When teaching class, one of my favorite things to do when nobody in the class wanted to answer a question was to put it up for a vote: “If we use the scattering potential drawn on the black board, will the phase shift of the scattered wave at infinity be positive or negative?”. And the students would reluctantly put their hands up looking carefully whether the other students put their hands up. If the majority got it right, I would say something like “Ah, so we proved that democracy works!” vis-a-vis “Uh Oh, another great failure of the democratic process”.

Now realize that much of the institutional/fund investment process can be understood like this, as a big class room—after all, where did the investment professionals all come from? That’s right, college!

One thing, that was very dangerous, at least with me as the teacher, was if you were one of the few students in the minority of a vote. In that case you could be semi-sure that I would ask why you were against the majority. From the students point of view, going against the grain was therefore a risky proposition (few students like to be grilled in front of the class), especially when most others seem to think they’re wrong. Going against the majority therefore requires a certain confidence; fortunately confidence usually means that you’re right and so if the vote was 90/10, the 10 was quite likely to be correct whereas no such conclusion could be made on a 60/40 vote.

I never asked random persons of the majority, because that would lead to the embarrassing revelation that many students simply voted on something because the others did and vice-a-versa.

Now I only used this teaching gimmick once or twice per semester, but suppose I used it all the time. And suppose I even used it for examinations. I would call out questions, people would vote on them, and I would write down their answers.

Which strategy would you use as a student?

Now it is [finally] clear to me that most students are lazy bastards who would like nothing better than to drink, get laid, sleep, and yet graduate with honors, so what is the best strategy for a student like that. Clearly, one strategy is to be an “average student”. In the system above, there is no need to study at all. At the examination, simply cast your vote with the majority all the time and you will be average by construction. Even better, you did not spend any time studying and so you came out ahead, in terms of boozing and sleeping, of those that wasted their time on studying.

Now it so happens that students often tend to have a much better understanding of how good they are relative to each other than the teacher, so a better strategy may be to copy whatever the good students are doing and vote the way they’re voting. This requires a little social networking and at least a modicum of technical understanding. This runs the risk that the good students may have a bad day. Obviously, there is also the risk of copying bad students. There’s the risk that you may lose confidence and start changing your vote. And there’s the ultimate risk that the good students may decide to mess around with you and give you false answers to throw you off. It happens.

A more costly approach is to study hard. This usually works but not always. I was always saddened by the hard working student that yet just did not seem to get it. Those who worked hard usually got handpicked for graduate school, whereas those with social networking skills (the show horses) got sent on to provide their expertise in the real world (this scares me!) along with those who worked hard but weren’t particularly talented (the work horses). The talented and hardworking students would consistently outperform the average because there were wrong choices dragging the average down. In addition some of the good students did not let other people in on the fact that they were good because they did not appreciate the freeloading.

Now realize that the investment universe is very similar to a class room, because, as mentioned above, it’s the same kind of people.

Now, it seems you HAVE to take this class, so

  1. You can decide that you don’t really care about learning anything and that your time is better spent elsewhere, and thus just with the average. This is the index fund strategy which will produce average returns (which are not necessarily positive, mind you!)
  2. You can get to know the good guys by reading about them and put in some technical effort to get an informed opinion of whether their past record is just luck or whether there is something to it. You want to know not just their “GPA”, but you also want to know why their GPA is what it is. Once you found a good manager, stick with him (or her). This usually brings superior results to the first strategy.
  3. Like 2, but abandoning the good manager in trying times or having chosen a bad manager because the results where not understood (perhaps he was bribing the teacher). This is the failed strategy. It is based on a combination of greed and incompetence.
  4. You can become a good manager yourself. You know it can’t be that difficult, when business students can do it! ;-D Seriously though, the more technical details you know, the better you will be able to make an informed opinion about picking an advisor, if you decide not to do it yourself. This goes for other fields than investing as well.

In conclusion, there is no such thing as a best investment strategy for everybody. It strictly depends on which kind of student you are when it comes to investments. I know, if returns were based on the top 50 chart of popular music or bestselling romance novels instead, I would absolutely go with the index approach and vote with the average. On the other hand reading balance sheets and following the business world, which is a subset  of the real world, is interesting [to me] and thus I see no need to settle for index investing when it comes to that.

Originally posted 2009-06-05 10:29:12.