Back when I was taking economics courses, during Alfred Marshall's heyday, economics professors drilled into us that financial markets were efficient, and therefore you should just put your money into a no load mutual fund because even professionals can't beat the market. Being a trusting soul, I believed them and went into marketing research. My classmates at MBA school in the turning point year of 1982 paid no attention, went to Wall Street, and got rich.
Now, we are told, it's the "efficiency" of the modern financial markets that is allowing a few thousand players to get richer than Croesus, while the rest of us putter along. At Marginal Revolution, Tyler Cowen quotes Jane Galt in The Economist:
To the extent that the superrich are pulling away from the rest of us...the most parsimonious explanation seems to be the massive increase in the efficiency, and size, of American capital markets.
Clearly, I don't know anything about getting rich, but, I responded:
"Shouldn't a more efficient financial market mean that the ROI gap on the investments of the rich and non-rich should narrow, not widen? In 1907, it helped to be as rich as J.P. Morgan to profit reliably in the financial markets because the cost of monitoring one's investments to make sure you weren't being ripped off was so great. Now, the friction cost of investments for small investors should be less prohibitive. So, I don't see this as much of an explanation."
For example, why have the giant endowments of Harvard and Yale been generating roughly a 5 percentage point better return on investment for the last decade and a half than the average college's endowment?
James Surowiecki, the New Yorker's business writer, added:
"Steve's right: a more efficient capital market is one in which there should be a smaller, not bigger, role for intermediaries. So it seems peculiar to argue that the greater efficiency of capital markets is responsible for making all these intermediaries incredibly rich."
Some fairly illuminating comments follow from people who know much more about the subject than I do, although I still don't understand how the old efficient markets theory with its glamorization of no load mutual funds can be reconciled with the fashionableness of hedge funds with million dollar minimum investments and huge fees.
My published articles are archived at iSteve.com -- Steve Sailer
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32 comments:
There seems to be a confusion here between riches gained by the holding of equities and those monies made by intermediaries in their trading.
Personally, I blame Keynes and his animal spirits. Not for any good reason, I just have an aversion to homosexuals.
According to Hans Herman Hoppe, homosexuals have lower time preferences (shorter life-spans, no kids/family) and that may be the reason for Keynes' "In the long run we are all dead" optimism. There was a homosexual in the class that day and Hans almost lost his job.
A lot of hedge funds go under. Then you read about the ones which did spectacularly well, and you think that is the universe.
Steve's particularly well-suited to comment on the link between intelligence and status in society.
If someone higher on the social ladder so much as looks approvingly down on him, Steve will have a nosebleed.
Warren Buffett demonstrated that the efficient market hypothesis was wrong in this speech at the Columbia Business School 23 years ago: The Super Investors of Graham-and-Doddsville. Anyone who listened to that speech and decided to hire Warren Buffett to manage their money (by buying Berkshire Hathaway stock) would need no convincing. That type of out-performance isn't the result of luck; it's the result of a talented investor taking advantage of inefficiencies in the market.
Nevertheless, the personal finance orthodoxy remains that most folks should plow their money into low-cost index funds. The chief apostle of this is the inventor of the index fund, Vanguard's Jack Bogle, and legions of personal finance gurus back him up.
Investors who follow the indexing advice consistently, by dollar-cost-averaging don't do as well as, say, Berkshire Hathaway investors, but they do do better than the average mutual fund investor -- whose returns lag those of the average mutual fund. The average mutual fund investor tends to buy funds high (after the fund has shown a few years of out performance) and sell low (after the end of a cyclical trend). This was the case with many tech fund investors in 2000 and is being repeated with commodity and some international funds today.
Steve,
Transaction costs to buy and sell securities are cheaper now than they have ever been. That has little to do with the high compensation hedge fund managers though. Average asset managers (e.g. mutual fund managers) make a lot of money because a) they get paid on a percentage of the assets they manage; and b) there is no marginal cost for adding adding additional investors and additional money. It takes the same amount of work to manage $100 million as it does to manage $500 million, and if the manager is getting the same 1% management fee, he's going to earn 5x as much by managing $500 million.
