Saturday, April 21, 2012

Science or Sales?

Investors can be placed into one of two categories: those who base their investment decisions on the massive amount of academic research that has been done over the last 60 years (science), or those who base their investment decisions on the marketing machine of the ginormous financial industry (sales). Which category are you in? Which category of investors do you think is likely to do better in the long run?

I doubt that most people are aware of the enormous amount of academic research that has been done on investing. Certainly people who trust their investments to active mutual fund managers, stock brokers, or high-cost investment advisors are not. It’s more likely that people invest this way simply because they don’t know any better, and there is no incentive for most of the financial industry to let them know there is a better way. Quite the opposite; it is in the interest of the financial industry to propagate the myths that have long been dispelled by the research (science), and they have the money to market the myths (sales).

As mentioned in my last post, Back to Basics, all of the basics of rational investing are supported by research that has been done over the last 60 years. To understand this, you should read at least one good book on investing--preferably a few. Or, you can take my word for it. Hopefully you won’t invest based on the marketing and sales machine of the financial industry.

In 1952, Harry Markowitz published published “Portfolio Selection” in The Journal of Finance, in which he formalized a way to analyze investment risk, and showed how assets could be combined in a portfolio to optimize the risk/return tradeoff. Markowitz is considered the father of modern portfolio theory, and his work is the foundation for much of the investment research that has followed. In 1990 he shared the Nobel prize in economics for his work.

William Sharpe extended Markowitz’s work to develop a more specific theory that related the risk of an asset (e.g., a stock for bond) to its market price, which in turn determines the rate of return demanded by investors. He published his work in The Journal of Finance in 1964, and shared the 1990 Nobel prize with Markowitz (and two others).

Tens of thousands of investment research papers have been published since the early 1950s, and thousands of academics and finance professionals publish new investment research papers each year. There are two problems:

  • First, there is no financial incentive to make non-professional investors (you and me) aware of this research, since most of it suggests that we should be investing in a way that would result in much of the financial industry withering away.
  • Second, the research now is so complex that it is virtually impossible for non-academics to understand. You are lucky if you happen to stumble across a blog, an article, or a book that helps you understand the implications of the investment research.

Getting into the details of investment research is beyond the scope of my blog. Authors who are very good at summarizing the academic research in a way that is accessible to non-academics are Larry Swedroe and William Bernstein. Any of their investment books are worth reading if you want to deepen your knowledge about the science of investing, or need more convincing that you should pay attention to it.

Larry also publishes a blog in which he often summarizes the results of the latest investment research (see link to “Larry Swedroe’s blog” under Investing Websites on my blog website). Larry’s blog presents more advanced material than I do, and he is solidly in the camp of diversifying beyond total market funds, which may not be appropriate for investors who want to keep things simple. If you don’t know what “diversifying beyond total market funds” means, see my blog post Lumpers vs. Splitters.

The science of investing is not perfect. It does not eliminate uncertainty (risk), nor allow us to predict the future. However, it does enable us to develop a deeper understanding of risk and its relationship to return (profit), and it provides a rational framework for making wise investment decisions.

Scientific theories often do not survive empirical research, experimentation, or the scrutiny of other scientists. As a matter of fact, the defining characteristic of a scientific theory is that it must be able to be disproven; i.e., it makes falsifiable predictions (this may seem strange, but it is true). There have been serious empirical challenges to many scientific theories on investing.

Nevertheless, science is one of the hallmarks of modern civilization, and often provides the best framework to make rational decisions. Scientific theory and empirical evidence are especially convincing when supported by common sense and logic. Market efficiency is an example.

Scientific research has shown that markets are reasonably efficient. This means that it is very difficult for anyone to profit from information that is known by other market participants. It is illegal to trade based on inside information (information not know by other market participants); you can go to jail for doing so (remember Martha Stewart?). Unless you are trading based on inside information (and want to risk going to jail), many other highly skilled market participants (managers of hedge funds, pension funds, mutual funds, etc.) also know and already have acted on whatever you know or your broker knows. As investment professionals say, the information is already “priced in”, meaning the the price of the asset already reflects the widely-known information, so it is too late for you to take advantage of it. So market efficiency is supported by common sense as well as by scientific research.

Scientific research has shown that virtually nobody is good at picking stocks, timing the market, or predicting what the market will do in the future. Scientific research has shown that in the case of the very few investment managers who have generated superior long-term results, it is impossible to determine whether their performance was based on luck or skill. Scientific research has shown that it is virtually impossible to predict which investment managers will outperform in the future.

You may ask, “what about Warren Buffett”? My answers are:

  • When you look in the mirror, do you see Warren Buffet?
  • Do you really think your broker, advisor, or mutual fund manager is the next Warren Buffett?
  • Do you really think you know for sure who the next Warren Buffett is?

You don’t even need complicated science to conclude that investing in low-cost index funds is almost certain to generate higher long-term returns than investing in high-cost actively-managed mutual funds (where the managers try to beat the market by stock selection or market timing). All you need is simple logic and basic arithmetic, as shown by William Sharpe (the Nobel laureate mentioned above) in his paper, “The Arithmetic of Active Management”, published in The Financial Analysts Journal in 1991. This is one “academic” paper that is not too hard to understand; it is only a couple of pages, and there are no equations. If you don’t want to read it, here is the summary:

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

Index funds are passively managed funds, so your investment in an index fund consists of passively managed dollars. Investments in actively managed funds consist of actively managed dollars. Therefore, in aggregate, passively managed funds must outperform actively managed funds.

If you have been investing based on the hype foisted on us by much of the financial industry, I hope I have at least raised some doubt about continuing to do so. Many members of the financial industry make their money by maintaining your belief that they are special, and somehow know something that their competitors don’t know. If you just think seriously about it for a few minutes, you should be able to conclude that this cannot be so.

Similarly, I hope I have raised some doubt that you should believe the hype foisted on us by much of the financial media, that makes its money from advertising (much of it from the financial industry), and needs to keep us interested to keep us reading or watching so they can keep selling advertising. Telling us about the basics of rational investing is not as exciting as telling us which hot mutual funds or stocks to buy this year. Once we understand the basics of the science of investing, we don’t need to pay any attention to the financial media, and they can no longer make money off of our ignorance.

So, science or sales, which shall it be? I choose science, and recommend that you fire your broker, active fund manager, or high-cost investment manager, and instead invest in a simple portfolio of low-cost index funds, knowing that doing so is supported by 60 years of scientific research on investing.

2 comments:

Dave said...

Excellent summation. So many people turn to the financial "sales" machine without asking about alternatives. Most do not know of the research you mention.

Having recently come away from 4 years of expensive, sales driven portfolio management from a national brokerage, it was blogs such as yours that allowed me to see more clearly. Thank you.

Kevin said...

Dave, thanks for the comment, and glad my blog is among those that helped you see the light.