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The Daily Reckoning | Wednesday, April 21, 2010 Goldman's "whole truth" predicament, How to lose money investing in a winning fund, Plus, Chris Mayer unpacks some age-old market wisdom and more... The "Hows" of Moneymaking Why Goldman is in more trouble than most people seem to think Eric Fry Reporting from Laguna Beach, California... On G+2 (Goldman plus 2), the stock market managed to inch ahead once again. For the second day in a row, most of the non-Goldman part of the stock market produced modest gains...even though Goldman, itself, slipped more than 2%. It was a very strange day for the immensely successful and widely despised financial firm. Before the market opened for trading, Goldman reported a dazzling earnings result for the first quarter - the second best quarterly result in the firm's 141-year history. And Goldman generated this result in classic Goldman fashion - a smattering of profits from traditional business lines like investment banking, along with a mountain of profits from proprietary trading. But investors did not cheer the earnings result; they were still too busy booing Goldman's fraudulent conduct...and the grim consequences that might ensue. The various investigations and lawsuits that Goldman will soon endure is bad news. The possibility that disgruntled clients might jump ship is worse. How, for example, could Goldman possibly produce its proprietary trading profits if there were no stooges around to take the other side of its trades? Goldman needs those stooges...er, clients...to grease the wheels of its profit machine. Goldman's top brass insists the firm has done no wrong. But many are the critics who insist the firm has done little right...for its clients, that is. This firm knows all about making money. No one doubts that. But the "hows" of that moneymaking are becoming a topic of national interest...and disgust. One faithful Daily Reckoning reader, who also happens to be a former attorney, provided the following insight: Goldman Sachs is in a lot of trouble. It is in far more trouble than most financial commentators seem to realize, for reasons that are deeply embedded in the American system of justice. Since Colonial times, American courts have required witnesses to take a specific oath. This oath has become a part of American folklore. From Perry Mason to Boston Legal, every witness who takes the stand must swear, "to tell the truth, the whole truth and nothing but the truth." It is the "whole truth" portion of this oath that puts Goldman in such trouble. The law recognizes that you can deceive people without ever saying anything false, just by omitting critical truths. A real estate ad that said, "This home is in a beautiful neighborhood, is immaculately designed and was at one time owned by a famous celebrity," might be 100% truthful. But it would also be 100% deceptive if the sales agent failed to mention the additional truth that "the walls are insulated with asbestos." Omitting important truths is a crime...especially in the financial industry. This concept is literally written into the definition of securities fraud. The most important expression of that definition is SEC Rule 10b-5 : Employment of Manipulative and Deceptive Practices. This rule states that in connection with the selling of securities, it is unlawful for anyone to "make any untrue statement of material fact, or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." In other words, you can't just tell someone the truth about the portfolio of collateralized mortgage obligations you are trying to sell, you have to tell them the whole truth. And this is why Goldman Sachs is in such deep trouble. When Goldman was attempting to sell the portfolio of mortgage obligations to various parties, it never told them: "We want you to know that we built this portfolio for a hedge fund manager who wants to short the collateralized mortgage market because he believes it is overpriced and may collapse. He could be wrong, of course, but he can't take a short position unless someone else buys the actual securities we have created. Would you like to buy those securities?" Call me naïve, but I expect that most ordinary Americans, which is to say, people who sit on juries, when they hear that testimony will be thinking to themselves, "Wow! I'm not sure I would have bought those securities if I had known the whole story." Goldman is in deep trouble if it has to tell its story in a courtroom, where every single employee-witness will have to tell the whole truth - perhaps for the first time. Here's our question: If Goldman Sachs is truly in trouble, isn't the stock market in even deeper trouble? Goldman is the largest player in the US stock market, and one of the most influential players in every other major financial market. Therefore, a discredited and enfeebled Goldman Sachs is probably not a bullish event for share prices. The Daily Reckoning Presents We Are Our Own Worst Enemy Chris Mayer Ken Heebner's CGM Focus Fund was the best US stock fund of the past decade. It rose 18% a year, beating its nearest rival by more than three percentage points. Yet according to research by Morningstar, the typical investor in the fund lost 11% annually! How can that happen? It happened because investors tended to take money out after a bad stretch and put it back in after a strong run. They sold low and bought high. Stories like this blow me away. Incredibly, these investors owned the best fund you could own over the last 10 years - and still managed to lose money. Psychologically, it's hard to do the right thing in investing, which often requires you to buy what has not done well of late so that you will do well in the future. We're hard-wired to do the opposite. I recently read James Montier's Value Investing: Tools and Techniques for Intelligent Investment. It's a meaty book that compiles a lot of research. Much of it shows how we are our own worst enemy. One of my favorite chapters is called "Confused Contrarians and Dark Days for Deep Value." Put simply, the main idea is that you can't expect to outperform as an investor all the time. In fact, the best investors often underperform over short periods of time. Montier cites research by the Brandes Institute that shows how, in any three-year period, the best investors find themselves among the worst performers about 40% of the time! It seems strange. Great chefs don't cook bad meals, but the best investors routinely make a hash of things. Shocking as it may seem at first, it makes sense in the context of markets. "If everyone else is dashing around trying to guess next quarter's earnings numbers," Montier writes, "and you are exploiting a long-term time frame, then you may well find yourself staring at the wrong end of a bout of underperformance." The point being you can't worry too much about short-term performance. Investing is a game won by determined turtles, not hares. That means you have to stick with solid ideas, instead of trying to catch what the hottest thing is. Another chapter I like is "Keep It Simple, Stupid." It illustrates another key point about the nature of investing: It pays to focus on a handful of essential details and ignore the rest. Montier shows us experiments in which people made worse decisions when given more information. For example, in one instance, researchers asked people to choose the best of four cars given only four pieces of information on each car. (In the examples, one car is noticeably and objectively better than the others.) People picked the best car 75% of the time. When given 12 pieces of information, their accuracy dropped to only 25%. The added information was more than just extraneous; it made their choices worse. In the context of investing in stocks, it's better to focus in on key variables that clearly matter and ignore the rest. My investment process aims to do that by boiling down the many details of investing in a company into four major areas. Too many details spoil the broth, but most investors haven't learned this. "Our industry is obsessed with the minutia of detail," Montier writes. I certainly would agree. I read quite a bit of investment research in any given year and I am always amused at the detailed modeling (and forecasting) that goes on. If an idea depends on such finely tuned analysis, then odds are it is not such a great deal. Throughout the book, Montier reveals and validates many ideas essential to smart investing. He also quotes liberally from scores of investing luminaries from Benjamin Graham to Sir John Templeton. There is a lot of wisdom here. Though repetitive at times, digesting these ideas is like eating your vegetables. They keep your portfolio healthy. Chris Mayer for The Daily Reckoning Joel's Note: Somewhat of a part time economics historian himself, Chris Mayer employs the kind of tried and true lessons from the investment giants of yore to inform the careful, methodical research he delivers members of his Mayer's Special Situation service. If you're a fan of the whizz-bang quants promoted during the bubble era, this service probably wont interest you. If you're more a fan of the kind of due diligence that led Messrs Graham and Templeton to their successes, you might like to check out what Chris' service offer can offer you.