Hedge fund managers make even more money simply because their fees are several times higher: the average might be somewhere in the range of 2% on assets plus 20% of profits (a unique additional compensation structure of hedge funds). I'm not sure how much better off most of the super-rich are investing in hedge funds though; average hedge fund returns aren't any better than mutual fund returns. For the super rich, it's mainly the status-value of being in an exclusive investment -- except for the handful who are in truly exceptional hedge funds like Mohnish Pabrai's fund (ironically, one of the smaller hedge funds).
Oh, Steve, it's all getting a bit technical.
I suggest you host an open public discussion forum, one facilitating real human biodiversity and not just those gene-centric Lawrence Austerphobes. Yes, even women could post there.
The surest way to increase site traffic is to allow people to talk about what interests themelves most, viz., themselves.
Steve, as someone interested in IQ and the hiring practices of Microsoft, are you familiar with D.E. Shaw? It is probably the most competitive, highest IQ group in the private sector -- that is, it probably has on average more powerful thinkers than you'd find anywhere in the world outside of the most quantitatively intense departments at elite universities.
From Wikipedia:
"D. E. Shaw & Co. is a New York-based investment and technology development firm whose activities center on various aspects of the intersection between technology and finance. Based in Times Square, New York, it was founded by David E. Shaw, who was formerly a faculty member in the computer science department at Columbia University. As of 2006, the company, described by Fortune in 1996 as "the most intriguing and mysterious force on Wall Street,"[2] manages approximately US $29 billion in aggregate capital over a number of different entities.[3]"
"The D. E. Shaw group is known for its quantitative investment strategies, particularly statistical arbitrage, and its rigorous recruiting policies, which especially target the math and science departments of major universities. Notable employees include former employee Jeff Bezos, who was a vice president at D. E. Shaw before departing to found Amazon.com, and now managing director Lawrence Summers.
As of 2006, D.E. Shaw employs approximately 1000 people. [4] Employment opportunities at D. E. Shaw are known to be extremely competitive, with less than one applicant in 500 being offered a position.[5] Employees are regarded as being among the world's most gifted in their fields.[citation needed] The staff of D. E. Shaw includes multiple Rhodes, Marshall, and Fulbright Scholarship winners, more than 20 International Math Olympiad medalists, Putnam winners, national chess champions and other world-class researchers and practitioners from a wide range of scientific, humanities, and social science disciplines."
The 1-in-500 is of course out of pool of Ivy League graduates. I can tell you that it is significantly harder to get a job there than at Google or Microsoft or any investment bank or consulting firm -- places which are generally known for recruiting the best young talent. They are literally looking for Putnam superstars -- a mere 4.0 at Harvard doesn't cut it.
So maybe investing is harder than we thought?
Hmmm, any demographic breakdown on their workforce?
Sounds like I may need to dig out my CV.
Ali Choudhury:
"There will be a few outliers who by skill or by luck will beat the marker but it's impossible to predict who they'll be."
Buffett addressed the skill-versus-luck issue in his speech. It's worth reading. Aside from his obvious investment skill, Warren Buffett is also a felicitous writer.
I have two other problems with traditional, market-cap weighted indexing (the predominant kind): 1) the market-cap weighting means it's not as diversified as people think; 2) buying stocks without any research or filters means you buy a good portion of crappy stocks. Sometimes problems 1 & 2 coincide and you end up with Enron as the seventh-largest holding in S&P 500 index funds.
I'm not an indexer myself, but if I were, I'd lean more toward the fundamental indexing ideas of Jeremy Siegal and Wisdom Tree. Instead of buying all stocks based on market cap, they construct index funds and ETFs weighted by earnings, dividends, or other fundamental criteria. Applying at least one simple fundamental criteria to index investing makes more sense to me than just buying the whole basket of stocks; for example, why not skip stocks with negative earnings?
Great point you made about Swenson though: he is actually an asset-allocator rather than an asset manager, and he's a quite good one at that. But most of the asset managers to whom he assigns portions of the endowment to invest are active managers.
