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.

“Sixty Percent Of The Time, It Works Every Time”

You may recognize the quote in the title from the movie Anchorman.  If not, here is the clip to refresh your memory:

This can be a lot like stock pickers, pundits and TV personalities.  Except the percentage of the time they are right are usually way under 60%.  A man like Marc Faber fits it to this camp.  For some reason he continues to get TV time with headlines like this one:  Marc Faber: S&P is set to crash 50%, giving back 5 years of gains.  At first blush, this sounds pretty scary.  That's the main reason CNBC is publishing it.  They know that fear sells and you are much more likely to watch a clip about a major market crash than something much more useful like diversification, cost management or tax minimization.  Unfortunately, no one seems to fact check their contributors actual results (who really cares about the data anyways?).  Here is a great chart showing Marc Faber's record over the last 7 years:

faber-timeline

He seems to predict a market crash as often as a meteorologist predicts rain.  Of course, at some point he'll be right.  The only problem is that if you continue to follow his advice, you'll most likely be broke before this happens.  This post is not meant to insult Marc Faber, but to illustrate the folly of predictions.  This is just another example to run (not walk) away from anyone who is using prediction for the basis of advice.  It may seem like making changes to your portfolio based on the prediction of what stock is going to do well, or whether the market is high or low makes sense, but nothing could be further from the truth.  Base your investment strategy on evidence and logic and all of this stuff just becomes noise.

Research On Getting Rich

For those intent on building their wealth, the focus is often on saving and investing.  There are countless articles on how to save money by cutting out that daily Starbucks latte, and then how much that will compound if invested wisely.  While there is no problem in focusing on frugality and investing, a new study finds that we may be focusing on the wrong factors.  The author of the study researched 233 self-made millionaires and found they fall into one of two categories:

  1. They were fanatical savers or
  2. They sold something

The article went deeper on this topic:

The average net worth of these 135 millionaires was $5.7 million. Seventy-one percent accumulated their wealth before the age of 56, or on average, in less than 22 years.

The millionaires who were fanatical savers had an average net worth of just over $3.2 million, accumulated over an average of thirty-six years.

In other words, those millionaires in my study who sold something had a net worth that was $2.5 million higher than the savers in my study and it took the sellers 14 fewer years to accumulate that wealth. Clearly, if you want to accumulate a lot of wealth in the shortest period of time, you need to sell something.

Those that sold something had higher net worths and incomes compared to millionaires that were more focused on saving.  Now, I am not saying you should forget about saving and investing to build your wealth.  What I am saying is that most of us miss one of the most important aspects of wealth building:  their income.  Those that sell something presumably have the ability to save more because they make more.  If you want to build wealth, keep this in mind.  Selling is not easy (which is why successful sales professionals get paid more), but for those who are looking to grow their net worth, this may be a great place to start.  The author ended the article with a list of well known wealthy individuals who focus on selling (or at least that consists of a part of their job):

  •     Warren Buffet sells his financial expertise.
  •     Elon Musk sells his Tesla cars or the use of his Space X rockets.
  •     Mark Zuckerberg sells Facebook advertising and marketing services.
  •     Dr. Ben Carson sold his expertise as a neurosurgeon.
  •     LeBron James sells his basketball skills.
  •     Tony Robbins sells his motivational and training seminars.
  •     J.K. Rowling sells her Harry Potter books.
  •     Taylor Swift sells her love songs.

 

 

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.