Beating the Index or Betting your Retirement

One of my favourite subjects in the futility of active investing. A 21 March 2016 Financial Times report found that 86% of active equity funds in Europe underperformed the benchmark indices over the past decade. This includes 100% of actively managed funds in Netherlands over the past 5 years! Also 95% in Switzerland and 88% in Denmark. Among US active funds, 98.9% over past ten years, 97% of emerging market funds, and 97.8% of global equity funds. These percentages are after considering the fees. As I often have remarked, yes you can beat the index over a year, but as the time horizon gets longer and longer, you are left with Warren Buffet. And, could you have predicted Warren Buffet thirty years ago?

The financial industry is truly run for the employees, not the customers. At least the US consumers are becoming savvier as last year (2015), active funds had a net outflow of $100 billion while passives attracted net inflows of $400 billion. Of course the smart people in the industry keep coming up with new strategies to beat the index. However, since passive funds are so much cheaper to run than active finds, any new strategy must be able to not only beat the index but must also cover the costs of active management. More recently, the fad had been for “smart beta” which would beat the index. One example of smart beta strategies has been value investing believing cheaper stocks do better than more expensive ones. Other smart beta strategies include low volatility – stable stocks perform relatively better or momentum – winning stocks continue their winning streak while losing stocks keep falling out of favour. Sometimes, these may work for a short period. But then everyone piles in and returns fall to normal – i.e., cheaper stocks get bid up. Of course, to show superior performance, active managers find the exact time period of “over-performance” and then advertise it as their ”representative” performance.

You would think that if active managers, whose job it is to beat the index, are unable to do so, there is little hope that an individual investor can pick stocks. Why would you succeed where an expert fails?  The New York Times had an excellent article on this which used well known results from the academic psychological literature. The most important is the “over confidence bias” which leads us to believe that we are better than average investors just as most people believe they are smarter than average and better than average drivers – all statistically impossible.

http://www.nytimes.com/2016/03/27/your-money/why-we-think-were-better-investors-than-we-are.html?smprod=nytcore-ipad&smid=nytcore-ipad-share

We human beings fall into these decision traps often, and not only when we are investing. One of the findings is that because of “loss aversion” bias – we hate to acknowledge the loss, people sell those stocks that are doing well and retain those that are underwater in the hope they will turn around and revert to the price paid. Thus, investors sell the winning stocks in their portfolio too quickly and hold on to their losing stocks for too long – ending up with a portfolio of ”losers”. 

At cocktails, people will often boast of this or that stock on which they made a lot of money. Two things happen here. First, there is no accounting of the baseline – perhaps they would still have been better off placing their money in a passive fund. Second, they only mention the winners, not the losers as people want to maintain their positive self-image.  You observe this in spades in the art world, especially the contemporary art world. I was with a couple, who are among the largest collectors of Chinese art in the world, having dinner on Singapore’s waterfront. The husband tells me how this artist they bought for $10,000, now sells for more than a million. Without knowing the details of their art collection, I remarked to them that you own more than 5,000 works of Chinese artists, I suspect most of them you probably can’t sell or at least for anything close to what you paid for. The wife looked at me and nodded her head. Most contemporary artists end up on the garbage heap of the forgotten.

And, finally even if we acknowledge the losers, the “attribution bias” leads us to argue that this poor outcome was the result of external factors such as the market went down. However, positive outcomes are attributed to the self – my great insight or efforts led to the glorious victory. This is a stable finding – analysis of annual reports of companies, CEO statements on performance, and numerous other applications.

Finally, here is the data from the Indian market on performance of different asset classes for different periods. If you are long term and can live with the volatility, then equities is the reasonable option. However, for some reason passive funds don’t exist in India – we are still waiting for the India Jack Bogle (champion of passive funds and founder of Vanguard the largest passive player in the word). 

What should one do after retirement with all the money and time. An article on that:

http://knowledge.wharton.upenn.edu/article/the-retirement-problem-what-will-you-do-with-all-that-time/

Warmly

Nirmalya

Magic Dust

http://theculturetrip.com/europe/united-kingdom/articles/the-10-must-see-buildings-designed-by-zaha-hadid/

6 Comments Add yours

  1. Muralikrishna says:

    Thanks for your insights Sir.. way to go! keep sharing your wisdom 🙂

    Liked by 1 person

  2. Superb analysis. Let me take three examples to explain staying invested in the rt class
    1.If you bought shares of TCS worth 25Lakhs at IPO it is today worth 3 crores.Dividends of 15Lakhs n profit tax free
    2.If you bought 1acre of land in KumbanadKerala for 38lakhs in 2008 it is today worth 4crores.Profit taxable unless invested in Govt stocks for 6yrs
    3.If you bought 100shares of Bosch in June 2015 and traded moving “with the market” you would have booked profits of close to 10Lakhs.Profit taxable.

    Like

  3. SID says:

    Marketing, psychology and finance – one really need to think from multiple disciplines to be successful in life… By law of averages, most people can’t beat it

    Like

  4. sharad says:

    interesting read, great learning

    Like

Leave a reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s