Greedy Goblin

Wednesday, March 5, 2014

Active portfolio management is theoretically useless

Real world economy post here, if not interested, move along.

Below I'll disprove the foundation of the stock exchange system: the idea that by proper placing of your investments, you can earn above the market average. Before we'd continue I'd like to clearly state that I do not say that you can't earn money by investing. As the GDP grows, the average stock value is growing, so if you buy the index, you win too. What I'm claiming is that it's theoretically impossible to beat the average on average.

The "average is average" is quite obvious and many people have already given up hopes for above-average returns by turning to passive investing. It is also coming up again and again that monkeys beat investment bankers, never stop causing hilarity.

However there is a consensus that one can consequently beat the market index, if he does it well. This consensus accepts that the average guy can't do it (because he is mediocre), but with proper skills it is possible. Every single investment banker or broker claims to have these elusive skills and reaps very nice management fees in return of his valuable services.

I'm hereby claiming that every single investment banker is an astrologist and his performance is based on nothing but blind luck, therefore no one should use their services, but either buy the index or trust his portfolio management to monkeys.

The proof is coming from realizing that the investment banker is doing the very same thing as the bureaucrats in the central economy planning department of a communist state. They both try to figure out what is best for the system and support the best plans with investor or state money.

Every single country with planned economy sank to poverty, despite its theoretical advantages and despite inhuman effort to make communism work. This forces us to accept that no one is capable to properly predict the economic future. This is caused by two major things: one is the inability to assess information that is not present in the decision time. For example Contergan was found a great drug by every tests of the time and no one knew that it causes malformations if pregnant women take it, since back then tests did not include this area. Therefore every reasonable decision makers did accept it. In a planned economy system this would mean Contergan being the only drug as all alternatives are canceled as redundancies and when the truth is found, the country is left with no drug. In a market-driven system there are always competitors and you could shift to them instantly. The other reason for the failure of planned economy is corruption of course.

If a broker would be able to constantly beat the market, everyone would soon hire him manage their investments, effectively making him the central planner of the economy (as he invests all the money of the country). As we've seen that such central planning cannot succeed, this broker cannot exist, so any kind of active portfolio management is folly.

PS about Warren Buffet: I got so many comments about Warren Buffet (one of the most successful investors) as counterexample. I first just deleted them, as you can surely find a "good" astrologist, someone whose predictions were found true more than average. If you hire 1000 people to toss coins for you, few of them are bound to have lot of heads and you can "rightfully" claim that they are very skilled coin tossers. Then I placed "witty" comment "Buy American. I am.", referring to his advice to buy American papers, right before the sub-prime crisis.

But after some thinking I found the proper rebuttal to the "Warren Buffet did it": he is giving his money away to charity unrelated to his work. This means that he doesn't consider his previous work a positive contribution to the World. Giving away his money is his admission of gaining it in zero-sum actions. Not illegal of course, but worthless in the big picture. He wants to be remembered as a philanthroph and not as an investor. If he'd believe that his investments enriched the World, he would do everything to upkeep his heritage: funding economy universities, organizations that teach investing, forming stock exchanges in poor countries so the World can enjoy the fruits of good investing.


Arrendis said...

Yes and no.

You're completely correct in that no broker can constantly beat the market - but a broker can consistently beat the market. Not 100%, obviously, but if someone's right even 60% of the time, then they're going to make you more money, overall, than just investing the index would.

The other place you're off is when you say the broker's doing the same thing as a central planning office. The broker isn't trying to decide what's best for the economy, only which of the available choices is likely to perform well. The central planner, for example, has to worry about exactly what you say: where are the hidden costs? What don't we know about how things will develop?

The broker, by contrast, only has to worry about how things are performing over the next few months/weeks/days/hours. He's got the freedom to make a massive investment if he thinks something's coming, let the stock jump, then bail out on it and display absolutely no confidence in the very thing he was hyping the day before.

