Ralph Waldo Emerson is one of America's icons and his famous essay, An American Scholar, has been very influential on people around the world. In that essay, Mr. Emerson says that there are three types of people:
Nobel Prize Winning Investment Research
Over the last 60 years, a great deal of research has been done on investing and investments. This research has elevated "finance" to a subject held in high esteem. God knows, without computers and spreadsheets, it would not have been possible.
One of the major breakthroughs was the creation of the Capital Asset Pricing Model (CAPM) by Dr. Harry Markowitz. This theory - for which Dr. Markowitz ultimately won the Nobel Memorial Prize in Economics - explains the expected return on an investment as a function of its risk. It's a risk vs. return story that is fundamental to finance. From the perspective of an investor that wants to know why the returns are what they are, the Capital Asset Pricing Model is able to account for about 70% of the variability of a portfolio's return. It is the foundation on which most of modern finance rests.
The next big research project came from the mid-west. Two professors at the University of Chicago, Dr. Eugene Fama and Dr. Kenneth French, developed what is now known as the 5-Factor Model. Their research added to the Capital Asset Pricing Model and it explains the five dimensions - otherwise known as factors - of a portfolio's returns.
While no model is perfect, the research done by Fama and French shows that those five factors account for ~70% to ~93% of the variability in the returns of a given portfolio. Conversely, that means that ~7% - 30% of the variability of a portfolio's return is a function of buying the right stock or bond at the right time. That is not a lot, but it is not insignificant either.
This is the fundamental reason we are fans of passive management strategies for most portfolios.
Information and Prices
But doesn't it seem so counter-intuitive? After all, if a professional money manager is studying the market, reading research reports, reading financial statements, traveling to visit company management and the customers of companies, shouldn't he or she be able to determine the real value of a company and be able profit from it? While it might seem so at first glance, do as Emerson suggested and think about that a little more. Specifically, think about how the price of something is actually determined.
An economist by the name of Frederick Von Hayek did a lot of work in the 20th century on the subject of price and it is incredible work. He showed that price is an amazing and very subtle thing. Price is a function of what you know, what I know, and what millions of other people...maybe billions of other people...know about something. None of us knows it all. And the fact is, we don't really have to, because our collective knowledge is included in, and represented by, the price.
If that is true, then how could a Harvard-educated, active money manager from fund company "A" really know more about - let's say Coca Cola - than Stanford-educated, active money manager from fund company "B"? They are both reading the same reports and speaking to the same people, right? Yes, they are. Because they are buying or selling the stock, their specific knowledge doesn't need to be known by all investors. If a few people know it, their knowledge will be shared to other buyers and sellers of the stock in the form of the price. And that price will be shared. And shared again, etc. We don't really care about their specific knowledge so much as we care about how that information impacts the price of the investment.
Let's look at a real life example. Do you remember the space shuttle Challenger disaster? I'll never forget it. It happened on January 28th, 1986 at 11:39 AM eastern time. Why do I know this? Well, I was a senior in high school then, living in Orlando, Florida. I was in my girlfriend's (now my wife) parent's backyard that morning and I watched the Challenger launch from Cape Kennedy (yes, you could see it from Orlando)...and then explode. While I didn't know it then, what happened on the stock market that morning is an example of pricing in action. You see, by 11:52 AM (that's 13 minutes after the explosion) the New York Stock Exchange called a halt to the trading of Morton Thiokol's stock because it started to fall in value so quickly. Morton Thiokol is the company that was ultimately found to be responsible for the engineering defect in the o-rings that caused the Challenger to explode. When the stock resumed trading at 12:36 PM that day, the stock continued its downward fall in price. By the day's end, it was down nearly 12%. Lockhead, Martin Marietta, and Rockwell International's stock also fell. Unlike Morton Thiokol however, the stocks of those other companies were back up in value by the day's close. Do you think that many, if any, Wall Street traders knew much about o-rings? Did those traders know enough to make the stock of the guilty company fall within a few minutes of the Challenger explosion? And then, did those some few traders also know that the three other companies weren't responsible for the explosion, such that the price of the stock of those other companies was back up by the end of the day?
I don't think so.
As Hayek observed, no one knows it all. But a few investors in those stocks did know and they acted. Others investors who weren't "in the know" saw that people were selling the stock. As a result, a lot of investors started behaving in a way that drove the stock price down. And this happened within minutes! And remember, personal computers were just coming on the market, but virtually no-one knew about "the internet." Cell phones weren't available to the masses either. The only thing we had - and it was big at the time - was 24 hour news from CNN.
Hmm, it's getting harder to see how an active money manager can really out perform "the market", isn't it.
"But wait a minute!" you say. "I understand how it might be difficult to get more information than the other guy when you're talking about Coca Cola, but what about little companies here in the US and around the world? Couldn't an active manager learn more about them and profit as a result?"
Good thought and Emerson would be impressed. If trading costs were the same for all stocks, your idea makes sense. But trading costs are not the same.
Investment transaction costs matter. The commissions you pay to your broker matters...and so does the bid-ask spread on the investments you buy. This is something that few people understand, so let's start with some definitions:
But what about a small company stock that isn't bought and sold all the time? Well, it is 1:52 PM on April 3, 2015 as I write this and Solar Winds, Inc - symbol SWI - is a small company stock according to Yahoo Finance. Its Ask price - the price you'd pay for it if you bough it - is $52/share. Its bid price is $46.83. That is a spread of $5.17 per share! That is a spread differential of 9.94%!
