Sunday, August 23, 2015

Beating the Market

I've been an investor for forty years.  (I'm either older than pictures indicate, started investing before high school, or both.  Please take your pick.)  And I've been a securities/capital markets attorney for most of those years.

For about thirty years I was an "active" investor.  Active in the sense in believing in my ability to pick individual securities and sectors better than the average investor.  (And better even than the average market professional.  Who, after all, is the average person one is competing against primarily when choosing securities.)

A clarification:  I was not "active" in the sense of trading frequently.  I traded (and continue to trade) maybe four to six times a year.

Some early successes -- a stock that appreciated ten-fold; another twenty-fold -- reinforced my belief I could pick stocks successfully.  That is, beat the market.

About ten years ago, after several years of focused study of emerging academic research, I became a convert to so-called index-based investing.  The research (especially the research that I'd suggest is objective), is increasingly incontrovertible, more so each passing quarter as additional studies are published, that index-based investing leads to better long-term risk-adjusted net investment returns.

Paradoxically, the early successes probably cost me money.  Because without them and the overconfidence they fostered I likely would have converted earlier.  But time proved those early successes were not replicable.

In the past, active investing had a decent shot at success, defined as above-average risk-adjusted returns.  But for the past several years active investing has not had that shot.  In 2015, active management is "betting against the house."  Sure, sometimes one beats the house.  But the odds are against it.  How this came to be recently is explained -- better than I can explain -- in the recently published book "The Incredible Shrinking Alpha." 

A main premise of index-based investing is that markets are inherently unpredictable.  This is a difficult concept for most people to accept.  Fundamentally because it has elements of randomness that are at odds with our predisposition to trained, analytical, linear thinking.  As humans it is part of our make-up to believe that we can with some degree of accuracy ascertain the future.  We can do so in other areas of life - results bear that out.  And that leads us to believe we can do so in securities markets.  But study after study after study shows we can't.  (Most of those very, very few "market beaters" lauded by the general interest financial press can be chalked up to - yep - probability.  Aka chance.  Not skill.)

Index-based investing is also difficult for people to accept because it often runs counter to a personal narrative.  As a personal example, in providing for my family - handling my family's investments, including my children's accounts - it is discordant to think that I wasn't doing things as I should have been.  And doing so for many years.  Years I cannot get back.  As another example, consider an investment professional whose livelihood is based on active management.  Can that person easily accept that there is and has been a "better model"?  From the view here, rarely.  To even raise the questions of "has active investment management been the right route?; is it still, now?" can be unsettling.

Let me suggest that the years-ongoing debate about active versus index-based investing is in some ways like the climate change debate:  huge amounts of data do not end the debate.  Psychology, climate politics, and vested interests, etc. complicate what would in another context likely be settled.  Much like the climate change debate, my one prediction (ironically) for this blog post is that the active versus index-based debate will continue for at least another decade.  Perhaps one more generation.

The strategy of index-based investing is pretty basic:  diversify, rebalance with discipline, and keep one's costs low.  As to the latter, little doubt we'll all seen the numerous popular finance press articles sprinkled here and there throughout the years that costs (one of the few factors controllable in investing) are the most accurate predictor -- top o' the list of factors (and a higher predictive factor than the identify of one's investment manager) -- of good-to-very-good risk-adjusted returns.  And that inattention to costs can eat up approximately one-quarter to one-third of one's account balance over the long term.

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