Many of the most successful brokers do exactly that - a close friend of mine used to work on Wall St, and that was his whole game: figure out what stock was going to have a minor uptick, convince a whole lot of other brokers that uptick, when it came, was only the beginning of a massive price spike, and then let them drive the prices up, fulfilling his prediction.

Then he'd jump ship, cash out, and buy something else before repeating the process, pointing to the very results of his con to establish that he knew what he was doing, so of course they should listen to him now. After all, his numbers were stellar.

He played that game for about 10 years, then married a model and moved to California, stupidly wealthy.

(Incidentally, that guy's why I have no faith in the finance industry. It's a bunch of grifters, scamming one another.)

A Central Planning Office clerk can't do that. He doesn't get to slam on the brakes and throw the entire economy in another direction after he's made his money.

Von Keigai said...

It is true that the median money-manager does not outperform the market. However, this is untrue of many money managers. Perhaps a quarter of them in any given year outperform the market. Some of them do so repeatedly.

So, i.e Warren Buffett (who contra to your idea has beaten the market consistently for years) is a self-made multi billionaire. Because he has beaten the market so consistently people have beaten a path to his door to give him money to invest. He has ended up with a large personal fortune, as well as control (on behalf of his stockholders) of a large portfolio.

A socialist apparatchik cannot do the same thing, no matter how skilled he is at choosing winners, because he does not gain significant money or power reward for good investing. There is no feedback loop in which his good investments cause him to gradually gain control of more and more capital. Thus, the rare man who is actually a good investor (and presumably they exist in socialism about as much as anywhere else) will never be discovered in a socialist system.

You can read up on the scholarly debate on the issue under the label Economic Calculation Problem; the particular issue you are interested in here is that of financial markets.

The position of a socialist apparatchik and a capitalist are different. This is why you are wrong.

Anonymous said...

Agreed that perhaps a quarter of fund/money managers outperform the market, however in saying that less than 1% do it to any "significant" degree.

In saying that, I'm not here to criticize your post, but I am a subscriber to the passive investment theory.

Roll on the debate over whether markets are efficient/inefficient....
and have you noticed the contrasting viewpoints of the three shared winners of The 2013 Sveriges Riksbank Prize in Economic Sciences.

Gevlon said...

@Arrendis: pump and dump is illegal. Also it does NOT make money to the client. What you described is simple corruption and a good reason NOT to give your money to a broker.

@Arrendis: there is a feedback loop in communism: the good appartchik gets promoted. If Warren Buffet was consistently good (and not just having a lucky streak mixed by not being afraid of investing into non-conservative assets) he could become the head of the planning office making the final call.

Also, there were many communist countries for many years and within those, many regions. A "rare man who is actually a good investor" would necessarily become a high-ranking party official by blind luck somewhere. In this region he could make a miracle growth gaining worldwide attention.

Anonymous said...

So there are no individuals who run an investment fund that you would use?

I agree no one wins every time, but, then no one expects them to win every time.

Pump and dump may be illegal, but short selling is definitely not (Whether it should be or not is open for discussion, and it is of course, open to corruption, as is anything in life)

TA in market use is complete woo in my opinion (although I understand it is very popular), as it tries to predict without knowing why things happened. As one of the Forex guys says "We don't care WHY the market moved we just care that it did".

The good investment broker will know why the market moved, and understand how people react to situations, so is as much a psychologist as an economist.

Even given the understanding of how people react, of course the markets are not guaranteed to make you money, anyone who invests thinking that is not someone who should be in charge of investing.

People also lose out because they think very short term on the market, and, this plays to the brokers....when stocks fall, or house prices plummet, your average investor panics and sells. The smarter guys know the markets always pick up, and investing is not a short term game.
As in Eve, the trick is to know when the market has topped out (and not to kick yourself when you exit a market a bit too early)

nightgerbil said...

"there is a feedback loop in communism: the good appartchik gets promoted. If Warren Buffet was consistently good (and not just having a lucky streak mixed by not being afraid of investing into non-conservative assets) he could become the head of the planning office making the final call."

Thats not true at all. In any system of local goverment it how good a politican you are not how good at the job you are that dictates wether you are promoted. Net working and social/political skills are what is needed to advance and they are a differnet skill set to financal awareness, project managing or understanding statistics.

