You know that superstition that says it’s bad luck to walk under a ladder? So we totally know that it’s based on myth and has no scientific basis whatsoever (If you’re curious, wisegeek gives a possible explanation on why this superstition exists), but we adhere to it anyway. Why take a chance, right? There’s this study that indicates around 70% of people in Britain still aren’t willing to walk under a ladder if another option exists (I’m still trying to figure out how the hell they managed to conduct that one – “Hey! Here’s 5 bucks, would you walk under this ladder please?”).
Here’s a possible reason why we stick to superstitions that we know aren’t true: BECAUSE WE DON’T WANNA DIE FROM A FALLING LADDER. It’s a sad way to go. I’d much rather die from taking a bullet to save someone’s life. Or flying a jet into the bellyhold of an alien spacecraft to save humanity. Or overdosing on delicious ramen from Ippudo. Or having too much sex. So I think the whole ladder superstition thing is to prevent an untimely Death by Ladder – and we stick to it because it just makes sense.
It’s entirely possible to adhere to something even though we don’t believe in it.
Anyone heard of the Efficient Market Hypothesis (EMH)? If you haven’t, check out this ridiculously boring Wikipedia article on it. Essentially, it’s this really cool academic theory that lots of professors and econometricians and financial economists believe in. It’s also the entire foundation upon which my Masters degree in Finance and Economics from the London School of Economics is based on…. and it’s also entirely wrong.
Say whaaaaaat?!
In a nutshell, EMH states that financial markets are essentially unpredictable, and that the only way to invest is to buy-and-hold an index fund – because while you can’t predict where the market will be in any given day, month, or even year, over the long run it will rise (because of various factors, which I outline here).
However, we now know that the EMH simply isn’t true. It’s been proven wrong over and over again by academic after academic after academic. But while we know that it isn’t true, it doesn’t mean that we should throw index investing out the window. In fact, even if we don’t believe in the EMH, passive index investing may still be the best way to invest.
Let’s look at performance
Okay, if the EMH isn’t right and financial markets are totally predictable, what’s the best alternative to index investing? Investing in a sexy, shiny MUTUAL FUND of course! (also known as “unit trusts” for my Singaporean friends) So these funds are run by really smart guys and girls, who have dozens of research teams under them and spend day after day analyzing the markets. If anyone could take advantage of predictable financial markets and beat the index, it’s them, right? Wrong.
Check out the findings from this paper, Passive Investment Strategies and Efficient Markets, by Burton Malkiel (yeah, I love reading nerdy academic papers in my free time because I’m geeky like that. Stop judging me).
“Over the 10-year period ending 31 December 2001, 71% of actively managed equity funds have produced total returns (including dividends and capital charges) that were inferior to the returns achieved by the index fund, after expenses… The same kinds of results have obtained for earlier decades.”
“In 1970, there were 355 equity mutual funds holding broadly diversified portfolios… Note that more than half of these funds did not survive over the 32-year period. We can be sure that the non-survivors had even poorer records than the surviving funds… Note that of the remaining 158 funds, only five produced returns that were two percentage points or more in excess of the index fund returns. Clearly, trying to select a winning fund is like picking a needle in a haystack. The likely result is to achieve well below average returns”
Smarter than the market?
So you can give me any strategy – value investing, momentum trading, small caps, technical analysis, whatever. It may work out well in theory, but the fact is that the majority of the professionals who have pursued these strategies were unable to beat the market at its own game. As Malkiel puts it: “Whatever predictable patterns may exist and whatever inefficiencies may occur, they do not give rise to profitable investing strategies.”
The success stories we’ve heard about – Warren Buffett, George Soros, etc are the proverbial needles in the mountain of haystacks of investment managers who have crashed and burned. The reality is that it is almost impossible to identify the next Buffett or Soros and invest in them.
And if the majority of professionals are unable to beat the market – I think it’s also highly unlikely that the average person, armed with his $49.95 book on Security Analysis, would be able to beat the market. Not impossible of course, just highly unlikely. Just sayin’.
Walking around ladders
As for me – I prefer to play where the odds are in my favor and invest in index funds. After all, they are far more likely to outperform the majority of investment professionals in the long run. Because while I don’t believe in the EMH or that walking under ladders may bring bad luck, why take a chance?
Another point to add index (passive) funds also charge much lower fees than active funds. Quantitave funds driven by factor models (that remove the emotional aspect of investing) would also be worth looking at as an alternative to active funds.