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STANDUP Advice: Reliably Identified Part 2

John J. De Goey, CFP
0 Comments|September 14, 2007

Active management is a little like gambling
Active management is a little like gambling

Part of the problem with money management is the sheer arrogance of the typical stock picker. Whether the person is picking stocks himself or deputizing someone (e.g. a mutual fund manager) to do it for him, the logic is the same. Stock picking is something that is exceedingly difficult to do successfully. Here's what Warren Buffett had to say about the subject in an article in CFA Magazine in early 2003:

    The ultimate irony of the investment business is that there's no question that an obstetrician will deliver babies better than the husband or the wife. Or if you take dentists as a whole, they will remove teeth or fill them better than if patients try to do it themselves. But in the investment world, somebody who believes in American business - and who will seek out the lowest way to participate in a business and do it consistently - will achieve results that exceed those of investment professionals as a group.

Most advisors genuinely try very hard to add value in doing their job. Unfortunately, most also define their "job" as being primarily one of picking stocks or funds that will outperform. There's no evidence that they can do this reliably, but that doesn't stop them from trying. The problem is not with the effort, it is in the unsubstantiated claims to success. Sadly, good advisors do many excellent things that consumers often don't think are valuable. Helping people set reasonable goals, split incomes, lower taxes, integrate pensions, get the right amount and the right kind of insurance and other things are all part of good financial advice-giving.

No one ever had a problem with Edison's Herculean effort in trying over 1,000 different ways of creating an incandescent light- but no one gave him credit for inventing one until he actually did it, either. Just like Edison, stock pickers try to add value through security selection. Unfortunately, they haven't quite figured that one out yet.

The irony of all this is that passive strategies work best when most people engage in active management, while active strategies work best when most people index. This should be self-evident, because efficiency increases as the number of analysts and traders increases. It was likely easier to "beat the benchmark" in the 1950s than it is today.

The end game of the story above has all the money invested with one (passive) manager. But if this were to happen, two active managers could set up shop and compete against one another. One of the two could very likely beat the benchmark. Right now, most people use active management, so indexing is likely more sensible. If, at some point in the future, 90% of all invested money was in index investments, there might actually be enough exploitable inefficiencies out there for active management strategies to work again. Being a contrarian could work not only in regard to individual investment opportunities, but also in regard to the choice of active or passive strategies.

There are public policy people who have suggested that lotteries and casinos are simply a "tax on the stupid," since the people running the games are certain to make money at the expense of people playing. People play nonetheless. It's a lot like active management. One might even go so far as to say that active management is a socially acceptable form of gambling. Taken together these little perspectives amount to financial product manufacturers having found a way to make a profit off people who have more money than knowledge.

John J. De Goey, CFP is a Senior Financial Advisor with Burgeonvest Securities Limited (BSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BSL.

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