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By Noah Solomon
Special to the Financial Independence Hub
In 1985, Philip Tetlock, a Professor at the Wharton School of Business, set out to ascertain how accurate expert forecasters are in their predictions of future events.
Tetlock’s study covered many areas, including economics, politics, financial markets, climate, military strategy, etc. His analysis spanned nearly 20 years, during which he interviewed 284 experts and obtained roughly 82,000 forecasts.
Tetlock’s expansive research led him to conclude that:
- Expert forecasts were less accurate than random guesses.
- Aggregate (average) forecasts were superior to individual forecasts but were still inferior to random guesses.
- Experts who made the most media appearances were the least accurate.
In short, you would have been better off throwing darts while blindfolded than following the advice of experts.
But Investment Professionals Are the Exception – NOT!
Successful wealth management is predicated on both security selection and asset allocation. In order to achieve long-term results that are better than those that could be obtained by flipping a coin, investors must be able to:
- Select outperforming stocks/sectors, and/or
- Identify outperforming asset classes (whether stocks will outperform bonds, which countries will outperform, etc.).
Unfortunately, there is ample evidence that demonstrates hese two skills are in extremely short supply, leaving most clients holding the proverbial bag of underperformance.
Stock Picking: A Zero-Sum Game
Nobel Prize winning economist Eugene Fama is widely heralded as “the father of modern finance.” According to Fama:
“Active management in aggregate is a zero-sum game. Good active managers can win only at the expense of bad active managers. Any time an active manager makes money by overweighting a stock, he wins because other active managers react by underweighting a stock. The two sides always net out – before the costs of active management. After costs, active management is a negative-sum game by the amount of costs borne by investors.
After costs, only the top 3% of managers produce a return that indicates they have sufficient skill to just cover their costs, which means that going forward, even the top performers are expected to be only as good as a low-cost passive index fund. The other 97% can be expected to do worse. It is a matter of arithmetic that investors who go with active management must on average lose by the amount of fees and expenses incurred.”
Time: Active Management’s Nemesis
Both Standard & Poors’ Index vs. Active (SPIVA) scorecards and Vanguard’s Case for Indexing reports have repeatedly demonstrated that while some managers do outperform, it typically is not by much and not for long. The following table strongly suggests that the longer a portfolio of actively managed funds is held, the greater chance it has of underperforming one comprised of index funds.
What about Risk?
A common defense offered by active managers is that their superior risk management/lower volatility more than makes up for their inability to outperform their benchmarks. However, as the table below shows, this claim is not supported by the evidence. In comparison with their index fund counterparts, actively managed portfolios have on average performed just as poorly on a risk-adjusted basis as they have on a raw return basis.
To be clear, we do not believe that active funds cannot beat their benchmarks because the evidence shows that some can. There have been and always will be those that can add value. However, even the most astute investors cannot predict which funds will outperform and over what period, making the exercise of predicting winning managers somewhat of a fool’s errand. In other words, it is possible to outperform by selecting winning managers, it’s just not probable.
What about all those Smart People? Benjamin Graham spawned a Tribe of Cannibals
Benjamin Graham is the architect of modern security analysis, which uses fundamental data (income statement and balance sheet items) to determine the fair value of stock prices. Graham’s approach was way ahead of its time and remained largely undiscovered for several decades. This enabled him to achieve an annualized return of roughly 20% from 1936 to 1956, as compared to 12.2% for the overall market. Warren Buffett describes Graham’s The Intelligent Investor (1949) as “the best book about investing ever written.”
Today, there is no shortage of adherents to Graham’s approach. The current active management universe is both inundated with and driven by Graham-style security analysis. Stocks are constantly and continuously scrutinized by armies of security analysts, armed with reams of widely available fundamental data.
It’s hard enough to outperform in an area heavily populated by “smart money.” It’s even harder to outperform when you are trying to make money the same way as all those smart people! Graham’s approach has become a victim of its own success, whereby its followers are literally eating each other’s lunch to the point where most of them fail to add value. All the smart people are doing the same smart things, which causes their results to look not so smart. In the end, Adam Smith hath vanquished Benjamin Graham!
No Reprieve from Asset Allocation
What about asset allocation? Maybe investment professionals who cannot select outperforming stocks can add value by identifying when stocks will out/underperform bonds, which countries/regions will outperform, etc. As is the case with stock-picking, investment professionals have struggled with asset allocation. Continue Reading…
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