16 July 2012

These heroes of finance are like beads on a string; when one slips off, all the rest follow.

Henrik Ibsen

I would like to talk about a statistical truth that is constantly ignored in the financial world. The truth is that we cannot beat the market. I'm willing to admit that there are certain individuals who are able, through skill, to beat the market in a sustainable fashion. However, you are likely not one of them, and the idea that large investment houses and pension funds are constantly trying to return above market returns makes absolutely zero sense.

You see, together, we make up the market. By definition, half of all investors will beat the market, and half will fall below the market. If everyone tries to invest in the smartest way, and we limit the investment management profession to the smartest people in the world, half would beat the market and half would be below the market. If instead of the smartest people in the world, we required that investment managers had to be the stupidest people in the world, half would beat the market, and half would be below the market.

From a mathematical perspective, it is impossible to beat the market forever. Due to the mathematics of compounding returns, any manager who beats the market over a long enough time will eventually manage all the money in the world. As an example, say that the market is 10 trillion dollars, and that a manager is managing 10 billion. If the market returns 5% per year, and the manager returns 10% per year, after 150 years, the manager will manage the same amount of money as the rest of the world combined. After 200 years, the manager will manage ten times as much money as the rest of the world combined. Obviously this is extreme and no manager will ever manage money for 150 years. However, note that it is mathematically impossible to beat the market forever. Therefore, the question is not whether a manager will stop beating the market, but when.

Past performance is not indicative of future returns. This is written as a disclosure on every single piece of investment advertisement, and then promptly ignored. In fact, investments are sold, even at the highest levels, as if this statement were the opposite. If you try to set up a meeting with a pension fund or consultant to speak about a strategy that has fallen beneath its benchmark, you will be completely ignored.

I want to point everyone to the example of Bill Miller, Chairman of Legg Mason and former manager of the Legg Mason Capital Management Value fund. For 15 years in a row, between 1991 and 2005 Bill's fund beat the market. He was given all kinds of awards. Morningstar named him the manager of the decade, Barrons named him to the "All Century Team," and he recieved countless other accolades. Unfortunately, his success did not last. In the following years, his fund lost so much money, that even if you had invested before the 15 year streak, and had beated the market for 15 years, you would still end up behind just investing in the market. The fund has gone from the most highly rated morningstar rating, to the lowest morningstar rating.

There are many reasons people think it should be easy to beat the market, even though, over the long run, this is statistically impossible. One of these reasons is called the availability heuristic. The availability heuristic makes us believe information based on it's availability to us, as opposed to it's actual probability in reality.

Imagine you had twenty friends, two of which made a killing in the stock market, and eighteen of which lost money. The two friends who made money go around bragging about how easy it is to make money in the stock market. The other eighteen are embarrased about losing money, and don't say anything.

When your brain analyzes the information, you remember two data points, both of which said it was easy to make money in the stock market. As a result, since 100% of your friends made easy money in the stock market, you believe that it is easy to make money in the stock market. However, your brain is only analyzing the small subset of information that is available to you. If you had the full set of information, that 90% of your friends lost money in the stock market, you would likely make a very different decision.

We have this problem of the availability heuristic exacerbated by the financial media. Their audience wants to listen to managers who beat the market, so since the news is there to make money and not to give an accurate representation of the world, they try to interview only people who beat the market. Therefore, if you watch the financial news all day, you will be exposed to a vast overrepresentation of managers who beat the market, and have no sense of the skill or luck that led to that result.

Why is understanding this concept so important? A couple of reasons. Firstly, our pension plans have unrealistic return expectations. Our governments, municipalities, and companies are planning for a future that will likely not occur. They are not setting aside enough money to pay for future liabilities because the return expectations they have set are too high. This poses a large risk for society

It adds a huge amount of risk to the financial system. Many of the financial products that caused such trouble in the housing market collapse were created as a way for pension plans to invest in riskier assets while still following the rules of their charters, which were meant to prohibit them from investing in those types of assets.

It is bad when people have such a fundamental misunderstanding of something so important. Like it or not, our lives are hugely influenced by the financial system. It isn't good when the vast majority of voters in a democratic system are uneducated about something so important.