Long Standing Debate: Market Data v. Individual Intuition – October 2012


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Long Standing Debate: Market Data v. Individual Intuition
October 18, 2012

by: Debbie Lovett, CFP®

Whether you are entertained, enlightened or enraged by this political debate season, it gives you the opportunity to measure how much detailed data or general platform preference guides your personal interpretation of the information in front of you. While we would all like to think that it is only the facts that drive our decisions, 1) we as a species have limited ability to separate emotion from the perception of fact (behavioral science is devoted to this topic) and 2) preference is akin to rose colored glasses—it colors the way in which you trust, ignore, or challenge incoming data. Preference frames an issue in a manner that makes leaving your initial opinion behind a sticky proposition. Obama v. Romney and Biden v. Ryan are viewed through the screen of your initial preference. One person’s malarkey is another man’s keystone.

Let’s leave the Blue vs. Red debate – as you no doubt have a healthy diet of that already – and go to the Market Data v. Individual Intuition debate. The latter is a debate that has been surging on since before the Dutch Tulip Market skyrocketed and then collapsed in the 1630s. Why would someone in the late 1630’s buy a single tulip bulb for absolutely obscene prices? Historically bulbs sold for a small percentage of a skilled worker’s annual salary, but for a time it has been recorded that they were going for as much as 10 annual salaries for one bulb. How one looked at the prices at that time was probably clouded by the frenzy they witnessed around them. Emotions and intuition ruled the day. In behavioral finance terms, the tendency to herd (follow the crowd), fall victim to recency bias (you remember the events that just occurred versus years of much lower prices), and optimism (each person predicts better outcomes for themselves than for others) just scratch what boils beneath the surface in times like that. The person left standing when the music stops, or left holding the tulip when the buyers disappear, will then have an entirely new set of emotions to sort out afterwards.

Here is some Market Data.

Recent market data shows that active managers in the mutual fund arena have not had better results than mere passive investing (investing in the index). This is not the case if you focus on recent data for International Small Cap Value Managers or only on the 5 year period for Large Cap Value Managers.

1. The semi-annual Standard & Poor’s Indices Versus Active Funds (SPIVA) Scorecard compares how active fund managers as a whole fare against their index benchmarks. The charts from SPIVA with more granular data follow at the end of this blog or click on the name of the report above to pull up the report in full.

The chart above shows that last year (1 year results being the most changeable over time) 90% of the time the index outpaced the more expensive active managers—the index has the advantage of low internal cost while the active managers carry the burden of additional staffing and resources for research. SPIVA has been tracking these results for over 10 years and the results are typically very similar. As far as the market data held in the SPIVA report, active equity management continually fights and more often loses an uphill battle.

Generally, persistence at the top is not a common occurrence in active management. “Winning” active managers do not consistently sit in those top spots over time. For the managers that remain in the top 50% of their peer group each year for five years, the results across all US equity fund categories are less than random expectations. For those that hang on to being in the top 25% of their peer group, the data suggests a slight edge over random expectations, particularly in multi-cap funds where managers have the freedom to roam across different capitalization categories.

2. The semi-annual S&P Persistence Scorecard tracks the consistency with which managers that are top performers in their peer group remain top performers. The charts from the Persistence Scorecard with more granular data follow at the end of this blog or click on the name of the report above to pull up the report in full.

Conclusions from Market Data:
While most active managers do not beat their benchmarks, those that do beat their peer group have a hard time sustaining that record over time—and “the best” seem to have strong competition from mere random expectations.

 

Banana, Anyone? (Or how about a random number?)

The phenomenon of trailing benchmarks and shifting top spots is sometimes compared to the acumen that hypothetical stock picking monkeys would have year in and year out. In the first year, half of stock picking monkeys statistically do not beat the average of their peer group so are dropped from the study. In year two, another half of the monkeys are dropped. This continues until only a handful of monkeys are left standing/crouching. Regardless of how many monkeys you start with, eventually one monkey will emerge the winner. Additionally, if more luck is in that monkey’s favor (didn’t luck get him there?), his record may even beat the index’s record despite his randomly pointing to stock names with a banana and ignoring all market fundamentals. That monkey could then be seated next to Warren Buffett and John Templeton at a gala heralding the incredible investment talent of all three. Perhaps the monkey would be labeled the oracle of the primate house–although to be fair, no zoo would be posh enough for such a gifted monkey. (I have to weaken my point by stating strongly that I admire Warren Buffett and John Templeton and understand that they have formulas, intelligence and convictions that far outweigh any random number generator.)

So if hypothetical monkeys can prevail and you are using market data alone to influence your decision, when should you seek active management? Don’t the numbers lean toward an answer of never or not very often?

Here is some Individual Intuition

Let’s say that your intuition is that never hiring active management is preposterous.
• People must benefit from hiring active managers all the time, or the market wouldn’t be so full of them.
• Active management must work because they charge more than index funds. Other people must be paying for something.
• I can’t pass up the chance that I might invest with the next market guru and get to ride their oversized returns off into an oversized retirement.
• (Active management for some is just an incredibly fascinating itch just begging to be scratched.)

Now let’s say that your intuition is strong enough that you decide to use active management after all. How do you choose the manager?

Don’t bother interviewing the earlier mentioned monkey–he has gotten so popular he’s not taking new clients. And the humans with fantastic track records that have not closed their books to new business are now charging the types of fees that the demand for their star power allows, perhaps even moving to the hedge fund world where you need quite a lot of assets to play ball. To get the most out of active management, you have to hire the manager before they are good, and then you have to fire them before they get bad. If you hire a manager at the top of their game, both statistics and mean reversion (the tendency for highs and lows to revert back to normal range) are against you and them.

My own personal market data v. individual intuition debate ends with using active management in small doses (not never) and as wisely as possible. Use active management with discrimination and with purpose.

This blog is geared toward helping investors improve the quality of their interactions with their advisors. Leaning back on the market data, it looks as if Small Cap International might be a great area to ask your financial advisor about active management. That’s if you are willing to subscribe to market history having some ability to predict what happens next. Or a better question would be, “Where am I using active management in my portfolio and why?” That discussion can be quite illuminating. And if you find yourself gunning for active management—stop and think about why. Is it personal (a political party) or mechanical (reviewing non-partisan data), and how should we reach conclusions given that as a species we are hard wired to decide using both?

In short…

In short—the market data v. individual intuition debate is just another name for active v. passive investing (or passive v. active investing to line up the players correctly). You will find that the more you and your advisors talk together about even a handful of market lenses when making decisions about your portfolio, the more refined and focused your decisions will become. Even choosing to index your entire portfolio and never opting to veer away from how the market distributes itself is your own active decision to be passive. You are the “active manager” in that case, choosing not to customize. And if you choose to use active management, you should strive to understand what you hope to accomplish by adding them to the portfolio instead of merely buying a name that you read in a headline. This sets the stage for thoughtful reviews as well. It is not just about quarterly performance numbers but evolves correctly into if that manager is serving their purpose in your portfolio. Over time your finances will read more legibly to you despite all of the uncertainty and variability in the world of investments. As for the political debates, you’re on your own to draw conclusions from those.

 

Debbie’s Blog wants you to build your own financial point of view. This is particularly helpful when working with financial advisors. It’s always better when everyone is speaking the same language, and finance is not a language that needs to rest somewhere out of reach. At Blue Prairie Group, we encourage an open and dynamic relationship with our clients, perceiving them as partners, not customers. That partnership is what supports our 98% client retention rate over our ten year history.

Like the shade tree mechanic who knows their way around an engine, you can have that same sort of savvy when checking under the hood of your portfolio.

© Debbie Lovett 2012.