I had a temp gig in compliance once at Goldman Sachs and had to read through the proposals GS asset management would send to large corporation and government retirement plans (e.g., proposals to manage an asset class for a state teachers' retirement fund, etc.). I always was curious to read the bios of the Goldman money managers. Schools such as Columbia, Wharton, Harvard, Michigan, U. of Chicago, and NYU would come up a lot, but sometimes these guys had more interesting backgrounds besides. One guy had two Olympic gold medals (for swimming).
It takes the same amount of work to manage $100 million as it does to manage $500 million,...
I'm not so sure this is true -- because of the demands of diversification.
Okay, so how do hedge funds, with their very high fees and this incredible 20% off profits but 0% of losses kicker, manage to attract, roughly, a gazillion dollars?
And how many economists predicted the rise of hedge funds?
Brings to mind those clever young Harvard students who came up with a super-lucrative scheme to cheat Vegas.
Also brings to mind Schroedinger's Cat. How much of this is prescience, and how much is outcome-determinative behavior? And how to distinguish?
In 1985 Ivan Boesky published a book, Merger Mania, about what a hardworking insightful genius of an "arbitrageur" he was. In 1986, his publisher dropped that book the way you might discard an apple after biting through a worm. It had come to light that Boesky made money the old fashioned way: he bribed people for inside information. From this incident, I learned that the stories successful Wall-Street'ers (or Chicago Loop'ers, or...) tell about themselves should be taken with a large shaker of salt.
I don't think that everyone who makes big bucks in the markets is a crook like Boesky. I think that a lot of the outsize returns come from rent-seeking, though (which produces anti-competitive rules like the SEC's ban on "small investors" in the private-equity markets). Also, outsize returns come from participating a cartel so large that no matter where you stand, you can't see the other side of it, but small enough that members inhabit that special financial stratum you've been discussing here.
Michael Lewis recently wrote about that cartel in his Bloomberg column "Stocks: Coach Class of Capitalism" (http://www.bloomberg.com/apps/news?pid=20601039&sid=a0wzLWr5Lbm8&refer=columnist_lewis) and he explained nicely how the very rich are not earning outsized returns in the very efficient stock market (or other public markets) today. They are earning outsized returns in a different market, which exploits stock market investors, partly for rents enabled by corrupt SEC rules.
Steve,
"Okay, so how do hedge funds, with their very high fees and this incredible 20% off profits but 0% of losses kicker, manage to attract, roughly, a gazillion dollars?"
One of the funds that seems to be actually worth investing in is the (relatively small) $300 million fund run by Mohnish Pabrai (who's a local guy for you, in the Los Angeles area). Pabrai's fee structure is a little different than that of most hedge fund managers: he charges no asset based fee, and nothing on the first 6% of annual return, and then collects 25% of performance above 6% returns. After taking out his fees, his fund has averaged 28% per year since 1999. There are, of course, plenty of hedge funds with higher fees and worse performance; why investors invest in those, I don't know.
BTW, Pabrai also has a unique background: before starting his fund, he was an IT entrepreneur. He maxed out his credit cards and cashed in his 401(k)to start a company he later sold for $20 million. Rather than rely on the sort of high finance exotica practiced by some quant funds, Pabrai is old school. His influences include Benjamin Graham, and current investors influenced by Graham, such as Buffett and Greenblatt.
Ali Choudhury,
Let me post with a name this time, since it's no longer just you and me conversing here. I thought it might be for a while: most of the regulars here don't seem too interested in this topic.
"I love Buffett and have read every speech he's done since '95. But even he, Charlie Munger, Benjamin Graham and Peter Lynch recommend low-cost indexing as the best way for regular people to invest in the market."
I would be surprised if Graham specifically advocated low-cost indexing since the Vanguard 500 Index Fund didn't start until less than a month before he died, in 1976. Graham did, however, advocate a form of passive investing for investors who didn't have the discipline or temperament to follow his methods. Peter Lynch has advocated indexing on occasion, and on other occasions (e.g., in his book "Beating the Street"), he has advocated active stock investing. Perhaps he makes the distinction Graham did between "enterprising investors" who have the temperament for active investing, and passive investors. I would take anything positive Munger and Buffett say about the efficient market theory and indexing (which was the logical outgrowth of it) with a grain of salt. Consider this quote from Buffett (from p. 74 of The Essays of Warren Buffett: Lessons for Corporate America):
"Naturally the disservice done students and gullible investors who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of contest -- financial, mental, or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT."