Now, imagine you are the money manager and you are able to know more about small cap stocks than the regular guy or gal. Maybe you really do. But now, not only do you need to know more, but you also need to know ENOUGH more that also lets you cover the 9.94% deficit you find yourself in as soon as you buy the stock. And that's just a one way trade! If you turn around and buy another stock with the same bid-ask spread differential, you can see you need to overcome a nearly 20% trading deficit!
I believe it is easier to make money as an active money manager for small company stocks than big company stocks, but it is still not easy. It's easier the way lifting a 2,000 pound car over year head is easier than lifting a 10,000 pound truck.
Triumvirate of Investment Management Problems
When it comes to your investments, there are three things that can get you into trouble:
Let's spend a little time talking about each one.
We human beings are funny creatures. To paraphrase Robert Heinlein, the famous science fiction writer, we are rationalizing creatures, not rational ones. For instance, we know that smoking is bad for us, yet we do it anyway. We know that chips and salsa are to be eaten sparingly, but the US is now about the most obese nation on the planet. We know that if we just walked around the block a few times after dinner - while we wouldn't look like the guys and gals on the fitness commercials - we would be reasonably healthy. Do most people do it?
My point is that what we know isn't all that important. It's what we do with what we know that's important.
Back in 2002, an interest thing happened in the world of finance. Daniel Kahneman, a psychologist from Princeton University, won the Nobel Memorial Prize in Economics. A psychologist - a psychologist, I say again - won the Nobel Memorial Prize in Economics. And why? He won for his groundbreaking work on Behavioral Economics. If you want a fun and interesting book, check out Thinking, Fast and Slow. It's the book on his research and it became a best seller a few years ago. You'll learn how humans are swayed in various directions based on how issues are framed, how we anchor to certain things, and how we see patterns that aren't really there...among others.
When it comes to investing, investments and money, our behavior can and often does get us into trouble.
Let me give you an example with one of my favorite stories. It involves tuna fish.
Imagine that every Saturday, you go grocery shopping. Normally, tuna fish is selling for $1/can, but on this particular Saturday, it's selling for $3/can. Now, how many cans of tuna fish are you going to buy at that price? Assuming the kids aren't starving, the answer is probably "NONE", right? Of course, that's right!
Let's change the story a little bit. Imagine that the tuna isn't selling for $3/can, but three cans for $1. Now, how much will you buy? Odds are, you'll buy as much as you can store in your pantry! Why? Because it's on sale and it's a deal!
Why is it that we behave so differently with investments though? Why is it that we only want to invest when the prices have incrementally increased over the years...to the equivalent of $3/can? And then we don't want to buy when the investments are the equivalent to "three cans for a $1?"
Remember - at the end of the day - it's all tuna fish!
That story is why an understanding of your personal risk profile is important. It is also why we spend a lot of time trying to identify how much risk you're willing to take with your money. There is no right answer, and it is perfectly reasonable to want to sleep well at night.
Let me tell you a quick story and then I'll explain how we get to the "real" you.
Having grown up in Florida, I'm a very good swimmer and a fair diver. When going to the beach, I swim out far....sometimes a 1/2 mile... into the ocean. Are there sharks there? Definitely. When I find a pool, I love jumping high off of the diving board as I swan dive into the deep end. Of course, to do that, I know that I need to go under the water - sometimes pretty deep - where the pressure hurts my ears. I could hit my head on the bottom of some of those pools and break my neck, too. In both of those situations though, I know the risk and feel confident in my behavior to handle the risk.
I'd never go Acapulco cliff diving, though. While I like to think that I could get into the shape necessary, I know that I am just not that much of a risk taker. I'm pretty confident that I would go to the top of one of those cliffs and freeze. Or I'd do something even worse and jump - at the wrong time - and land in the rocks.
My wife is a good swimmer, too. When in the pool though, she is always wading in the shallow end. At the beach, she doesn't like to go where the water is above her waist. That's her comfort zone and that's where she stays. And that's ok, too.
Investors and their investing comforts are analogous to my swimming and diving proclivities. Some people want to go off the high dive and are willing to go deep underwater to do it. Some only want to hang out in the shallow-end. If the person that likes to be in the shallow end gets put on the high-dive though, they might get scared and do something that can get them hurt (like selling in a down market). And if the Acapulco cliff diver is always kept at the shallow end of the pool, he or she will probably do something stupid....like diving into 2 feet of water (or, by analogy, using a financial product to do something it wasn't designed to do).
Investing and risk go hand in hand. If you want to make higher returns, you need to be willing to let your portfolio's value go down in value from time to time. How much you're willing to let it fall will let us know how much risk you're willing to take. Most of us hate losses more than we want gains, so most people are not crazy aggressive with their investments.
When you invest, it's important to pay attention to costs. And the fees that many active managers charge are very high. When you pay big fees, you clearly are paying out dollars that could otherwise have been yours. There's a bigger cost though....the opportunity cost of those fees.
By way of example, let's assume you have a $1,000,000 and can chose between portfolio A and portfolio B. Both portfolios earn the same 8.5% gross rate of return, but portfolio A is actively managed and has expenses of 1.5% year. Portfolio B is passively managed with expenses of 0.50% per year. At the end of 20 years, portfolio B is worth $791,272.68 more than portfolio A because of its lower cost.
When it comes to your investments, taxes are important. Generally speaking, you need to be aware of two big ones:
One of the reasons that active investment management can be problematic is that, because of all of the trading, active managers turn what could be a long-term capital gain into short-term capital gain. For high income tax payers, that means that your tax bill can nearly double from 20% to 37% (not including the Net Investment Income tax).
When using evidence-based passive investing strategies, because of the lower investment turnover inherent in the approach, capital gain is more likely to be long-term capital gain.
Contact us and let us know how we can help.