Complexity and Other Mirror Tricks: Why the Guru’s Glass Is More Than Half Empty
April 1st is past, but we still want to address some of the daily trickery found on Wall Street.
Unlike the harmless fun that takes place on April Fools’ Day, financial complexities that mask unnecessary costs and conflicted interests cost investors real money. That’s why we’re going to dedicate all of April to exposing a few of the most distracting mirror tricks that can cause you to lose focus on your critical financial goals. With so much to cover, we might spill into May.
What the Gurus Don’t Know
Today, let’s talk about the greatest trick of all: active management “gurus” who claim they can outperform the market by divining when it’s time for you to buy in and sell out. Splashed across the popular press in attention-grabbing headlines, they’ll juggle all manners of dazzling data, flashy forecasts and compelling concepts to convince you that they know what the future holds, how it is going to impact market pricing and how you should react to the news.
The problem is, their crystal ball is more than half empty. Or is it less than half full? Either way, all of the number-crunching in the actively managed world has got to be smoke and mirrors. Decades of solid evidence has demonstrated time and again that following forecasts – particularly after the costs involved – does not help explain the differences between higher or lower returns.
Forbes contributor Rick Ferri cites some of the most recent evidence in his article, “Gurus Achieve an Astounding 47.4% Accuracy.” Ferri notes, “After tracking 68 experts and 6,582 market forecasts, CXO Advisory Group has concluded that the average market prediction offered by experts has been below 50% accuracy. Flip a coin and your odds for predicting the market are better.”
Simple Math Wins Out
How can a group of “experts” actually underperform a coin toss? We would propose it’s related to the complexities involved in active investing. By seeking to beat the market rather than play along with it, active managers in aggregate incur greater costs than their passive manager counterparts, which puts them at a disadvantage right out of the gate.
This is no trick; it’s simple math, described some time ago by Nobel laureate William F. Sharpe. In his paper, “The Arithmetic of Active Management,” Dr. Sharpe says, “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
Next Up: Survivorship Bias
Survivorship bias is another important concept that helps us understand the disconnect between active managers’ diligent efforts and their disappointing results … a teaser for our next blog post.
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