On the same page, Buffett writes of academic Efficient Market theorists:
"Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between those propositions is night and day."
You may consider this a refinement of EMT/EMH, but I consider it more of a refutation of it to me.
I do agree with you that most investors would be better off indexing than doing some of the stupid things many do now (e.g., buying expensive closet index funds, buying individual stocks if they don't know how to value them, etc.). That said, they would be even better off if they had the temperament and knowledge to follow Graham's wisdom -- or the notion to let someone who does (e.g., Pabrai or Buffett and Munger) manage their money.
As for your point about the folly of trying to duplicate Berkshire Hathaway's common stock portfolio, I agree with you on that too. Better to simply buy shares in Berkshire Hathaway and take advantage of the growth of its investments in wholly-owned companies (and its occasional arbitrage activities) too.
Steve,
The great amounts of money earned by financial intermediaries may be explained by the law of demand and supply.
Us financial markets have been growing tremendously, may be they are ten times larger than a generation ago. The number of transactions has grown exponentially. The demand for extremely high IQ young people, with credentials appliable to the financial business, with strong cardiovascular and nervous systems, willing to work like slaves, willing to endure the unfriendly environment of Wall Street, well, the demand is very high.
On the other hand, the supply of these young fellows has been dropping precipitously, one for purely demographic reasons (the unfertility of American intellectual-middle class), second thanks to the opening of very interesting and profitable new fields that may attract these young people, such as the internet (see Jeff Bezos) and modern physics. Also having a close role model seems to be important to succeed in this field as well in others.
It would be interesting to make a La Graffe de Lion type of quantify the demand and the supply of these individuals.
In my opinion, supply is not growing while demand is exploding, so the lucky few will be even better rewarded.
To end: successful financiers were always very rich, remember the Fuggers, Rothschilds and Morgans.
i had an economics professor who was also of the opinion that the average person, who does not have hours every day to think about money, should simply put their cash into funds with low fees.
personally i've noticed that money is similar to weather. not possible to predict with precision on a time scale of days, but becoming increasingly more predictable as the time scale increases. almost to the point that when the time scale is several months, money trends begin to resemble seasons in weather.
money professionals can move money around depending on the "season" to take advantage of trends.
Here's a common theory about how hedge funds manage to attract a lot of capital: they make very risky investments. Many of them go bankrupt. The ones that survive look very good, and attract more capital. But they were just lucky in the past and probably won't be in the future.
Because no one knows how many funds there are out there, it's really hard to see how well the typical fund does, to see if the above description is correct, but all the evidence is that it's true.
Here's an approximation to the EMH that is true: it's really hard to tell who's good and who's merely lucky.
The point I think is this:
Anyone can beat the market, but not everyone can.
By definition, not everyone can be above average (i.e. the refutation of the Lake Woebegon fallacy).
Of course, there is the question of whether there is a true zero-sum game here or whether people investing really wisely will cause the market to grow, so that you can do better even if you don't beat the market (because "the market" is doing better than it would have done if investments were poor).
But I think that the maxim "you can't beat the market" is based on the idea that this strategy will have as much or more failure than "going with the market."
It's a little like showing someone who makes a living playing BlackJack [with breaking even in BlackJack being compared to having returns on par with the market]. Yes, you can beat the house playing BlackJack, but there are at least as good odds you will lose money, and if the fees are higher for the high-performance funds, you will most often lose money.
Some people doubt Sailer's characterizion of EMH. Yes, it really is that stupid.
To the commenter above who suggests that it may take a couple dozen Putnam geniuses to outperform the market, you may be suprised what Warren Buffet has to say on that. He doesn't think it takes a super genius to beat the market (I doubt Buffet's IQ is much over 150 myself). Buffet's strategy isn't sexy or glamorous or difficult to understand, it's more like the Keep It Simple Stupid theory of investing, which is more or less: Understanding basic accounting and business. Invest in businesses that you understand (that's why Buffet hasn't invested in technology). This guidline would have probably prevented just about anybody from investing in Enron (and those that did understand it, might have been smart enough to avoid it). And, lastly, only invest in a company when the expected value of future earnings is significantly less than the purchase price. That is, buy companies that are obvious values. Berkshire Hathaway owns and invests in a lot of companies you may have heard of (GEICO, Coca Cola), and a lot you may not have heard of (See's Candy, Jordan's furniture), but none are the hot new brand or technological marvel or must-have growth stock. I guess value investing isn't counter-intuitive enough to appeal to economists.
