Over the past week I have come across powerful evidence for abandoning active management of your investment portfolio. The first, comes from Daniel Kahneman's brilliant Thinking Fast and Slow. Kahneman is a psychologist, who by his own admission, knew nothing of finance prior to studying investor success.
The book is so much more than a book on investing. It is a book on how humans make decisions and it should be on the top of everyones reading list.
The book is so much more than a book on investing. It is a book on how humans make decisions and it should be on the top of everyones reading list.
But dont take my word for it, look at the accolades below:
Winner of the National Academy of Sciences Best Book Award in 2012
Selected by the New York Times Book Review as one of the best books of 2011
A Globe and Mail Best Books of the Year 2011 Title
One of The Economist’s 2011 Books of the Year
One of The Wall Steet Journal's Best Nonfiction Books of the Year 2011
“Brilliant . . . It is impossible to exaggerate the importance of Daniel Kahneman’s contribution to the understanding of the way we think and choose. He stands among the giants, a weaver of the threads of Charles Darwin, Adam Smith and Sigmund Freud. Arguably the most important psychologist in history, Kahneman has reshaped cognitive psychology, the analysis of rationality and reason, the understanding of risk and the study of happiness and well-being . . . A magisterial work, stunning in its ambition, infused with knowledge, laced with wisdom, informed by modesty and deeply humane. If you can read only one book this year, read this one.”— Janice Gross Stein, The Globe and Mail
The quote I copy below is part of a larger chapter on "The Illusion of Validity." Kahneman uses the lack of persistant success in stock picking to demonstrate an area where this cognitive illusion exists. Remember, this is a guy just studying the facts. No bias to sell you his skill in finance:
“In 1984, Amos (Kahneman research partner) and I and our friend Richard Thaler visited a Wall Street firm. Our host, a senior investment manager, had invited us to discuss the role of judgment biases in investing. I knew so little about finance that I did not even know what to ask him, but I remember one exchange. “When you sell a stock,” I asked, “who buys it?” He answered with a wave in the vague direction of the window, indicating that he expected the buyer to be someone else very much like him. That was odd: What made one person buy and the other sell? What did the sellers think they knew that the buyers did not?
Since then, my questions about the stock market have hardened into a larger puzzle: a major industry appears to be built largely on an illusion of skill. Billions of shares are traded every day, with many people buying each stock and others selling it to them. It is not unusual for more than 100 million shares of a single stock to change hands in one day. Most of the buyers and sellers know that they have the same information; they exchange the stocks primarily because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop. The puzzle is why buyers and sellers alike think that the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion.
“In its broad outlines, the standard theory of how the stock market works is accepted by all the participants in the industry. Everybody in the investment business has read Burton Malkiel’s wonderful book A Random Walk Down Wall Street. Malkiel’s central idea is that a stock’s price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. If some people believe that the price of a stock will be higher tomorrow, they will buy more of it today. This, in turn, will cause its price to rise. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect prices leave no scope for cleverness, but they also protect fools from their own folly. We now know, however, that the theory is not quite right. Many individual investors lose consistently by trading, an achievement that a dart-throwing chimp could not match. ......
“Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund managers, fail a basic test of skill: persistent achievement. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among golfers, car salespeople, orthodontists, or speedy toll collectors on the turnpike.
Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year.
More important, the year-to-year correlation between the outcomes of mutual funds is very small, barely higher than zero. The successful funds in any given year are mostly lucky; they
have a good roll of the dice. There is general agreement among researchers that nearly all stock pickers, whether they know it or not—and few of them do—are playing a game of chance. The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses" (the bold is mine).
Then after reading this section in Kahneman's book, I read in Forbes that it was announced that the largest pension fund in the country is coming to the same conclusion. The following is from Forbes:
"The country’s largest public pension fund may shift more assets into passive indexing if the pension committee takes the advice of their consultant. The California Public Employees’ Retirement System (CalPERS) is considering the move because external active managers have failed to keep pace with the markets. This news is nothing new to people who closely track active management performance.
CalPERS invests the retirement savings for over 1.6 million public employees, retirees, and their families and more than 3,000 public employers. Assets total more than $256 billion, making it the largest public pension fund in the country.
The fund currently allocates about 50 percent of assets to the global public equity markets. Approximately 60 percent of the allocation is already managed in passive index-tracking portfolios and the remaining 40 percent is managed externally by active investment management firms.
Pension & Investing reported this week that the CalPERs investment committee is considering putting more into indexing after investment consultant Allan Emkin of Pension Consulting Alliance showed that at any given time, only about one-quarter of the fund’s external active managers are outperforming their benchmarks. Further, the results of the winning managers may not be high enough to cancel out the underperformance by the losing managers. He also noted that winning active managers change over time, which complicates the selection process.
Allan’s observations are nothing new to astute investors who track active management performance. It has been know in academia and in the consulting industry that a majority of active managers underperform the indexes they are trying to beat. It’s also known that choosing a winning manager is extremely difficult because there is so much noise in the data. The most interesting point that Allan makes is that losing managers more than cancel the winning managers’ gains, and this leaves a portfolio in a net loss position."
This is profound. It is the a validation of the research findings being born out in real world experience!
If the 256 Billion dollar pension fund cant beat the market, can you?
The beauty is that being the market year after year you will do better than 2/3 of active management each year and by some account 90% of active management over 10 years.
Finally: If the above has triggered your interest, I highly recommend the short 7 minute videos from Sensible Investing. Although the producers advocate passive (index) investing. The presentation and evidence presented are compelling and worth your time:
