Better Odds- Blackjack Or Active Management?

When we review prospective client portfolios, it is almost guaranteed some portion of their money is invested in some sort of active management strategy.  As you may know, active management is the strategy of attempting to beat a benchmark.  This could be done through market timing (buying and selling at opportune times) or stock picking (buying winning stocks and selling ones that will underperform).  The alternative strategy is often called passive management, though we like to call it "evidenced based" management.  Essentially, you own the entire market and don't try to time when to buy or sell securities or pick one stock over another.  The "evidence" suggests that this method of investing has a much higher probability of success.

As I was thinking about the idea of probabilities, I thought it might be fun to compare active management to another game that is all about probabilities…blackjack.  First, let's look at the statistics on active management.  Actual results* show us that 17% of stock mutual funds have beaten their benchmark over the last 15 years.  Bond funds fared much worse, with only 7% beating their benchmark during the same period.  If the goal of active management is to beat a benchmark, they are not doing a very good job.

So what about blackjack?  The odds you will win one hand of blackjack (factoring out ties) is 46.36%.  But we are measuring 15 years of whether an active manager can beat the benchmark.  What is the chance you will win money at blackjack if you play 15 hands in a row?  The answer:  17.5%.

Long story short- you have almost identical odds to walk away with more money after 15 hands of blackjack than you do trying to pick an active manager that will beat the market over 15 years.  The odds are much worse trying to pick a bond fund that will beat the market.  We all have heard that as long as you play for a long enough time, the house always wins.  Maybe you should think about who the "House" is when you are investing and shift the odds more in your favor.


*The US Mutual Fund Landscape, 2016 Report

Soccer and Investing Have Similar Qualities

The author Malcolm Gladwell recently explored the idea of strong-link and weak-link networks in his podcast, Revisionist History.  A strong-link network is when a few great people matter most to your success.  A good example of this would be basketball.  When you have LeBron James on your team, you don't need a whole lot of other superstars to be great.  In fact, you could have a bunch of below average players on your team and still win the championship.  A weak-link network is when an above-average group matters most.  In keeping with the sports analogy, soccer is a great example of this.  An above average team has a better chance of winning than a team with one superstar.  The reason is that the entire team is essential to win the game.  Lionel Messi is considered the best soccer player on the planet now, but it still may take 5 or more passes from his teammates to set him up to make a play.  If you have below average teammates your success will be limited.

So what type of network is investing?  Is it better to try to pick a few stocks with the hope of having one or two be huge gainers (strong-link network) or have an above-average type of portfolio with no superstars, but no disasters either (weak-link network)?  We are of the belief that the weak-link network, by diversifying the portfolio using low-cost funds (not superstars but above average) is superior when it comes to investing.  Here is our thinking:

  • Losses are harder to recover from- if your portfolio goes down 50% then up by 50%, you are not back to even.  You are down 25%.  A weak-link strategy lessens the probability of major losses because of the diversification benefits.
  • Loss aversion- a strong-link strategy would require major fortitude to see substantial portfolio volatility (since this strategy would be more concentrated).  Loss aversion refers to an investor's tendency to prefer avoiding losses to acquiring equivalent gains.  We believe most investors trying to pursue a strong-link strategy would have a higher tendency to bail out of their portfolio at the worst possible time.
  • There is no evidence that strong network strategies would work- trying to pick a few great investments can work, but most evidence seems to suggest that positive results are more based on luck than skill.  Luck is not an effective investment strategy.
  • The odds are against you- research shows that picking individual stocks (a strong-link strategy) is a low probability approach.  During their lifetime, 64% of stocks underperformed the Russell 3000.  You have about a 1 in 3 chance of outperforming the overall market when you pick a stock.  The weak-link strategy of owning the market gives you a higher probability of success.

Instead of trying to pick the next Apple, focus on a weak link-strategy.  Make sure every part of your portfolio is above average. Maybe not the best, but above average.  The way to ensure you have above average investments is to focus on low-cost, passive vehicles.  Research tells us these investments won't be number one in their asset class, but they will be in the top third.  This is a textbook weak-link strategy.

Active Management ALWAYS Underperforms

Active asset management is the strategy of picking a small number of holdings with the goal of outperforming the broad index.  For example, an active manager may invest in small US companies and pick 40 of those companies to include in his portfolio with the hope of outperforming the actual 2,000 small US companies in existence.  Most people believe that with enough hard work and intelligence this is very possible, especially in areas where there is less competition (like small companies, emerging market stocks or high yield bonds).  But there is a simple truth that the active managers won't tell you.  The average active manager in any asset class will always underperform his/her benchmark.  It is simple math that Nobel prize winner Bill Sharpe wrote in his brilliant paper, The Arithmetic of Active Management:

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

Think of it this way.  The ownership of an entire asset class is made up of the combination of passive investors (those that buy and hold the entire asset class) and active investors (those that pick and choose the funds they want to own inside that asset class).  If the passive investors own the asset class (some portion of it), the remaining active investors MUST own that same asset class if you look at them in the aggregate.  Therefore, if one investor overweights Walmart in their portfolio, some other investor must be underweighting it.  It is impossible for everyone to overweight or underweight a stock since someone has to own it.  In the same vein, when an active manager buys a stock (and profits from it) someone has to have sold it to him (and therefore lost out).  Trading is a zero sum game amongst active managers.

Notice, I have not said that all active managers will underperform.  It is the average of all active managers that will always underperform because of their fees.  There will be winners and there will be losers, but the average active manager will always do worse than his/her benchmark (FYI- this plays out perfectly in the data).  This is true over any time period:  one day, one month, one year, or 100 years.  So, if you believe in this simple math equation, you need to ask yourself one more question- can I pick a manager (or be one myself) that will be in the minority camp of active managers that outperform?  We'll save that topic for a future post.

