Efficient Market Hypothesis
Starting with the theory, most economic doctrine is underpinned
by this EMH premise, which makes a lot of assumptions about rational behaviour,
perfect information, etc. Basically everything is already in the price thanks
to the efficient market. If you believe this, then it leads towards a passive
index approach, because there is no value arbitrage to be monetised via active
investing.
I don’t believe markets are efficient in this sense. You
just have to look at the bubbles and crashes to see that the level of price
variation goes far beyond the movement in fundamental asset value. Largely this
is because of human behavioural aspects, e.g. fear and greed, which defy the
assumption of rational behaviour. So then, does that make me an active investor
? Well not really nowadays, but I have certainly tried over the years.
Basically I evolved to the view that it is possible, but not easy, to beat the
market. A safer and more reliable approach is to simply accept market returns,
focus on asset allocation and minimise costs whereever possible.
Follow the smart money
It’s funny to hear phrases like this. I thought all those
$20 notes were the same, but apparently some are smarter than others. And then
there’s the “dumb” money going into passive index funds. Diworsification, as
some traders/investors/fund managers might mock. You hear comments like “why
would you want to buy the index when it means you’re going to own BHP / WOW”
(or in the past it would’ve been TLS, or whatever company/sector is out of
vogue). I don’t really buy into these arguments. Call me cynical, but if
someone really had an investing edge to sustainably beat the market, then they
should be smart enough to use it to their own advantage and bet their own money
(with leverage of course). I guess most of them must hope for healthy overall
market performance in which case many investors will gloss over the issue of
performance vs benchmark and fees.
There is one glaring case that deserves a special mention.
This of course is Warren Buffett and Berkshire Hathaway. Surely this must be the
poster child for active investment. But is he the exception rather than the
rule? Statistically you would have to say so.
Stock picking and market timing is foolish
At the other end of the spectrum, you will hear index
advocates pan active investing as foolish and pull out any number of statistics
to support their view. You will read a lot of this especially if you hang
around bogleheads, MMM, etc forums. While I have gravitated towards this end of
the spectrum, I am certainly not in this camp either. As I said already, I
believe it is certainly possible to beat the index, just not easy. However for
those who have the interest, desire and mindset, I think it certainly is a
valid approach to pick stocks and/or time the market. Some of the biggest
investment opportunities I have seen in my lifetime have been during market
crashes (2002/3 Iraq war, 2008 GFC). If you had the temperament and conviction
to buy when everyone else was running for cover, then these opportunities (that
will come up a handful of times in your life) are huge shortcuts to FF. Of course,
the opposite is also true. If you don’t have the temperament and discipline,
then you will end up buying the bubble and selling the crash, which is a great way
to extend your working career. I will say it again, it’s not easy to beat the
market. One might think bottoms and tops are easily spotted on a chart, after
the fact. They are much harder to see at the right end side though. And further
to this, even if you can pick the top/bottom, will you have the conviction to
trade it.... Or will you lose your neutral, unemotional view and get caught up
in the fear/greed like most others ? I’m convinced the mindset factors are
critical to success. Unfortunately human beings seem to be hard wired to fail
at speculative investing. As I read somewhere, you need to reverse your natural
instincts. Learn to be fearful with your losing trades (cut loss) and greedy
with your winners (let profits run). Most people are fearful with their winners
(worry about giving up gains / being “wrong”, take profit early) and
greedy/stubborn with their losers (hold on and hope, usually as losses get
magnified).
So far I’ve been talking market timing but how about stock
picking - can one even hope to compete with the army of market analysts out
there ? At risk of sounding like a broken record, I think it will be tough. Even
to find the time to read all the annual reports and company disclosures
nowadays is a challenge. Also one of the key drivers is the quality of
management. Is it possible to really judge this as an amateur investor who will
never be granted a private audience with the CEO and management team of a
listed company ? It really takes skill and effort to succeed here, but again,
I’m sure it’s possible. Personally if I had to pick one or the other, I would
choose market timing as a better chance of success, purely because of the
market cycles of fear and greed that you can try and gauge (provided of course that
you can remain adequately detached yourself!).
Willingness, capability and need to take risk
I think that’s a quote from the bogleheads, and something
I’ve found quite instructive. For me, nowadays, there is not much need to take
risk. Therefore I’ve kind of ended up ditching any thoughts of active
investing. Even though I believe it’s possible and I have an interest in the
area, why bother if there is 1) no need and 2) bearing in mind my view that
it’s not easy to achieve a positive result. If I was starting out again, or still
on the journey to FF (i.e. 1) does not apply and there is a need), I guess I
would be tempted to give active investing a try. It is yet another “shortcut to
riches” that I have written about before. But I hope ultimately I’d have the
sense to follow my own advice and stick with the boglehead approach, which I
have now broadly adopted (although not in a religious way). Nearly all of it
resonates with me, especially the part about minimising costs (why pay for your
fund manager’s Ferrari). I think investors are spoilt nowadays to have index
ETF’s with such negligible fees. Really when you think about it, having the
opportunity to invest in 100’s or 1000’s of companies with a relatively small
amount of capital and paying <0.2% p.a. Most people would be best served to
be thankful for such facilities. Just take this easy option and find a less
costly hobby. Old habits die hard though, and on the market timing front, I
haven’t entirely given up : I am holding a decent cash allocation and hoping I
will have the courage to “fill my boots” should another serious market panic
arise in the coming years. I do slightly regret missing the previous few opportunities
I’ve had in my investing lifespan.
Active investing
I’ll just finish with a few thoughts on what it might take
to succeed as an active investor. As already stated, I’m not an active investor
myself so take it for what it’s worth...
Firstly, should you DIY or delegate to a fund manager ? I
think it depends on your capability, interest and approach. In most cases, it
will be better to use a fund manager. And if you DIY, you should mentally
consider it as though you are employing yourself as a fund manager. Sounds a
bit silly/contrived, but basically you need to have two hats, one as the
investor and another as the fund manager who works for the investor. This fund
manager should prepare an investment plan, quarterly reports to review results
and actions taken. The investor could even pay the fund manager (a notional payment
of course, it’s all your money afterall) a fee of say 1% of funds under
management, and see if this fee is recovered or even outperformed. Basically
the point is you have to treat it like a pro. If you are going to be an amateur
/ hobbyist, then either don’t do it (use an active fund manager or go back to
indexing), or keep the percentage of assets low, e.g. 20% max, to minimise the risk
to your hard earned stash.
Secondly, if you decide to use an active fund
manager, the question will arise of how to pick one. As many researchers have
shown, past performance is not a reliable indicator. So I wouldn’t just pick
the fund with the best returns last year. Really you are betting on the fund
manager’s skill and capability so it makes sense to get to know the fund
manager. As a minimum, read their prospectus and market reports. Do they have
an active website/blog which gives good insights into their investment
approach. Do you understand what they are doing and their strategy to beat the
average market return ? Are their fees reasonable ? These are the questions I’d
be asking myself. If all else fails, there are some Listed Investment Co’s in
Australia and a very notable one in the US that have a long track record of
solid performance and reasonable fees. They might be a good starting point for
your research!
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