What would have happened is warren buffet would have been used as a tool by his bosses to promote their careers and he would have remained a minor clerk (in the trap of being too good at his job to be promoted from it). Unless hes also a very good politican.

Anonymous said...

I dont disagree with your comments at a basic or general level. But do you actually know who Warren Buffet is and what he has achieved with this investment company in the last 50 years?

Oska Rus said...

Your reasoning is too simple to be close to reality.

IMHO similarity of fund mannager and central planner is more in working with someone others money than with centralism. Youll never be motivated to work effectively with someone others money (property, work) than with your own.

Gevlon said...

@Anonymous: "Buy American. I am."

@Oska Rus: I mentioned corruption. Either way, the central planner is doing the same thing as the investment broker: manages other people's money for growth.

Anonymous said...

To Annon - "I dont disagree with your comments at a basic or general level. But do you actually know who Bernie Madoff is and what he has achieved with this investment company in the last 50 years?"

I fixed that for you.

Buffet just hasn't been caught yet.

Ephemeron said...

Every single country with planned economy sank to poverty, despite its theoretical advantages and despite inhuman effort to make communism work. This forces us to accept that no one is capable to properly predict the economic future.

"Flight by machines heavier than air is impractical and insignificant, if not utterly impossible." -- Simon Newcomb, Director, U.S. Naval Observatory, 1902

The failure of communist regimes does not necessary mean that planned economy is intrinsically doomed to failure for ever and ever. They may have simply lacked the necessary computer technology at that time.

Basil said...

Buffet barely beats the market. He does slightly better because he has the advantage of scale on his side. If he is shopping around for a place to dump his latest profits that will make as much profit as his target, he can call them and tell them to stop wasting money on unnecessary growth.

Most companies are trying to impress short-sighted investors, and that's done by growing. He's more impressed with profit margins. And if you get a call from someone offering to buy the entire company and let you stop worrying about short-sighted 3 month investors and stick to worrying about how to make the company profitable for the long term, you take that call. If one of us with the same wisdom makes that call, we don't get through.

So in essence, in my opinion, Buffet gets what the market should. He only beats the market because it's wound up and filled with stupid people that try to sell active investment portfolios and convince companies that whatever it does to their long term performance, they need to grow this quarter.

Anonymous said...

Re buffet, its also worth noting that of the players able to achieve such status, they are fantastically rich, is the people trolling for money to invest really those people?
also at this point buffet is to big to fail, if he were to invest in hot air balloons as a replacement for air travel enough dumb money would follow.

besides the best stock tip you can get is this, buy the 10 best stocks of last year.
studies have shown it beats the index more often than not, something, Very, few brokers can boast.

TL;DR, just as in say poker, most of the wealth accrued in the system (stock broking) comes from the dumb money, like the people playing shit hands instead of folding before the river in holdem pays for my student loans.

Anonymous said...

You're basically reiterating the core conclusion of the Efficient-market hypothesis which has been largely discredited. If markets were efficient, then it would not be possible to consistently produce abnormal (above market) returns.

However, existence of financial bubbles demonstrates that markets are not completely efficient, because not all market participants act completely rational all the time. Bitcoin for instance is the latest (and purest) financial bubble as it has no intrinsic value whatsoever and there have been more than enough recent and not so recent examples of other bubbles. So, if markets are not completely efficient, inefficiencies exist that can be exploited to generate abnormal returns.

Let's looks at this from another angle. your argument that some people are bound to have more heads than tails or vice versa if you let enough people toss coins is in itself correct. If we let a number of people toss coins and then look at the difference between the number of head and tails for each individual, those differences will follow a normal distribution with an expected value of zero. You will also be able to calculate the standard deviation and the odds of someone's results deviating from the expected value by a given margin.

We can use the very same principle for investing. If markets were efficient, the average above market returns of investment managers would conform to a normal distribution with an expected value of zero and there would be only very few individuals consistently generating excess returns. However, this is not the case. In reality there are many more people consistently "beating" the market than there should be if markets were indeed efficient. Thus, we can conclude that they are not efficient and that abnormal returns are a possibility.

