Are You Overpaying for Bad Investment Management?

January 23, 2018 Taylor Schulte Blog

The shortcomings of active management are well-documented, with mounds of evidence that should leave you drawing the conclusion that active investment managers aren’t the secret to financial success.

Seriously. Just pick your source:

Or skip the news and go straight to mutual fund companies themselves. This report from Vanguard shows that only 18% of the funds that have been around for the last 15 years outperformed their benchmark.

The question may not be so much about whether active managers can outperform the market.  The data answers that with a resounding no.

But you still might wonder why this is the case. The answer depends from firm to firm, but by and large active managers go wrong by thinking they know something the rest of the market doesn’t.

Why Active Management So Often Fails

Thinking you have secret or special information that no one else knows about flies in the face of the Efficient Market Hypothesis. That’s the theory that financial markets are efficient ones in which securities are almost always priced correctly according to their value.

That doesn’t mean prices can’t be wrong. It just means that they reflect how the market currently values those securities.

Any time a new piece of information enters the market, prices (on things like stocks and bonds) change to reflect that bit of data. And information flies into the market constantly.

Not only that, but there are millions of market participants just like you out there. There are even some who are much more sophisticated than you are. Don’t take that personally! In this case, it just means that they are professional traders who do this all day long.

They use complicated tech and algorithms to seek out information about the market. When you multiply this by the number of people participating in financial markets, the result is that it’s almost impossible for a single, random individual to know more than the wisdom of the crowds.

Understanding the Wisdom of the Crowds

In fact, there are a few experiments that demonstrate just how powerful our collective, average knowledge is.

One was done by NPR with Penelope the cow (yes, you read that right). Planet Money team members had people guess the weight of a cow at a state fair. Even though there were some outliers in the guesses, with some people guessing really far under the cow’s weight and others guessing incredibly far over…

The average guess, out of over 17,000 people submitting their best estimate, was 1,287 pounds. Penelope’s actual weight was 1,355. That’s just 68 pounds of the exact right answer.

This experiment has been repeated over and over again with jars of jelly beans — and you can do this yourself if you’re curious. Grab a bowl, fill it with tiny candy pieces, and then ask everyone in your office to guess how many candies are in the bowl.

You’ll find that while there are some extreme answers at either end, the average will likely come in very close to the actual number of candies in the jar.

That’s the wisdom of the crowds. It works with cows, it works with jellybeans — and it works with assets in a financial market.

Millions of market participants are all “guessing” the “correct” price of a stock. The stock’s price represents an average of all those assertions, and as it turns out, the average is almost always incredibly close to being spot on.

This is what active managers are up against. They base their actions on the (often incorrect) idea that they know more than the market and all its participants do. This is why a passive investment strategy probably makes far more sense for you and your financial life.

The Advantage of Passive Investment Philosophies

Passive investing is simple. Where active managers try to find mispriced securities, passive investment managers build out well-diversified portfolios that represent broad segments of the market.

Passive investment managers don’t believe they have special information that allows them to beat every other market participant to the punch. That means they don’t pick individual stocks nor do they think they know when the next big market fluctuation is going to happen.

The truth is that no one knows when the next big market downturn will happen. We don’t know when the market will hit its peak. People can make predictions and forecasts all they want, but it doesn’t change the fact that no one knows with certainty when these things will happen.

Passive managers don’t try to forecast or guess. They invest for the long term, knowing that historically, the market has always gone up over decades of time (although past performance is never an indicator of future results, no matter what you invest in).

They also know that selling out of the market when things get volatile often leads to worse results than simply riding out the month to month fluctuations and continuing to buy in with dollar cost averaging.

What Does Your Financial Advisor Believe?

One of the questions you need to ask a financial advisor before you work with them is, “what’s your investment philosophy?”

If you run into someone who thinks they know more than the market, you may want to keep looking. Not only are they highly unlikely to underperform, which costs you in potential returns, but they’ll likely charge you a premium for doing so!

Active managers may charge 1 to 2 percent of the assets you have under their management as their fee. That’s on top of the fees and expenses included in the funds they invest your money within, which can bring your total fees up to 2 to 4 percent.

And if they’re not a fiduciary and sell you into investment products loaded with commissions, you could be paying even more.

That’s another advantage of financial advisors who help their clients with investments through passive strategies. Not only do they provide a better return for their clients, but they charge less for their service.

Thanks to innovations in technology — and the fact that index funds are much lower-cost than actively managed mutual funds — a passive investment manager can provide an investment management service for a much lower fee.

That’s critical because even small differences in fees can add up to hundreds of thousands of dollars you don’t get in your net return over your investing lifetime.

Before you hire any financial advisor, make sure they are willing to work as your fiduciary 100 percent of the time. They should also be fee-only, meaning they don’t receive any kind of commissions or kickbacks.

You are the only person who pays your advisor, which eliminates conflicts of interest that would exist if they also got paid by mutual fund companies for investing their clients in certain products.

Finally, an advisor should be able to explain their investment philosophy to you. If you don’t feel comfortable with their approach, keep looking.