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Investment Myths and Realities – New Perceptions for a New Year
As an active individual investor for over a decade, I’ve become accustomed to treating much of the conventional wisdom put forth by the investment industry with a great deal of skepticism. Because many people understandably don’t want to focus much time on their investments, investors can often be led into accepting a number of questionable assumptions that can benefit certain members of the financial industry more than their clients. One of the most profitable New Year’s resolutions could be to spend some time questioning the factual basis behind some of the conventional assumptions investors are often asked to accept.
Assumption:
There is no point in trying to do a better job at investing than the average financial professional – it’s always a wise decision to faithfully entrust all your money to mutual funds or managed accounts marketed by the investment management industry, since the skilled experts managing these funds will certainly perform far better than you ever could.
Reality:
It is a widely known (but not widely advertised) fact that the efforts of many of the alleged experts working in the investment management industry are effectively inferior to placebo. Most professional money managers fail to show any evidence of any significant investment skill, and often perform at a worse than chance level. The majority of professionally managed mutual funds deliver significantly worse returns than selecting stocks entirely at random. Even before deducting their substantial fees, many can systematically perform even worse than would be expected by chance alone due to overconfidence and other behavioral biases.
The Myth of Mutual Funds
ETF Report – Over 50% of Active Managers Underperform
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=8036
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1100786
Although I believe that a select group of dedicated value investors do show evidence of very significant skill at investing, and can gain substantial benefits by carefully exercising the discipline to overcome behavioral biases (for example, see evidence on systematic outperformance by members of the Value Investors Club), these individuals can in practice be exceptionally rare. The assumption that the average member of the financial industry can outperform the market is very clearly a dangerous one to make.
Assumption:
It is safe to assume that a broker, advisor or other representative of an investment firm has a significant degree of highly valuable investment skills and knowledge that you, as an outsider, can never hope to match. You can also assume that person is being employed only to independently and carefully select optimal investments for the sole benefit of their clients.
Reality:
A significant number of people employed by the investment management industry to interact with customers serve primarily a sales or marketing role, and are incentivized to generate commissions and fees for their firm. Often, the training of many representatives may be focused much more on “customer relationship management” than on performing any independent investment research. It is a real possibility that these individuals may have little to no involvement in independently analyzing investments on their intrinsic merits, and may simply guide customers toward choices that generate fees or ancillary benefits for their firm. As the neurologist and economic historian William Bernstein writes in his 4 Pillars of Investing:
Brokers do undergo rigorous training, sometimes lasting months — in sales techniques. All brokerage houses spend an enormous amount of money on teaching their trainees and registered reps what they need to know: how to approach clients, pitch ideas, and close sales. One journalist, after spending several days at the training facilities of Merrill Lynch and Prudential-Bache, observed that most of the trainees had no financial background at all. (Or, as one used car salesman/broker trainee put it, “Investments were just another vehicle.”)
What do brokers think about almost every minute of the day? Selling. Selling. And Selling. Because if they don’t sell, they’re on the next train home to Peoria. The focus on sales breeds a curious kind of ethical anesthesia. Like all human beings placed in morally dubious positions, brokers are capable of rationalizing the damage to their client’s portfolios in a multitude of ways. They provide valuable advice and discipline. They are able to beat the market. They provide moral comfort and personal advice during difficult times in the market. Anything but face the awful truth: that their clients would be far better off without them.
Although I wouldn’t agree with Dr. Bernstein that markets are always perfectly efficient, his central point about the value of a healthy skepticism when approaching the investment management industry cannot be made forcefully enough.
Assumption:
In interacting with any advisor or stockbroker, it is safe to assume they necessarily must be a highly ethical and dispassionate professional who will always put your interests ahead of their own. Or, even if they’re self-interested, all other interests will surely be secondary to their clients’ investment performance.
Reality:
Unfortunately, as borne out by repeated scandals from Bernard Madoff to Jon Corzine, it is not always safe to assume that all people in the investment industry uphold the same ethical standards shared by physicians. While the majority may try to act ethically and are not involved in any blatant scam, the compensation of many managers or advisors generally has no relation at all to the results experienced by clients, and much of their role may be to generate commissions and management fees or sell securities that directly or indirectly benefit their employers. As independent research has borne out, the lack of any performance incentive for brokers and money managers can often cause them to actively make decisions that are bad for their customers.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1092744
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875395
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526737
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=616981
Assumption:
Even if the actively managed mutual funds sold by the investment industry perform poorly, I can always do well by assuming that passively managed index funds are always the best possible choice. I can simply place all my money in passive index funds and ETFs without needing to worry about the likely risk and return resulting from that decision.
Reality:
Although they can and will perform somewhat better than most professional money managers just by staying away from their counterproductive activities, most passive index investors may not currently have a realistic perception of the real risks involved. Average market returns of the past 30-year period may have been artificially boosted by excessive accumulation of debt and leverage during that time, a trend which is now at risk of reversing, with potentially severe consequences for asset prices. Based on several measures of historical valuation such as the Shiller P/E ratio, and a current ratio of corporate profits to GDP that may prove unsustainable in the long term, the likely range of returns from investing in the market index at current levels may be much lower than many investors have been trained to assume. Multiple macroeconomic risk factors including the continuing European sovereign debt crisis, excessive leverage by global financial institutions and governments, and a large and unstable real estate bubble in China, are now creating a very significant degree of real risk that is still not fully anticipated by most market participants.
Happy New Year – A Guarded Prognosis for 2012
I know this is a gloomy outlook to start the New Year, but I’m not calling for immediate financial Armageddon or a total collapse of society, just an appreciation that the real risks involved are much greater than most investment professionals are likely telling their customers. Personally, I have continued to invest in several specific stocks that I believe to be deeply undervalued, while attempting to hedge against risk with put options that will pay off significantly during a market decline; however, I know this type of strategy still has some risks of its own, and will be not be suitable for most individual investors without significant prior experience.
For most people, a more prudent course may be simply to reduce market exposure and hold cash reserves, enabling them to sleep better at night and benefit from a potential decline. The January Effect may provide a near-term boost for the market in the coming weeks, providing an opportunity for investors to reduce market exposure and raise cash. In the event of a sharp market decline, investors who have built cash reserves in appreciation of the risks may find themselves wealthier in real terms, with a rare opportunity to invest in attractive assets at significantly depressed levels.
Physician Investors 