Beaten by the Market
I am spending more and more time these days working as an expert witness in investment management cases. One thing keeps coming up over and over again and that is the value or lack thereof of active management versus passive management. In simplistic terms, for readers who are not financially-focused people, the simple issue is whether people can consistently beat the market or whether the market will always dominate and make any attempt to beat it a waste of time. For investors, this translates into whether it is worthwhile to pay extra fees to funds or managers that promise to give you a return edge when evidence overwhelmingly shows that few, if any, can do that and what you are really doing is lining the managers’ pockets rather than your own. This is a concern in both the traditional investment world of stocks and bonds and the new alternative worlds of hedge funds, private equity funds, real estate funds and venture capital funds. One thing that remains always true is that the more liquid, and thus large, a market is, the better the full dissemination of information, the less likely it is that you can consistently gain an edge over it. The more “emerging” or new and small a market is, the more likely it is that there are various sorts of knowledge or awareness that are not yet widely held or understood and thus, information can provide an edge that creates outsized returns. This is all hardly a new game, but rather one that has existed since the Phoenicians were trading with rocks or Mel Brook’s 2,000 Year-Old Man was hitting a tree with a stick to create value.
I have been in the position of running three of the largest investment management companies in the world. I didn’t do it by design, but fell into it by virtue of saluting the powers that be at my primary employer, Bankers Trust Company, and jumping through the hoops they asked me to jump through. That meant that thirty years ago I went into running a Global Private Bank that led the way into alternative investments for its high net worth clientele, and then following that into running the bigger institutional investment management business (which had the third largest passive management business in the world at the time), followed by merging the four businesses owned and/or bought by Bankers Trust and Deutsche Bank into the $325 Billion Deutsche Asset Management. I also went on to run the very avant garde and somewhat high-rolling Bear Stearns Asset Management. The one lesson I took from all of this was that when my sister would ask for investment advice I would say to go to Vanguard and buy index funds and let them sit and do their thing. This does not sound very sophisticated, but the objective in investment management is NOT to be sophisticated, but rather, to produce good and reliable returns net of fees and other costs. That advice serves that purpose perfectly and I will stack it up sight-unseen against any other investment strategy in the world if you look at it over something like a ten year horizon or longer.
So, I ask myself whenever I get into these weeds, why is man so prone to want to beat the market, or better yet, why against all evidence to the contrary, does man think he CAN beat the market? There was an article in the Wall Street Journal on this very topic the other day and I noted that it starts to try to answer those questions. That author, Meir Statman, suggests that it is all about mental shortcuts that people take in making their decisions. Effectively, he is suggesting that people mistake the problems and thus come up with faulty or overly-aggressive solutions. In some ways the Malcolm Gladwell concept that spending more time practicing something makes you better at it is at the heart of this issue. Sometimes trading more doe NOT lead to better results. Statman calls it a “curse of overconfidence”. He sees us often mistaking hindsight for foresight and concludes that we all too often think that we can predict what is unpredictable by its very nature. The random walk concept of markets and the reversion to mean concept should tell us that the statistical analysis of random events (a.k.a. Markets) is a mug’s game.
But that ends up being Statman’s handle on an answer as to why people do this at all. He suggests that it is less about the money or even really winning or losing, and more about our need to play the game. I’m not sure how I feel about that answer since I think it depends on whether you think of investing as a game or as more serious life and death stuff. Clearly there are people for whom investing is all about discretionary income, but equally clearly, the aging population of the world has moved into a zone of increasing reliance on retirement savings on which to live (the old, will-I-have-to-eat-dog-food-in-my-final-days conundrum). I would posit that this is less a game than it used to be. Even with the newest estimate of global retirement assets having grown to some 65 Trillion, that is still FAR short of where it needs to be, and ever FARTHER short of how it needs to be allocated to insure that we are living in a humane world where people won’t have to eat the proverbial dog food in their final days.
One of the curses of having been in the finance business for over forty years, and particularly in the money management business for over thirty of that, is that I have lost my respect for money. I have seen people who haven’t done much to deserve the wealth they have, make wealth accumulation and preservation the most important thing in their world. My favorite wealth preservation joke is about the Boston Brahmin walking along the street and spying a relative on the porch of a red-light district hotel. He rushes up and says, “Cousin Louisa, what has become of you?!” Louisa responds with a simple explanation, “But Elliot, it was either this or invade principal!”
I have seen children sapped of their motivation and often their moral compass by virtue of having too much assurance of access to money. If it were up to me I would level the playing field and thereby improve every young person’s prospects by giving them a free education to the best of their ability and desire (they would have to both be worthy of advancement by virtue of their ability and/or hard work and they would need to want the benefit of the education), but I see little or no benefit to them or society of handing them a legacy. Parents think they are making their children happy, when they may well be insuring the opposite. Whoever said money can’t buy happiness certainly understood the pitfalls of inherited wealth.
So my advice to the world of aging retirees is to put your money in index funds, understand that trying to beat the market is a game best left to the games men. Leave the money there, taking out what you need of the total return accumulation (forget about income per se since income is an investment ruse to get you to buy bonds, in my opinion). So. live and do your best to plan to die broke by not worrying about what you are leaving your children or grandchildren beyond their educational needs. Make as many generous gifts to them that you wish, but don’t burden them with a big inheritance. Given them their own path to learn what you have learned about beating and getting beaten by the market.