What? Me Worry?

Michael L. Gay, MBA, CFP®

During the past decade, investors had an awful lot to worry about. 

From the aftershocks of the 9/11 terrorist attack and an ongoing war in the Middle East, to an unprecedented rise in oil and gas prices, investors had little in the way of good news to think about.

……not to mention:

  • the most severe financial crisis in our history (which included a 46% decline in stock prices)
  • a historic collapse in housing prices
  • a sovereign government that was so incapable of making sensible financial decisions that its debt was downgraded
  • historic U.S. federal deficits

And today, heading into 2013, things are no different.  The media has peppered us with headlines of a looming “fiscal cliff” and the related possibilities of large tax increases, massive cuts in federal spending, and a subsequent recession. 

…..not to mention:

  • the possibility of war or a potential nuclear event with Iran
  • the potential of increased inflation caused by the Federal Reserve’s stimulus programs
  • the reality of an ongoing financial crisis at home and in Europe
  • repeated warnings from the financial press of an inevitable collapse in the dollar

And, once again, investors have little in the way of good news to think about.

Which makes me think that the next decade may very well be just like the last one.  Which is to say:

A very good decade for passive investors. 

You see, despite all the crises, despite all the worrisome possibilities, and despite all the “risk on, risk off” talking points raised by Wall Street and its agents in the media, investors who managed to ignore all the noise fared quite well.

Because during the past decade (the 10 years ending 8/31/2012), an investor who held a simple buy-and-hold portfolio of 10 common asset classes earned an average annual return of 10.8%.  That’s a 160% increase in wealth during what was arguably one of the most volatile decades since World War II.

And all that was required of investors was a bit of discipline.  The discipline to create a goals-based allocation and stick with it through thick and thin, ignoring (or, at least, not acting upon) pretty much everything reported by Wall Street and its agents in the media.

So the next time you are tempted change your portfolio based on the latest bit of commentary about the “fiscal cliff” or who won the election (or any other bit of headline news), take a deep breath and remind yourself that living with market volatility is the price we pay for earning the return we need to achieve our most important financial goals. 

Such is the nature of risk.  And without risk there would be no reward.

The Soothsayers are Few and Far Between

Michael L. Gay, MBA, CFP®

The question is decades old: Can professional money managers consistently pick stocks that outperform the broad stock market averages – as opposed to just being lucky now and then?

Countless studies have addressed this question, and most have concluded that very few managers have the ability to beat the market over the long term. Nevertheless, researchers have been unable to agree on how small that minority really is, leaving the industry to debate whether it makes sense for some investors to try to beat the market by buying shares of actively managed mutual funds.

Recently, a new study was concluded which used a far more sophisticated statistical analysis than we’ve seen in the past. The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas”, uses a sensitive statistical test (the False Discovery Rate) borrowed from astrophysics and chemistry, among other scientific communities.

In effect, the method is designed to simultaneously avoid false positives and false negatives — in other words, to avoid concluding that something is statistically significant when it is entirely random, or that something is random when it is statistically significant. Both of these problems have hampered many previous studies of mutual funds.

So, what happens when you apply the False Discovery Rate test to 30 years of data (and almost 2,100 actively managed funds)?  The researchers – Professors Barras, Scaillet, and Wermers – found a marked decline over the last two decades in the number of fund managers able to pass the test. They found, for example, that 14.4% of managers had genuine stock-picking ability back in 1990; by 2006, however, they found that the proportion had declined to just 0.6% – statistically indistinguishable from zero.

This, while not surprising to those of us who have spent years standing passionately behind our “passive beats active” mantra, is yet another stunning blow to the financial services industry. It is also, one can hope, a wake-up call for those investors who still believe in active management; perhaps they will finally realize that the gamble they are taking, at significant expense, has an expected return of less than ZERO.

Why the decline?

Professor Wermers says he and his colleagues suspect several causes, including high fees and increasingly efficient markets. Whatever the cause(s), the investment implications of the study are the same: buying and holding low cost passively-managed funds is the only rational choice for most, if not all, equity investors.

 The financial services industry will, of course, continue to promote its rock-star money managers, doing all they can to convince you (and themselves) that extraordinary skill (rather than luck) is the reason for their 5-Star rating.  But, as we now know with certainty, it’s luck – not skill – that most often results in market-beating performance.  As this study makes perfectly clear: The soothsayers are, indeed, few and far between.