"Yes, you can beat the house playing BlackJack, but there are at least as good odds you will lose money, and if the fees are higher for the high-performance funds, you will most often lose money."
Applying this logic to Warren Buffet, he's been beating the house for fifty plus years now. How'd he become America's second richest man? By sustained revenue growth of around (I think) 15%. That may not sound like much, but over 50 years of consistent growth, that's a chunk of change. You can't explain a lifetime of performance as "beating the odds." That's just EMH drivel.
Ali Choudhury,
You're right that Buffett does advocate indexing for investors who aren't knowledgeable -- he actually says this on the next page of the book I quoted from last time. I knew he had offered a blurb for Bogle's new book, but I couldn't figure out why. He clarifies this on p. 80 of the Essays collection. Buffett seems to make a similar distinction between investors as his mentor Graham, but instead of calling them "passive" and "enterprising", Buffett distinguishes between "know nothing" and "no something" investors:
"By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals...
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt to simply hurt your results and increase your risk."
So, Buffett basically says what I said before: you could do worse than indexing, but you could do better.
With respect to your point that it's tough to do the due diligence on active managers without David Swenson's resources, I think that is overstating the case. I'm not a huge fan of mutual funds, but there are plenty of resources for average investors to rely on, including Morningstar, Lipper, etc. for objective evaluations.
Also, I'd reconsider picking up at least one share of BRK/B. Buffett & Munger's ages are already factored in to the stock price; it's common knowledge how old they are. Buffett has said that there are three Berkshire employees who could do his job managing the controlled companies (mainly, setting compensation and goals for the CEOs and allocating capital generated from the firms to ones best able to employ it). All those companies are run by extremely competent managers who do their jobs well without any interference from BRK HQ. They will continue to do so after Buffett & Munger are gone.
Those wholly-owned companies are the main reason I own some Berkshire Hathaway. As talented as Buffett and Munger are, at this point, the sheer size of their assets hinders their performance in common stock investing; they anticipate more of their performance in the future coming from their privately-held companies.
With respect to investing in publicly traded stocks, I think that the culture and board of BRK is of sufficient character that if they aren't able to find a suitable successor as chief investment officer, in effect, they will deal with the situation equitably (perhaps by investing exclusively in private companies, returning BRK's cash to its shareholders as a special dividend, or using it to buy back shares); the value of the existing stock positions and wholly-owned companies will remain.
BTW, investing in Berkshire Hathaway can be low cost and tax efficient, just like efficient frontier-types like. I bought 4 of the b-shares in a taxable account today at Scottrade. My cost? $7 in commissions -- but, as a BRK shareholder, I also get a discount on GEICO car insurance worth $44 per year. So much for transaction charges. As for tax efficiency -- since BRK doesn't pay dividends, there are no tax consequences until I sell, which may never happen.
Seems to me there is an analogy between dieting and successfully investing: Neither is rocket science, but neither is easy to do. Most people don't have the discipline to do either well, even though the general principles behind each have been common knowledge for years.
To flesh out the analogy, what the Grahams, Browns, Buffetts, etc. do is like the Atkins diet: The conventional wisdom is that it's bad for you and it doesn't work, but everyone who actually follows the diet loses weight (and keeps it off, if they stick with the program).
Dave,
I'm in the UK so buying US stock tends to incur higher transaction charges and can't be sheltered in my tax-free account. I might buy some Berkshire nevertheless but maybe when Buffett or Munger die, since the stock will probably take a hit then. A rather ghoulish strategy I have to admit though.
I'm very sceptical about Morningstar's ratings and so is David Swensen. They tend to favour hot funds more than steady winners.