Gevlon said...

@Anonymous: I claim that markets are theoretically unpredictable, therefore "efficient" has no more meaning as "being efficient in predicting coin toss".

If there are people who consistently beating the market, why aren't THEY the market? I mean there isn't theoretical barrier over investment money flow, one broker can literally manage all the money (while it's impossible for everyone to buy a Ford next year). In other words, if there are good and bad brokers, what makes the bad ones in business?

Anonymous said...

There is so much misinformation in your post and in the comments that reading has become painful for me. I won't refute any of them, it isn't worth my time.

Over a ten year span, about 85% of money managers fail to outperform the S&P. Point being, there are plenty who do.

As of year end 2013, Berkshire's return in the 49 years since formation is 19.7% compunded annually. The return of the S&P including dividends in that period was 9.8%. I wouldn't say that Berkshire is "barely" beating anything. Buffett tends to underperform the S&P in years where the index does exceedingly well, (which is what happened last year) and outperform when the index does poorly. Berkshire has only failed to ourpeform the S&P in 10 of its 49 years.

More importantly, ALL of Buffett's methods for buying publicly traded equities are common knowledge, documented in an endless stream of books that any swinging dick can buy. Anyone that can fill out a spreadsheet can invest like he does and do quite well at it. Unfortunately most people are emotional about money and don't have the patience for the methods.

With all that said, doing "well" doesn't mean you get rich overnight. It means you get rich very slowly and very surely. Gevlon, if you would like more information about Buffett's investing methods just post up in these comments, I will send you a list of books via in game email. Just a fair bit of warning up front, most shares are overvalued at the moment with few exceptions so if you employ his methods you are going to be sitting around with nothing to do for a while, waiting for things to get cheaper.

Satori Okanata said...

Real state for rental units and Preferred stock (in that order) is the way to go.

Provi Miner said...

some thoughts frist off a planned society gives rise to the "good boy" net work. success is not a measure of advancement. In fact it is a hinderence IMO. Your best bet to advancement in a planned economy is let others take the risk and when they are wrong slam them into the ground and trod on their rotting corpses. Next buffett first off he fails more then he succeeds (I know it sounds odd but stay with me). His success out weigh his loss's and thats the point. Google has an internal philosphy of "Fail Fast". Essentially buffett and google play the same game explore XYZ devote resources to XYZ. Then if Z is underperforming dump it before more resources are sucked in. If Y is performing dump the conserved resources from Z into it. Rinse and Repeat. I think his success with companys is under 40%.

Now for the final last thought and the one take away that all investors need to understand there is no difference between buying a stock and hitting the 21 table. Both are the same investment. You can improve your odds with knowledge (understanding business trends ie card counting) but you can not and should not expect to beat the house day in and day out on every deal.

Petri Petrified said...

An interesting analogy, however, there is a significant difference between A government doing central planning and an individual - one risks the assets of a nation and enforces it's ability by law while the other bears the burden (along with others who invested with him) of risk and any changes in the law.

The ability to see trends, not to be bogged down myoptically but to see the overall pitcure is something not everyone has. A few people have it and use it in the financial sector. They tend to be more successful than others with the money entrusted to them. Not perfect, but they gain more than they lose.

As for Charity, it is far better for the individual to give to the needy than the State. The willful giver vs. the coerced.

NH said...

Basically you're stating the efficient market hypothesis - to which I agree with.

However, there is a small paradox with the issue: the reason no one can beat the market more than random chance is that because everyone is trying to beat the market (by active portfolio management). In other words, if everyone invests in index fund, the only one guy who does active investing would then beat the rest(and then beat the market average).

NH said...

Another note: your comparison between the investor and central planning committee is not quite apt. The biggest difference is that there is multiple investors trying to maximize the return: some investors might prefer Contergan, but there will exist some others who distrust, or prefer other drugs - for one reason or another. And THAT is free market at work.