.

The problem with fear and its evil twin greed for that matter is that it is almost always short-sighted. Wall Street has always suffered from this disease, but in recent years it has gotten much worse. The CFA Institute has even given it a name, Short-Termism. Short-termism results in the permanent destruction of wealth, or at least the permanent transfer of wealth. This was the conclusion drawn by Jack Gray, investment strategist at the firm of Grantham, Mayo, Van Otterloo and Company in Sydney, Australia. Gray presented his findings at the CFA Institute’s 2006 annual conference.

Gray points out that from 1945 to 2005 the average turnover of US equity mutual funds has gone from just over 20% to over 100%. In 2005 the average mutual fund held a stock for no more than 9 months. The results speak for themselves. Jack Bogle, founder of Vanguard, points out in his research that from 1983 to 2003 the average mutual fund had an average annual return of 10%, while the S&P 500 had an average annual return of 13%. The actual investor did even worse, with a 6% return according to Bogle. Not only are the mutual fund managers short-term focused with 9 month holding periods, but the mutual fund investor was also short-term focused holding their investment for only 2 years. Let me put this in perspective for you. If you invested $100,000 in a tax free account in 1983 and got the 13% return from the S&P 500, in 2003 you would have accumulated $1,152,309. If you got the 10% return from an average mutual fund you would have accumulated $672,750, and the 6% return of the average investor would net only $320,714. Those differences in percentage returns may not seem that great, but the difference in resulting wealth is huge.

Much of that wealth destruction can be blamed on shorttermism. Gray conducted a poll to determine who was responsible for short-termism and 89% of respondents selected the media. Mutual fund managers know they can get on the cover of Money magazine, or one of the other financial tabloids, only if they post huge short-term returns. You as an investor may have a time horizon of 10, 20 or even 30 years but no one in the financial system shares that view. Starting with government regulators, who are either political appointees whose time may be short, or are young attorneys padding the resume to make the big move to a Wall Street firm. Their time horizon may be 3 years if you are lucky. Investment managers are judged monthly by their institutional clients. The media may have a time horizon as short as hourly. The good people at CNBC want to know what is going to happen in the next 15 minutes. Finally, traders and hedge fund managers have the shortest time horizons of all. The system is heavily biased towards the short-term which causes what Gray refers to as a substantial principal-agency horizon misfit.

This leads us to the newly popular momentum investing fad, which is the quintessential form of short-termism. Momentum investors buy what has gone up and sell what has gone down. Momentum investing can be a self-fulfilling process as prices go up or down not because they should but because momentum carries them in that direction. This private gain comes at a public loss as the market ceases to be a mechanism to allocate capital efficiently in order to maximize total economic output, and becomes instead a ponzi scheme leading to bubble after bubble.

I have often been asked how it is that Warren Buffett is able to do what he does, and my answer is simple. He never has to answer to clients or the media. He has the benefit of being able to think long-term. Long-termism has three distinct advantages to short-termism. First, there is better predictability. It is nearly impossible to accurately predict what the market will do next week or next month. However, in the long-run the market tends to get valuations right, therefore assets that are over-valued currently will tend to go down while assets that are under-valued currently will tend to go up. In fact Bill Miller of Legg Mason has suggested that the current short-termism epidemic has actually caused what he referred to as a “long-term arbitrage opportunity.” For investors who are brave enough to move against the grain, great long-term gains can be earned. However, the pull of short-termism is great. In late October, I was asked by a friend what we thought of the current market conditions and where we saw opportunities. I told him that we saw great opportunities in banks that have been overly beaten down by Wall Street short-termers. I saw my friend again over Christmas, and he told me that our bank idea had not turned out that well. I had to laugh. It had been less than two months, we won’t know how it “turns out” for several years. We are investing here, not speculating.

Long-termism also leads to lower cost because of lower turnover, and lower risk of real investment losses. As we discussed last quarter, long-term investors are owners who are less concerned about price fluctuations than they are about the fundamental health of the companies they own.

There is a scene later on in It’s a Wonderful Life when Potter offers George Bailey a job. Potter, singing George’s praises, remembers the depression and says that George and he were the only two who didn’t panic. “You saved the Building and Loan, and I saved the rest.” George responds, “…most say you stole the rest.” Potter retorts, “The jealous ones say that…” In our current environment gripped with fear of the short-term most will panic but we will not. A few years from now when we look at the gains we have achieved from this point, some may suggest that we stole them, but those will be the jealous people who didn’t have the courage it takes to think past this current crisis.

CHUCK OSBORNE, CFA, Managing Director