Wednesday, July 16, 2008

Misunderstandings of the Efficient Market Hypothesis can be a serious threat to your financial health

Recently, someone on a financial planning mailing list I was on tried to sell active investing again, citing this post. He essentially bragged that he was beating the S&P 500, and repeated the tired old claims that the S&P 500 was essentially actively managed anyway, since companies shifted in and out of the index. I felt compelled to reply, and here's an abridged version of it:
  1. Performance benchmarking --- As mentioned before, the S&P 500 shouldn't be your benchmark if your portfolio doesn't have the risk characteristics that are similar. The efficient market hypothesis doesn't say it's impossible for you to beat S&P 500 --- what it says is that you can't beat the S&P 500 without taking more risk in your portfolio! The important thing to remember is that firstly, investment performance is measured in decades, not years, and that over the same period, a brain-dead simple asset allocation (say, Vanguard Target Retirement 2045) can also beat the S&P 500 by 2-3 percentage points over the same period just by taking more risk --- say, by investing in international stocks. One of my favorite examples is the financial blogger Early on, he claimed that he was doing so much better than the S&P 500, which meant that he was a genius. Then someone pointed out that he had to benchmark against a similar-risk portfolio, and it turned out that his out- performance wasn't there after all, and definitely in recent quarters it had been non-existent.
  2. Investment Strategy. I'm going to do research and beat the benchmark. I actually know one person who succeeded in doing this --- he quit his day job and invested full time. But that out-performance came at the expense of his job performance as a software engineer --- after 3-4 years of doing this, he was no longer able to survive a typical software engineering interview in Silicon Valley. If you already have a multi-million dollar portfolio it might be worth while to do this. If you're still dependent on your day job, don't do it! Getting that next promotion is likely to be worth more from a long term career point of view!
  3. Over multi-decade periods, I've seen more portfolio disasters from active management than from passive management. One extreme example was described in an earlier blog post.
  4. As William Bernstein said during his visit to Google: Just because you believe in the efficient market does not absolve you of the responsibility to do the math and look at what makes sense." But when the math points you in a certain direction, it is sufficient to make small adjustments to capture some additional return ---there's no need to bet your entire nest-egg. Several years ago, I saw that the way Americans guzzled oil was unlikely to be sustainable --- my way of dealing with it was to add something like 5% Energy to my portfolio during an asset re-allocation (through Vanguard's Energy Fund --- I didn't bother trying to find a good active fund --- my office mate bought Brazilian oil stocks with much better returns --- he's satisfied with his return and won't stop bragging about them, and I'm happy that I did something --- it did give me a slight performance bump --- but I'm not that proud of it because I did so by taking more risk)
  5. History. It is hard for most modern investors to imagine the world in the 1970s when Vanguard was founded. Back then, there was not a single index fund. John Bogle did an amazing two things: first, he introduced the index fund (as imperfect as the S&P 500 was, it's still very good, especially compared to the typically managed active index fund). Secondly, he setup Vanguard's corporate structure in such a way that there's no conflict of interest between the interests of the customer, and the way Vanguard was run. If he had set up Vanguard's structure the way Fidelity's structure was, he'd be worth vastly more money today --- at the expense of Vanguard's customers. It is this reason that John Bogle is a hero. Understanding this history (and why Vanguard is much less likely to screw you over in the long multi-decade time frame which is when investment success is determined) is the key to understanding why people speak of him in such reverential terms.
In any case, it's no coincidence that one of the most successful investors of all time (20% growth over 20 years) when he had to write an investment book for individual investors, still ended up recommending the tired old index funds. And to a large extent, I agree with Swensen --- in the world where there is every incentive on wall street to sell you the active story (none of the under-performing real life examples I used above were stupid people --- yet they made more money for their advisors than for themselves), going the passive, asset-allocation route is truly unconventional and is more likely to lead to success.
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