Taking an Evidence Based View on Investing
Many investors have unfulfilled expectations. They are looking for a better solution, one that can lead to a better investment experience. What would that approach look like? How can they improve their odds of success?Let’s begin by considering what you want to accomplish as an investor. Why do people invest at all? People have different financial needs and goals, and therefore, they may invest for different reasons. One major reason is to grow their wealth—for example, in preparation for retirement. Whatever their reason for accumulating money, there’s another concern that creates the need to invest: the threat of inflation.
Investing means taking risks. Not investing means taking risks, too.Inflation erodes the real purchasing power of your wealth. Consider an illustration of the effects of inflation over time. In 1913, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And 100 years later, nine cents would only buy about six tablespoons of milk. So, as the value of a dollar declines over time, you invest to grow wealth and preserve purchasing power. We often hear people say, “yes, but investing is risky.” But considering the long-term threat of inflation, not investing means taking risks, too. If you don’t grow your money, you may not be able to afford things in the future.
So, how do people invest to grow their wealth?Most look to the financial markets as their main investment avenue—and the good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has offset inflation. Data on performance from different indexes illustrates the beneficial role of stocks in creating real wealth over time.
T-bills have barely covered inflation, while longer-term bonds have provided higher returns over inflation. Stock returns have far exceeded inflation and have significantly outperformed bonds. One thing to note is that not all stocks, or bonds, are the same. The differences are evident in the performance of US small cap stocks over this time period. A dollar invested in small cap stocks in 1926 would be worth more than $18,000 in 2014. Keep in mind that there’s risk and uncertainty in the markets and that historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. Otherwise, people would not invest their capital.
How do many people invest?Let’s think about how a lot of people attempt to grow wealth in the capital markets. The most common approach is based on prediction and forecasting. Methods include: •Picking stocks expected to perform well in the future,•Moving in and out of industry sectors, or•Attempting to time the market These methods are based on trying to predict the future direction of the economy, the stock market, or an individual stock. This conventional approach assumes that someone has a crystal ball. Many people think this is the key to successful investing. In fact, when people meet financial advisors or others in the investment business, their first question is typically, “where do you think the market is going?” They are basically asking that person to make a prediction. Yet, no one can know the future—and if an investment person could predict the market’s future direction, why would he share that knowledge for free? A prediction about an uncertain future is just an opinion, and it should not determine anyone’s investment decision. Many people learn this the hard way.
What have we learned?There is another way to invest—a way that can put the odds of success in your favor. It starts by considering what academic research has revealed about markets and investing over the past 60 years. We call this financial science. It is based on time-tested research into financial markets, asset pricing, expected returns, and other aspects of investing. But what does it mean to follow science? Here’s an example of science applied in everyday life. When you visit a medical doctor, you expect that specialist to be connected to the latest medical knowledge. If your doctor recommends a treatment or writes a prescription, you assume that the advice is based upon a large body of scientific evidence that resulted from a rigorous process of research, testing, and practical application. In the same way, financial science can be applied to practical investing. One can build an approach based on decades of research into the financial markets, including pricing dynamics and the behavior of different areas of the market. The academic community offers a wealth of insight into how markets work and the sources of expected returns. This timeline offers some of the high points in the evolution of modern finance.One driving principle is that “markets work”—that is, market prices reflect all available information and expectations of the future. This is known as market efficiency. The forces of supply and demand are constantly at work in the financial markets, and the intense competition pushes stock and bond prices toward their actual value. People trust markets every day. For example, when shopping, you probably don’t question whether the price for an item is “right” or “wrong.” You simply assume the price reflects local market conditions. You might decide the price is too high and choose not to buy—and if enough people don’t buy the item, the price drops. This is how a market works. Yet, many people’s perception of market pricing breaks down when they invest because they assume that the price of a stock or bond may not be right. They are conditioned to view some stocks as being “overvalued” or “undervalued.” In reality, the financial markets work much like any other market, with information and opinions affecting the price of a stock or bond. That price reflects the aggregate view of what the investment is worth at that moment in time. The forces of supply and demand push prices toward market equilibrium—and these forces are at work in the financial markets. So, consider how this aggregation of knowledge and opinions works in the financial markets. Millions of participants buy and sell securities around the world. In the US markets alone, investors trade billions of dollars in stocks and bonds each day. The new information buyers and sellers bring to the markets help set prices—and with each bit of new information, prices adjust accordingly. No one knows what the next bit of new information will be, as the future is uncertain. But we can accept current prices as fair. This doesn’t mean that a price is always right because there’s no way to prove that. But investors can accept the market price as the best estimate. If you don’t believe that market prices are good estimates—if you believe that the market has it wrong, you are pitting your knowledge or hunches against the combined knowledge of thousands or millions of other market participants.
What is the best way to invest?So, guided by these principles and a wealth of research about the financial markets, how should we think about investing? Your particular view of market pricing will shape how you invest, and there are basically three approaches: conventional management, indexing, and our way of investing, which is based on market pricing and dimensions of expected returns.
Conventional ManagementThe dominant or “conventional” investment approach assumes that prices are not accurate. This leads to an attempt to predict the future, which incurs higher costs and risk. We have already looked at the main problems that people encounter when they follow a predictive investment approach. Let’s see if professional investment managers can do a better job at conventional investing. Mutual fund research shows that conventional investing has low odds of success. Over the 10-year period ending in 2013, only 19% of stock managers and 15% of bond managers survived and outperformed their benchmarks. Said another way, 81% of stock managers and 85% of the bond managers who started the 10-year period underperformed their market index. About half of the stock and bond managers did not even survive the 10-year period. Some investors try to improve these odds by picking managers who have outperformed in the past. There’s a significant amount of research into the persistence of manager performance. It shows that among managers that outperformed in the past, only a small fraction continued to beat their market benchmark in the future. Should we be surprised by this poor record of performance? Not really. This makes sense if market prices are the best estimates of actual value. Manager underperformance is not necessarily due to a lack of knowledge or expertise. In fact, many professional investment managers are very bright, educated, and hard working. The problem is that this high level of expertise and motivation results in intense market competition, which drives prices to fair value. With the advent of computing power and data availability, academic research has documented the poor outcome of most conventional managers. This is one reason for the rise in the popularity of another investment approach—indexing.
IndexingIndexing offers a number of investment benefits over a conventional approach. Broad-based indexes offer better diversification, have lower fees, and follow a more transparent investment process, which means investors have a clearer idea of what they are getting. The problem with indexing is that the commercial index provider determines the stocks or bonds held in the portfolio. The firm publishes a list—usually annually or semi-annually—containing all the stocks composing that index, or benchmark. The manager attempts to closely track the benchmark. But rigid construction works against the strategy. Most index fund managers are judged by their ability to closely track their respective index. The main problems with this approach are loss of control, trading disadvantage, and style drift. Let’s consider each of these. Loss of control
An index manager does not start with the whole market, but with a list of stocks published by the index provider. The manager holds a basket of stocks in an attempt to match or closely replicate that list. The investment strategy is defined by a commercial index provider, and the manager has no control over what the fund holds. Trading disadvantageWhen the new list is released, managers must buy and sell at the same time to keep their portfolios (and returns) in line with the index. This updating process is known as rebalancing or index reconstitution. Everyone knows what the index fund is holding and when the index manager will rebalance. The index provider has shown the cards to the marketplace, and the index fund manager will have to trade with urgency along with other managers who follow the index. This puts the managers at a trading disadvantage, which usually results in higher costs.