Wednesday, 27 August 2008

Why Pros Will Not Automatically Outperform DIY Investors

On August 22nd, Larry MacDonald published a note about another investment pro David West dumping scorn on the ability of DIY investors, following on the one put out in July by Avner Mandelman. Various commenters and blogger CanadianCapitalist rebutted the fallacy of professional outperformance in the simplest fashion - it generally is not true! Duh!

There's a fundamental reason why professional stock and bond pickers cannot and almost certainly will never be able automatically to do better than individual DIY investors - investing outperformance requires the successful prediction of the future and the future is complex and very uncertain. Too many factors and events, including especially the decisions and actions of that most bizarrely partly rational and unpredictable animal, the human being, make it extremely difficult for anyone to be able to reliably and repeatably pick the winning (or losing) investments. Investing is NOT like accounting or lawyering, two professions often cited as examples where the professionals' expertise produces better results that an amateur can do. These professions work within a body of knowledge, and a large one at that (which fact alone makes it impossible to do as well as the pro) which gives the pro the advantage. You can actually learn all that you need to guarantee success. Results are most always predictable according to the actions. Not so with investing. Having a Chartered Financial Analyst diploma (the gold standard of investing knowledge) and faithfully applying those methods does not ensure success.

[Part of the problem with discussing DIY investing is that financial planning gets mixed into the investment picking - the tax body of knowledge can influence net investing results and there the pros do have an advantage when things get more complicated. For the average RRSP Joe, things are likely so simple that a couple of high school courses on managing your money could suffice. The point is that financial planning ≠ investing.]

Some commentators like Nassim Nicholas Taleb in his book Fooled by Randomness, maintain that stocks and markets are essentially and inherently unpredictable and that therefore no one can presume to always beat the market. Less well known but far more informed and serious scholars such as Richard Lipsey, Kenneth Carlaw and Clifford Bekar in their opus Economic Transformations argue that society-altering technologies "cannot have unique pre-determined results"(p.16). At a macro level winners and losers cannot be predicted and so will that be the case at the micro level of the companies that develop and use the new technologies to make profits (e.g. Microsoft). With different conditions, it could have been Corel. It isn't hard to believe the plot device in Sliding Doors, where someone's whole romantic future depends on whether she catches or barely misses a subway train home.


Michael James said...

Good post. I agree that uncertainty about the future is a big reason why pros can't beat the index. Another reason is the incentive structure that many pros work within. Many are closet indexers making only small bets because they get to keep their jobs as long as they don't underperform too much. Why bother taking risks to go for big returns if you'll be fired when things go badly?

Anonymous said...

Thanks for the mention. The paradox with hiring someone for managing your investments is that you'll need some knowledge of managing money to tell if they are any good. But if you had that knowledge, you don't have to hire an investment advisor anymore!

CanadianInvestor said...

Yes CC, a variation of that thought is what led me to decide to ditch actively managed mutual funds - instead of researching stocks myself, I had the time and effort of researching managers. Either one should go direct to stocks oneself or not do it at all and just go for passive indexing.

And yes, MJ, the pros are probably just as subject to human behaviour failings as we individuals, only maybe not the same ones.

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