As for the Atkins diet, I'd say there are better diets out there. The total exclusion of carbs is really hard to maintain and Atkins doesn't seem to consider how oily, fatty foods can affect your cholesterol levels. I've lost about 25 pounds in the last three and a half months by doing a weight routine five times a week, starting my breakfast with unsweetened porridge for the wholegrain carbs, having chicken\tuna\meat with salad for lunch and dinner and excluding anything with refined sugar in it. Except for Sunday where I allow myself some ice-cream and pizza.
Atkins' best insight was that white bread, white rice and pasta should be avoided because of how they affect blood sugar levels thus making you crave the sugar highs that candy and doughnuts deliver.
Oh and thanks for pointing me towards Mohnish Prabhai. His bio seems solid and I bought his book from Amazon based on your recommendation.
In return I would recommend checking out the articles at efficientfrontier.com and Bill Bernstein's The Four Pillars Of Investing.
I thought EMT was dead as a doornail after the Long Term Capital Management fiasco...
Applying this logic to Warren Buffet, he's been beating the house for fifty plus years now. How'd he become America's second richest man? By sustained revenue growth of around (I think) 15%. That may not sound like much, but over 50 years of consistent growth, that's a chunk of change. You can't explain a lifetime of performance as "beating the odds." That's just EMH drivel.
Hans, I did not intend to imply that Buffet simply "beat the odds." I specifically chose BlackJack because that is the one game in which a person can actually beat the house regularly (at least until they started doing umpteen deck shuffles). However, most people are not in that elte category and will have to rely on luck.
My point was that a few people who learn the tricks can beat the house consistently, but most people who try will fail (unless only a small number are trying).
The fact of the matter is, not every investor can beat the market, for the same reason that not everyone can be above average. If enough people do it, then the market average shifts upward.
However, it is possible that investors can raise the level at which the market is operating.
I'm not saying anything about the efficient market hypothesis, by the way. I'm just assuming that the market is sort of the average performance of investments.
So I interpreting the idea of "beating the market" to mean "doing better than average," which is not something everyone can do, for pure statistical reasons.
Ali,
Berkshire Hathaway's shareholders are unique in that 1), they are a largely constant group (something like 98% of shareholders this year will be shareholders next year), 2) they are long term holders, 3) they are "on the same page" as Buffett & Munger WRT investing philosophy. I doubt there will be much of a sell-off when Buffett & Munger leave the scene, since their advanced ages are already priced into the stock; on the contrary, if, say, Buffett announced that someone like Mohnish Pabrai or Joel Greenblatt will be Berkshire's new investment officer, that might boost BRK's stock. In any case, Buffett is in perfect health and could be running things at BRK for a decade or more; in that time, I'd expect BRK to advance far more than it would decline on news of his passing.
The main reason I don't have most of my money in BRK is that its huge size limits its returns when investing in common stock. In my own portfolio, I invest more in smaller companies with greater growth potential.
In my experience, I have found Morningstar to be a useful resource, though not one I rely on exclusively. As I mentioned before though, I am not a big fan of mutual funds. I particularly don't like paying fees to have fund managers buy stocks like GE and PFE for me -- I can and do do that on my own. I also have a system I use to buy small cap U.S. stocks myself. What I use mutual funds for is primarily for exposure to international and emerging markets stocks. I have done well over the last couple of years using DODFX and TREMX for these two areas.
As for Atkins, he actually did consider the impact of high fat foods on cholesterol, and oddly enough, dieters' cholesterol levels tend to go down when they are on Atkins. Some who disagree, like Dean Ornish, claim that the diet is still bad for your heart, but so far the evidence hasn't borne that out. In any case, to expand the analogy somewhat, and tie it back to our original topic: there is more than one way to successfully lose weight, as there is more than one way to produce superior investment returns. Methods are known, but most don't have the stomach to follow them.
Glad you found Pabrai interesting. I happen to own stock in a company he just took a 10% stake in, so I hope he's right on that one. I plan to buy his book as well, as soon as I finish the collection of Buffett essays I'm reading and a Peter Lynch book I have on deck.
LTCM failed because their hedging strategies were based on faulty assumptions. Didn't have anything to do with EMT.
An entertaining book which explains the rise and fall of LTCM is "When Genius Failed" by Roger Lowenstein. As Ali writes, it didn't have anything to do with EMH.
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