Key Investment Insights: The Myth of the Financial Guru
August 11, 2014
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Welcome to the next installment in our series of Key Investment Insights.
In our last post, “News and Market Prices,” we explored how price-setting occurs in capital markets, and why investors should avoid reacting to breaking news. It’s clear that the cost and competition hurdles are simply just too high. Today, we will explain why you’d be ill-advised to seek out a pinch-hitting expert, the so-called “financial guru,” to compete for you. As Morningstar strategist Samuel Lee has said, managers who have persistently outperformed their benchmarks are “rarer than rare.”
Group Intelligence Wins Again
As we discussed in “Market Prices,” independently thinking groups (like participants in capital markets) are better at arriving at an accurate answer than even the smartest individuals within the group. In part, that’s because their collective wisdom is already bundled into prices, which we already learned adjust with fierce speed and relative accuracy to any new, unanticipated news.
Thus, even the experts, those who specialize in analyzing business, economic, geopolitical or any other market-related information, face the same challenges you would, if they attempt to beat the market by predicting an outcome to unexpected news. For them, too, particularly after costs, group intelligence remains a prohibitively high hurdle to overcome.
The Proof is in the Pudding
Let’s say a friend of a friend’s cousin’s uncle has told you of a financial guru — an extraordinary stock broker, fund manager or TV personality who strikes you, perhaps, as being among the elite few who can successfully make the leap over that high hurdle. Maybe this guru has a stellar track record, impeccable credentials or brand-name recognition. Should you, then, rely on this guru for the latest market tips, instead of settling for “average” returns?
Setting aside market theory for just a moment, let’s consider what actually works. Bottom line; if investors were able to depend on these so-called gurus who claim that they have consistently outperformed the market, shouldn’t we be seeing credible evidence of that?
We should, but not only are such data lacking, the body of evidence to the contrary is overwhelming. Star performers – “active managers” – often fail to survive, let alone persistently beat comparable market returns. A 2013 Vanguard Group analysis found that only about half of some 1,500 actively managed funds which were available in 1998 still existed by the end of 2012, and only 18% of those had outperformed their benchmarks. Dimensional Fund Advisors found similar results in its independent analysis of 10-year mutual fund performance through year-end 2013. In a nutshell, across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking.
- Among the earliest of these studies is Michael Jensen’s groundbreaking 1967 paper, “The Performance of Mutual Funds in the Period 1945–1964.” Jensen, who was my professor at the University of Rochester, concluded that there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”
- In 2009, Eugene Fama, a Nobel Prize winning economist, and Kenneth French conducted what is now widely considered a landmark study, “Luck Versus Skill in the Cross Section of Mutual Fund Returns.” They demonstrated that “the high costs of active management show up intact as lower returns to investors.”
- In the decades between 1967 and 2009, there have been as many as 100 similar studies published by a “who’s who” list of academic luminaries, all echoing Jensen, Fama and French. In 2011, the Netherlands Authority for the Financial Markets (AFM) scrutinized this body of research and concluded: “Selecting active funds in advance that will achieve outperformance after deduction of costs is therefore exceptionally difficult.”
Lest you think hedge fund managers and similar experts can fare better in their more rarefied environments, the evidence dispels that notion as well. For example, a March 2014 Barron’s column took a look at hedge fund survivorship. The author reported that nearly 10% of hedge funds existing at the beginning of 2013 had closed by year’s end, and nearly half of the hedge funds which had been available only five years prior were no longer available (presumably due to poor performance).
So far, we’ve assessed some of the investment obstacles you either have or may face. The good news is that there is a way to invest which enables you to nimbly sidestep those obstacles rather than face them head on, and which simply allows the market to do what it does best, on your behalf. In our next installment of Key Investment Insights, we will begin to introduce you to the strategies involved, and your many financial friends. First up, an exploration of what some have called the closest thing you’ll find to an investment free lunch: Diversification.