There’s a relatively small group of market professionals that run most of the market. Each person controls tens or hundreds of millions of dollars or more. Far more than their personal wealth. These people are salaried professionals who work for mutual funds, pension funds, and insurance funds. They all ride the same subway to Wall Street; they all talk with each other, attending the same meetings and conferences; they call each other on the phone to discuss investments; they all have a degree from Harvard or some other Ivy League student hotel—not necessarily because this makes for the smartest graduates but because people thinks this makes for the smartest graduates and they’re willing to pay accordingly; they read the same newspapers (WSJ, Barrons, Forbes, and Business Week) …

They exhibit herd behavior. Group think.

You can verify this for yourself by getting a subscription to the four magazines above (actually, the last three will do, WSJ is too expensive). Then you’ll develop the uncanny ability to correctly guess whatever particular company some newsletter writer describes as “Destined for 400% growth over the next 10 years due to the new discovery of Rare Resource X”. Indeed, newsletter writers read those four publications as well.

Being salaried professionals, they are gauged on their performance relative to their piers.

This is useless to an investor. Here’s how the performance reward for a professional money manager looks in terms of market outcomes

  • The money manager is wrong about the market, but so is his peers. Result: Keep job, no bonus.
  • The money manager is wrong about the market, unlike his peers. Result: Job lost.
  • The money manager is right about the market, but so is his peers. Result: Keep job, no bonus.
  • The money manager is right about the market, unlike his peers. Result: Keep job, get bonus.

For someone who depends on his salary much more than the performance of his investment—and believe you me, if you look at your wealth in terms of investments to expenses, you are wealthier than most professionals—this creates a principal agent problem.

A professional manager is MUCH more interested in doing what his peers are doing than growing your money faster than the market. His risk-reward structure is skewed against the motivation to act on inefficiencies which may not materialize before AFTER next quarter.

In contrast, here’s your game theoretic matrix

  • You’re wrong about the market. You lose money.
  • You’re right about the market. You gain money.

It is somewhat different, eh?

Furthermore, professionals are often limited in what they can do by the prospectus and other regulations. Worse, they usually control such huge positions that they can’t just buy or sell them without changing the market price. This is a completely different problem than what usually faces the retail investor—unless you trade large positions compared to the rate-of-volume.

The herd behavior + principal agent problem + the regulations + the size means that the market is far from efficient.

As an informed retail investor, you can beat the professionals. I’ve done so for the past 5 years to the tune of 5% per year(*). Most of the money is not made in selecting the better companies but in not panicking along with the herd and being able to liquidate complete positions at the snap of a finger. In other words, having _money_ and NOT worrying about losing one’s job by failing to meet market performance in any given year is a HUGE advantage!

(*) No I am NOT going to tell you what to invest in. I’m pretty sure what will happen: “I don’t agree with everything you say, so I’m just going to pick whatever seems good to me.” The failing to get my results, I get the blame—see outcome schematics above 😉

However, one does need to pay relatively constant attention to the market. I do not mean that one needs to analyze individual stocks all the time. In this sense, I think you probably really do have no advantage over a professional who’s on a first name basis with investor relations. (Maybe I’m just biased here due to personal inability—I’ve never called IR nor visited a company) However, in terms of calling macro trends it’s not too hard to spot a slow train wreck in advance and watch how the professionals are unable to jump off because they’re too tied to their positions by either their dependence on their salary, their regulations, or their sheer size.

What do I conclude from this?

  1. If you have the ability to think and the nerve to support your thinking, you can outperform the market. (Sometimes, I’m not sure that I’ll be able to maintain the nerve for the next 60 years. It does take some intestinal fortitude to disagree with the majority.)
  2. Unless you have detailed knowledge of a fund manager, you’re unlikely to pick a good one. Endowments are actively managed funds and they actually do OUTPERFORM THE MARKET IN THE LONG RUN. However, such endowments are able to get to know and check on their managers a lot better than you will be able to do so just be reading a shiny brochure. To pick a good fund, you need to look at the manager. Also you need to realize that if the manager leaves and gets replaced by some other guy, that fund may suddenly change fundamentally! The key here is to look at manager tenure. You should also look at the tenure of the board of directors. Very long (>15-20 years per person is good!).
  3. If you’re just going to pick a fund a random, you’re probably better off picking a market index fund. It won’t protect you from the herd behavior but it will protect you from having to pay the salary of a manager that ads no value. Also, like professional managers have figured out, it also protects you completely from any kind of doubt that you’re doing the right thing. Sometimes I do find this approach appealing for that very reason despite all the bad things I say about [market] index funds.

What is important to realize is that the market efficiency that sellers of professional managers is apt to point out, whether that be for individual funds or index funds which is the sum-average of all funds IS NOT always due to the professionals. There is in fact a contribution from non-professionals which becomes apparent whenever the herd of professionals panic or become illiquid or otherwise run up against the restrictions of their investment plans.

You should also stop thinking about market efficiency as a freebie. If something is undervalued (inefficient) because panic drove it down and people are out of cash; then guys like me, a private individual with some sense and willingness to act on it, can buy it. Then I got the share and since each share only can have one owner and I’m it, you can’t buy the same share through an index fund or whatever fund(*). Efficiency is partially restored and the index is up but the share wasn’t picked up by a fund manager. It was sold by a fund manager and I bought it. The index may have dropped briefly due to the data point created by that transaction, but no one in the index actually bought or sold the stock because the index is just a mathematical construction. (I may however have been bought of sold by someone using an index fund, but that index fund would then be dealing with tracking error for the reasons above.) Thus efficiency doesn’t come for free. You can’t just piggyback on it. It has a cost and that cost is paid by lowering the performance of the market average. See?

(*) Remember that the “market price” is just the price of the last recorded transaction of which there was a seller and a buyer. It does not mean that this price is universally obtainable for everybody. The price is less like buying bread in the supermarket and more like an auction with only one winner.

So there we go …

Originally posted 2011-07-30 21:28:02.