Archives for October 2011

Daniel Kahneman, behavioral economics guru and Nobel Prize winner, has a new book out called Thinking, Fast and Slow. This one is definitely on my to-read list. You may remember him from his TED Talk about Happiness = Earning $60,000 A Year?

He wrote an article for the NY Times called Don’t Blink! The Hazards of Confidence (a little jab at Gladwell?), which covers one of the cognitive fallacies discussed in the book caused by overconfidence amongst professional stock-pickers and money managers. First, he covers what some of you may already know about the performance of actively-managed mutual funds:

Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.

More important, the year-to-year correlation among the outcomes of mutual funds is very small, barely different from zero. The funds that were successful in any given year were mostly lucky; they had a good roll of the dice. There is general agreement among researchers that this is true for nearly all stock pickers, whether they know it or not — and most do not. The subjective experience of traders is that they are making sensible, educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are not more accurate than blind guesses.

The second story was more personal, and had to do with a small group of financial advisors.

I asked for some data to prepare my presentation and was granted a small treasure: a spreadsheet summarizing the investment outcomes of some 25 anonymous wealth advisers, for eight consecutive years. The advisers’ scores for each year were the main determinant of their year-end bonuses. It was a simple matter to rank the advisers by their performance and to answer a question: Did the same advisers consistently achieve better returns for their clients year after year? Did some advisers consistently display more skill than others?

To find the answer, I computed the correlations between the rankings of advisers in different years, comparing Year 1 with Year 2, Year 1 with Year 3 and so on up through Year 7 with Year 8. That yielded 28 correlations, one for each pair of years. While I was prepared to find little year-to-year consistency, I was still surprised to find that the average of the 28 correlations was .01. In other words, zero. The stability that would indicate differences in skill was not to be found. The results resembled what you would expect from a dice-rolling contest, not a game of skill.

My, that must have been an uncomfortable presentation! Investing is an area where it is very hard to discern skill from luck, so be careful when asked to pay a nice chunk of money for it, be it through mutual fund expense ratios or portfolio management fees.

Vanguard’s research division published a new report [pdf] that found that a portfolio split 50/50 between stocks and bonds had very similar inflation-adjusted returns regardless of whether the U.S. economy was growing or in recession. Here are the numbers from 1926-2009 taken from the report summary:

Given that timing recessions and expansions has been shown to be very difficult, this would suggest that making big asset allocation moves (bets, really) to 100% stocks or 100% bonds in anticipation is not worth the effort.

It also reminds me that as a portfolio asset allocation gets closer to 50/50, the swings in return each year are less wild. After 2008 and 2009, I think many people have a new appreciation for lower volatility. Maybe it would be better for many investors that don’t have full “faith” in the stock market to move their asset allocation to 60% stocks/40% bonds or similar, instead of the 80 or 90% stocks that some calculators or target-date retirement funds would suggest.

Along those same lines, Morningstar has found that most “tactical asset allocation” funds have had a hard time beating the simple-and-cheap Vanguard Balanced Index Fund (VBINX), which is basically just two index funds in a fixed 60% stock/40% bond ratio. The 10-year returns are in the top quartile of similar funds, with a below-average standard deviation.

Vanguard recently decided to kill off it’s own market timing fund, the Vanguard Asset Allocation Fund, formerly actively managed by Mellon Capital. Even a low expense ratio of 0.27% couldn’t save this one.