As individuals, each of us is unique. While we each have distinct investment objectives, we tend to fall into two general groups for the core of our investment portfolios.
An Efficient Debate
A long-standing debate about stock markets centers around whether they are “efficient.” The Efficient Market Hypothesis (EMH) is the basis for the body of academic work known as Modern Portfolio Theory, upon which the American Law Institute built its prudent investing guidelines for trust fiduciaries.
EMH states that markets quickly and accurately reflect available information, and are setting “fair” prices for buyer and seller. Inefficient markets, in contrast, would enable a savvy investor to exploit security prices that do not accurately reflect all available information, or do not respond quickly to new information.
Few would argue either extreme — that markets are purely efficient or inefficient. But those who actively invest believe that markets are at least inefficient enough to make it worth the treasure hunt. They will pay the costs involved in attempting to find mispriced stocks, bonds, sectors or markets to buy and sell. Instead, heeding the academic evidence, our conclusion is that markets are too efficient to allow investors to consistently overcome the costs involved in identifying potentially mispriced securities in the short-term.
However, with a disciplined approach aimed at capturing what the market gives you in each asset class, minimizing investment costs and being tax-efficient, investors can have a great investing experience that outperforms the overwhelming majority of active managers.
We Can Be Our Own Worst Enemies
Despite the academic evidence, many of us still are tempted to pursue that “undiscovered” stock-picking method that successfully picks the winners and avoids the losers. Behavioral economists have studied this tendency toward investor overconfidence — as well as a large array of behavioral traits (such as regret avoidance, irrational exuberance, and the endowment effect, to name just a few). Examining these ingrained behavioral instincts under the light of academic scrutiny, researchers have detected numerous examples of how they can have a significant negative impact on a portfolio’s long-term outcome for those who are unwary of their existence.
To provide one example related to overconfidence, the consulting firm FutureMetrics studies the performance of major U.S. corporate pension plans; their most recent analysis included 201 firms during the 17-year period 1987-2003. Out of the 201 pension plans attempting to outperform the benchmark, 13 percent (26 plans) succeeded. Eighty-seven percent failed to outperform the simple passive benchmark. It would be logical to assume that individual investors, with far fewer resources available to them, would likely fare even worse.
By accepting an evidence-based philosophy as fundamental to your investment strategy (whether “you” are an individual, family or retirement plan), you don’t have to spend time chasing the very few mispriced securities that might exist. Instead, you can focus your efforts on:
- Defining and incorporating an appropriate amount of risk within your investments
- Capturing as much of the market returns as possible given your risk tolerances
- Minimizing costs that might otherwise detract from your returns
- Periodically rebalancing your portfolio according to these guidelines
- Spending your leisure time pursuing your life’s interests, rather than trying to predict or react to every market fluctuation.
For more detail on our Investment Philosophy and approach to Investment Management, you can download our Investment Methodology White Paper.