Oh somewhere in this favored land the sun is shining bright. The band is playing somewhere, and somewhere hearts are light. And, somewhere men are laughing, and little children shout, but there is no joy in Mudville, mighty Casey has struck out.

There are two basic investment strategy theories. The first is that Free Markets Fail to accurately price stocks, therefore smart people, working diligently, can discover which stocks are mispriced by the market. Thus, they can buy stocks that are undervalued and avoid (or sell short) the stocks that are overvalued. They can also time the market, that is, they can get into the market at the bottom (buy low) and exit at the top (sell high).  The second is Free Markets Work, therefore stock prices established by seven billion investors daily accurately reflect all known information, and only unknown or unknowable information will change the price.  Accordingly there is no superior individual, or group of individuals, who can consistently and predictably identify undervalued stocks to buy, and overvalued stocks to sell short.

Free Markets Fail is what the practice of active management is all about – stock picking, market timing and track record (past performance) investing.  In other words, diligence, hard work, research, and intelligence will pay off in superior investment results. The problem is that while it may be a correct generalization (and as a result is the conventional wisdom), it doesn’t mean that it holds true in the world of investing.

Intelligent people don’t accept a belief as correct simply because it is considered conventional wisdom – an idea that is so ingrained that it often goes unquestioned. Instead, they seek evidence to support the belief. So let’s look at the evidence to see if active investing (Free Markets Fail) is the winning strategy; or is passive investing (Free Markets Work), the buying and holding all of the stocks in each asset class to which the investor seeks exposure, the winning strategy.

The three most common ways that investors engage in active management (Free Markets Fail) strategies are investing in individual stocks on their own, choosing their own professional money managers (i.e., mutual funds and separate account managers) to do that for them, or hiring an investment advisor, a manager of managers, who will, through a careful due diligence process, select the best fund managers for them.

Individual Investors

Brad Barber, professor of finance at the University of California , Davis , and Terrance Odean, associate professor of finance at the University of California , Berkeley , have done a series of studies on the performance of individual investors and concluded that individual investors aren’t as bad at stock picking as many people think. They’re worse! The following is a summary of their findings:

• The stocks individual investors buy  trail  the overall market, and stocks they sell beat the market after the sale. And this result did not even consider the transactions costs or the tax implications of an active trading strategy.

• The more investors traded, the worse the results. The average individual   that traded the most underperformed a market index by over 5 percent annually. On a risk-adjusted basis, the underperformance increases to 10 percent annually. The author’s concluded there was an inverse correlation between confidence and performance – the more confident one is in his/her ability to either identify mispriced securities or time the market, the worse their results.

• Although the stock selections of women do not outperform those of men, women produce higher net returns (by 1.4 percent annually) due to lower turnover (lower trading costs). Also, married men outperform single men. The obvious explanation is that single men do not have the benefit of their spouse’s counsel to temper their own overconfidence.

• Proving that more heads are not better than one, investment clubs trailed a broad market index by almost 4 percent annually.  STRIKE ONE!

Mutual Funds

A study covering a 10-year period found that on an after-tax basis, only 8 percent of all actively managed mutual funds outperformed the S&P.  Further the average over-performance was by just 0.9 percent. The 92 percent that failed underperformed the S&P by 3.1 percent. Thus you had a very slim chance of winning (8%) and even when you won, you tended to win by just the slimmest of margins (+.9%).

Inversely, you had a very high likelihood of losing (92%) and when you lost, your margin of underperformance (-3.1%) was quite large. The risk-adjusted odds against beating the S&P were about 38 to 1. Even Las Vegas gives you better odds than that. But the story is worse than it appears on the surface. The reason is that the data contains survivorship bias – poorly performing funds tend to disappear and thus their data was not included. Similar results were found when the study was extended to almost 20 years.

Unfortunately, the story gets even worse. Investors don’t seem able to even earn the returns of the very funds in which they invest. A study by Morningstar, covering the period 1989-1994, found that while the average no-load growth mutual fund earned over 12 percent  annually, the average investor in those very same funds earned just over 2 percent annually. The result is due to investor behavior. They are not buy-and-hold investors. Instead of owning the same funds for the entire five-year period, the average holding period was less than two years. Investors tended to buy yesterday’s winners (assuming they would be tomorrow’s winners), and therefore buy them at their high price, and sell yesterday’s losers (assuming they will continue to be losers) and sell them at their low price. Not exactly a prescription for investment success.