Disagreement With A Legend

Jack Bogle may have contributed more to the investment management industry than any other human in history.  Mr. Bogle is the founder of Vanguard, the largest mutual fund company in the world, and innovator who came up with the idea of the shareholders owning the funds they invest in.  Because of this structure (no shareholders who are demanding profits), they are able to keep their fees exceptionally low, which is one of the reason we use them for our clients.  They are also the fund company that popularized index funds, espousing the idea that owning the entire market passively is a much better bet than trying to pick winning stocks.  Low fees, broad diversification…what's not to like?

In listening to a recent interview with Mr. Bogle, I found myself agreeing with almost everything he said.  Almost everything.  When the interviewer asked Bogle about investing outside the US he argued against it, claiming excessive risk and lack of returns.  Here are his comments when asked about investing in an international index fund (that his company provides!):

"So if people knew they were putting 45% of their so-called international, non-US, money in Great Britain, France and Japan — I mean every one of those three countries has real problems," Bogle said.

"The French don’t work very hard, The Japanese have a structured and deeply aging economy overburdened by future retirement claims… Britain doesn’t know what’s going to happen if they do the exit from the European community, nor do they know what’s going to happen if they stay in."

Seems like a logical argument.  The heaviest weightings in the international index have real problems.  Why would you want to invest in them?

Here is the issue.  It flies in the face of the very theory he is promoting at Vanguard!  When you invest in index funds you are taking the stance that markets are efficient so it is pointless to try to outguess it by picking stocks.  The data totally backs up Vanguard's claim on the merits of index funds, by the way.  So when Bogle states all the reasons why international stocks won't perform as well as US stocks, he is basically saying that the market is inefficient.  You see, he is probably right when he states all the problems with France, Japan and Great Britain, but what he doesn't seem to understand is that the market knows exactly what he knows (probably more).  If that is the case, the market should be pricing in that lower growth in the form of cheaper stock prices.  In fact, the market is doing exactly that.  According to Henderson Global Investors, the Price-to-Earnings Ratio (which is a measure of how expensive a stock is) in 2016 for the US is 17 while in Japan and Europe it is 14. 

Let me even do a little thought experiment using Japan.  Let's say tomorrow morning you wake up to the headline that Japan has had a massive census error and instead of their population being older than every other developed nation, that it is in fact the opposite.  There is a huge generation of working aged Japanese that were unaccounted for.  In addition, their massive debt has really been an accounting error.  In fact, they have been in the black for years and in fact have surpluses (I know it seems crazy, but bear with me).  What do you think would happen to their stock market when it opened for trading?  My guess is that it would go up…probably a lot.  Why?  Because the market would adjust to the new reality that Japan is not as bad as originally thought.  If you believe that statement, then you also have inadvertently believed that the market is efficient.  It is pricing Japanese stocks today at a level much lower than it otherwise would, to account for all the problems in the Japanese economy.

This explains the simple truth that "the stock market is not the economy" (it is actually very funny to look at the chart on this post since it comes from Vanguard!).  Trying to claim, like Bogle, that the stock market's performance will be the same as the country's performance is just not backed by any evidence. The US economy could do significantly better than Japan over the next 10 years and their stock markets could do the exact opposite.  All that matters with the stock market is expectations.  If Japan beats very low expectations, they could easily do better than the US (who has very high expectations).

So to circle back on the original question- Greenspring respectfully disagrees with Mr. Bogle.  We believe that investors should have an allocation of their portfolio to foreign stocks.  We have found they add diversification value (as evidenced here, here and here) which for many investors is key to smooth out their returns.

The Value Of Predictions

As we close out 2015, we find ourselves in one of the most comical parts of the year in finance.  The time to make predictions for 2016. Why is this comical?  Because Wall Street strategists are usually spectacularly wrong, yet investors still seem mesmerized by what they will say.  Wall Street strategists are not dumb.  There is no career risk in saying that the S&P 500 is going to go up 8 or 10% in a year.  Since that is the long-term average, you aren't really going out on a limb making this prediction.  No one is going to crucify you for it.  While you won't lose your job, you almost certainly won't be right.  In a recent article on MarketWatch 10 leading analysts are predicting a 6% gain for the S&P 500 next year.  Last year, these same analysts were looking for approximately 10%.  In fact, when you go back and look at analyst predictions, you will always see they predict returns in the upcoming year to be around 6 to 10%.  Let's take a look at the distribution of returns of the S&P 500 over the last 89 years to see what actually tends to happen:

Return distribution

We see that returns will be between 0 to 10% less than 15% of the time!  Here are some staggering statistics to consider as you ponder the validity of predictions:

  • Annual returns between 10 to 20% have been 46% more likely than annual returns between 0 and 10%
  • You've had the same odds of annual returns being between -10 and 0% versus 0 and 10%
  • It has been slightly better odds of generating annual returns between 30 and 40% versus 0 and 10%
  • 58% of all years measured (1926-2014) saw returns greater than 10%
  • 27% of all years measured (1926-2014) experienced negative returns

Rarely are returns average over a one-year period.  They have a tendency to be either much higher or lower than what analysts predict.  Given that analysts are probably right around 15% of the time (based on the frequency of returns above) it is hard to comprehend the value these predictions create for investors.  Maybe it's time to start realizing that the value of predictions is not for you, but the Wall Street firms (by selling you products) and the media (by you clicking on articles).  

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.