Summer 2014
Fads come and go, but investing is like music: true classics stand the test of time and remain relevant long after they were initially composed. The classic concepts below are all members of the “Investing Hall of Fame.”
1) Markets Work
Many people wonder, “What stock should I buy?” or “Where is the market going?” These folks believe that in order to have investment success they have to look into a crystal ball and predict the future (or find someone who will do it for them).
A completely different approach evolved in the halls of academia. Evidence shows that free markets work because of the balance between prices and information. As the economist and philosopher F.A. Hayek pointed out in his Nobel laureate lecture, “We are only beginning to understand how subtle and efficient is the communication mechanism we call the market. It garners, comprehends, and disseminates widely dispersed information better and faster than any system man has deliberately designed.”1 In the realm of fiercely competitive capital markets, Hayek believed that stock prices are fair. Competition among profit-seeking investors causes prices to change very quickly in response to new information, and neither the buyer nor the seller of a publicly traded security has a systematic advantage. Therefore, the current price is our best estimate of fair value.
2) Simple Arithmetic Means Everyone Can Be a Winner
The sum of all investment returns is earned by the sum of all investors (before fees). This is true at every instant as well as in the long term. The market reflects the collective holdings of all investors, so the value-weighted average return must be the market return (minus fees and expenses). This is not just a theory; it is a universal truth.
It is not necessary for someone to have a lousy investment experience for you to have a successful one. Everyone can win because with capitalism, there is always a positive expected return on capital. The expected return is there for the taking, and as a provider of capital (via your purchase of a stock or bond), you are entitled to earn it. That doesn’t mean it’s guaranteed to be positive, only that it is always expected to be positive. Well-functioning capital markets maintain a strong and pervasive relationship between risk and expected return. You can earn a higher return by taking on more risk. There is no free lunch.
3) Money Managers Can’t (Consistently) Beat the Market
Can anyone systematically identify—in advance—money managers who will outperform the market? Finding managers who have outperformed in the past is as easy as looking up the scores from last night’s sporting events. Yet there is very little persistence in the performance of managers and no documented way of determining who will outperform in the future. While it’s tempting to be caught up in the enthusiasm of a manager on a winning streak, it’s best for your investment plan to avoid doing so. As the advertising says, past performance is no guarantee of future results.
There are many smart, serious money managers who work hard to get the best results they can for their clients. But the market is hard to beat because there are so many smart managers—not in spite of this fact. If you take the world’s greatest bass fisherman to a dry lake, he won’t catch any fish. He may still be the world’s greatest bass fisherman, but that’s beside the point if the lake is dry.
4) Emotion Is the Enemy
Traveling the road to a successful investment experience requires more than just a map. Keeping your hands on the wheel and your eyes on the horizon requires the emotional discipline to execute faithfully in the face of conflicting messages from the attention-grabbing media and the profit-seeking investment industry. Investors are bombarded with information designed to lead them off course and toward strategies that involve excessive trading and high costs.
Unfortunately, the investment industry thrives on complexity, while frequently shunning simple yet effective solutions. Adhering to a prudent investment strategy often becomes elusive in a world of continually streaming news and confusing investment products. These forces can overwhelm our emotions and lead many investors astray.
Research into how the human brain is wired reveals tendencies known as behavioral biases. These biases make even highly intelligent investors particularly susceptible to the conventional approach of Wall Street and the messages purveyed by the media. Behavioral finance studies the intersection of economics and psychology in an attempt to identify biases that influence investment decisions. In a nutshell, these findings show investors may not be rational, but they are normal—meaning they’re often their own worst enemy.
As for the sensationalist financial media, tune it out or turn it off.
5) Diversification is Divine
Not all risks generate higher expected returns. Markets only compensate investors for risks that are “systematic” and cannot be eliminated. For example, a football team won’t pay a star quarterback more money to play without a helmet. Head injuries are a risk that can easily be avoided by wearing a helmet and buckling the chin strap. Similarly, investors shouldn’t expect an additional reward for taking the risk of concentrating their portfolio in a few securities, industries, or countries because the increased risk of doing so is easily eliminated through diversification.
To diversify effectively, investors should allocate capital across multiple asset classes around the globe, and these investments should suit their unique circumstances, financial goals, and risk preferences.
A prudent investment approach following these fundamentals is like a steady diet of healthy food—simple, effective, boring, and difficult to maintain. But definitely worth the effort, since good food, exercise, and sufficient sleep will improve the odds of being healthier. Similarly, accepting that markets work, avoiding stock picking and market timing, effectively diversifying a portfolio, and paying attention to costs will improve your odds of being wealthier.
Like a lot of true classics, it sounds simple, but it isn’t easy.
With thanks to Brad Steiman, Head of Canadian Financial Advisor Services, Dimensional.
- Friedrich August von Hayek, “The Pretence of Knowledge” (lecture to the memory of Alfred Nobel, December 11, 1974), Link (accessed July 6, 2012).