Mutual funds provided a very slim chance of out performing the market. When we adjust the mutual fund returns to take into account investor behavior (underperforming the very funds they invest in by 10 percent annually), it appears that investors were taking all the risks of stock ownership but earning only a very tiny percentage of the available returns. When presented with this evidence, an often-heard reply is: “Who cares about the average mutual fund? I don’t buy the average fund. I only buy the best of the best.”

One of the most common strategies followed by individuals is to invest in funds with great track records, funds to which Morningstar gives its coveted five-star rating. “The Hulbert Financial Digest” tracked the performance of Morningstar’s five-star funds for the period 1993-2000. For that eight-year period the total (pretax) return on Morningstar’s top-rated U.S. funds averaged +106 percent, compared to a total return of +222 percent for the Wilshire 5000 Index. Hulbert also found that the top-rated funds, while achieving less than 50 percent of the market’s return, carried a relative risk (standard deviation) that was 26 percent greater than that of the market. If the performance had been measured on an after-tax basis, the tax inefficiency of actively managed funds relative to a passive fund would have made the comparison significantly worse.

In another study, Hulbert found that a portfolio from January, 1991 to March, 2002 that was fully invested in Morningstar’s 55 highest rated mutual funds (based on their semi-monthly newsletter), buying when they climb into this elite group and selling when they drop out, trailed the market by 5.9 percent annually, after paying sales charges, redemption fees, and other transaction costs. And finally, for the period 1995-2001, funds rated one star outperformed funds rated five star by 45 percent.


Best of the Best

There are investment advisory firms that are managers of managers. These firms perform searches of historical databases in order to identify the very best performing funds or separate account money managers for each asset class. Through a rigorous due diligence process that includes interviewing the various candidates and eliminating those that fail to pass strict selection criteria, they narrow their choices to the very best managers before making their final selections. The process seems quite logical and is the conventional wisdom on how to beat the market. The question is, does the process deliver superior results?

Why do these firms, with all of their resources, fail? Inevitably, several of the managers hired begin to under perform their benchmarks (market indexes) and they are put on a watch list. Eventually, several get fired and the selection process is repeated. Over time most, or even all, of the original group are replaced. No one seems to give any thought to the notion that if the same process is repeated, you are likely to have the same results – managers that under perform. The reason the process fails to deliver superior performance is that conventional wisdom, past performance is a good predictor of the future performance, is wrong. And thus the process is flawed. STRIKE THREE!


So ….

Many individuals are discouraged by poor investment results, since the foregoing facts demonstrate that investors are unable to consistently and predictably obtain market rates of return. On the contrary, the news is actually very good. In fact, the outcome is precisely what we would expect to see.  Free Markets Work!

Competitive markets are a wonderful invention. All the studies showing that experts struggle to achieve market returns means that the financial markets are functioning properly and prices for public securities are fair, and accordingly represent the best estimate of their current value. The result is that with seven billion investors competing with each other, even the most highly informed experts cannot consistently and predictably take advantage of the uninformed to earn excess profits. It seems that the “wisdom of the crowd” is mightier than the knowledge of the few.

Wall Street wants you to play the game of “active investing”. They know that your odds of success are extremely low. But they need you to play so that they (not you) make the most money. They make money by charging high fees (trading commissions, bid/ask spread, and mutual fund expenses) for active management that consistently delivers poor performance. But you don’t have to engage in active management strategies. Instead, you can simply accept market (not average) rates of return by utilizing passively managed asset class diversified funds with very low expenses and high tax efficiency. By doing so, you are virtually guaranteed to outperform the vast majority of both professional and individual investors.

In other words, you win by not playing their game of trying to outperform the market. This is why active investing is called the loser’s game. It is not that the people playing are losers. And it is not that you cannot win. Instead, it is that the odds of success are so low that it’s imprudent to try.

Yes, active investing can be exciting, or extremely depressing. Wall Street and the media create the hype. Prudent investing is about providing you with the greatest odds of achieving your financial goals with the least amount of risk. That is what differentiates investing from speculating and gambling.

The following words of wisdom from Daniel Kahneman, professor of psychology and public affairs at Princeton University , are a fitting conclusion. “What’s really quite remarkable in the investment world is that people are playing a game which, in some sense, cannot be played. There are so many people out there in the market; the idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it, and full of other people who believe them. This is one of the great mysteries of finance: Why do people believe they can do the impossible? And why do other people believe them?”

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