Swedroe: Investors Defy Evidence

July 25, 2018

The opening chapter of my first book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” published in 1998, is titled “Why Individual Investors Play the Loser’s Game.” The chapter presents my attempts to explain this anomalous behavior. It begins with a story about Galileo.

I write: “Galileo was an Italian astronomer who lived in the sixteenth and seventeenth centuries. He spent the last eight years of his life under house arrest, ordered by the Church for committing the ‘crime’ of believing in and teaching the doctrines of Copernicus. Galileo’s conflict with the Church arose because he was fighting the accepted church doctrine that the Earth was the center of the universe. Ptolemy, a Greek astronomer, had proposed this theory in the second century. It went unchallenged until 1530, when Copernicus published his major work, “On the Revolutions of the Celestial Spheres,” which stated that the Earth rotated around the Sun rather than the other way around.

“History is filled with people clinging to the infallibility of an idea even when there is an overwhelming body of evidence to suggest that the idea has no basis in reality—particularly when a powerful establishment finds it in its interest to resist change. In Galileo’s case, the establishment was the Church. In the case of the belief in active management, the establishment is comprised of Wall Street, most of the mutual fund industry, and the publications that cover the financial markets. All of them would make far less money if investors were fully aware of the failure of active management.”

“Most investors, investment advisors, and portfolio managers engage in active management of their investment portfolios. They try to select individual stocks they believe will outperform the market. They also try to time their investment decisions by increasing their stock investments when they believe the market will rise and decreasing them when they believe the market will fall. These investors, advisors, and portfolio managers attempt to beat the market through active management strategies despite an overwhelming body of academic evidence that has demonstrated that the vast majority of returns of a diversified portfolio of securities is explained by investment policy (asset allocation). The evidence is that only a very small% of returns is explained by active management.”

Today studies such as Eugene Fama and Ken French’s “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance, have found that only about 2% of actively managed funds are generating statistically significant alpha, less than we would expect to randomly find. What’s more, that’s on a pretax basis. For taxable investors, the odds would be lower, as taxes are typically their largest expense.

The chapter continues by providing what I believed were the most likely explanations for investors ignoring the evidence and continuing to play the loser’s game. The first explanation is what I called the black hole of knowledge. The points I make there are just as applicable today as they were 20 years ago when my first book was published.

Black Hole Of Knowledge

I write: “Most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance. My daughter is a senior in an excellent high school, and she is graduating very close to the top of her class. Having taken a biology course, she can tell you all you would ever need to know about amoebas. She could not, however, tell you the first thing about how financial markets work.”

“Just as nature abhors a vacuum, Wall Street rushes in to fill the void. Investors, lacking the protection of knowledge, are susceptible to all the advertising, hype, and sales pressure that the investment establishment is capable of putting out. The problem with this hype is that, in general, the only people who are actually enriched are part of the investment establishment itself.”

The second explanation I gave for investors continuing to play the loser’s game was related to the faith we have in the Protestant work ethic: Hard work should produce superior results.

I write: “To quote my ex-boss, an otherwise intelligent and rational man: ‘Diligence, hard work, research, and intelligence just have to pay off in superior results. How can no management be better than professional management? The problem with this thought process is that, while these statements are correct generalizations, efforts to beat the market are an exception to the rule. If hard work and diligence always produce superior results, how do you account for the failure of the vast majority of professional money managers (in all likelihood all bright, intelligent, capable, hard-working individuals) to beat the market year in and year out? In the face of all this evidence, they continue to give it the old college try. The lesson: Never confuse efforts with results. As you will see, hard work is unlikely to produce superior results because the markets are [highly, though not perfectly] efficient.”

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