I’ve recently read two articles about the state of healthcare in the world today, one by speculator and libertarian Doug Casey, with a somewhat paranoid (but perhaps justified) view of the state of cancer treatment, and another in Business Week, about the lack of evidence based decision making in medicine today. The underlying theme in both these articles is that medicine, as it is practiced today, shows a remarkable hostility in the medical establishment towards rigorous evaluation of therapeutic alternatives.
I see a parallel here between medical treatment and investment advice. In both cases, the choice of expert is an extremely high-stakes decision: if your landscaper does a lousy job, you may have to replace a few dead shrubs. If your doctor prescribes the wrong course of treatment, you may not wake up the next day. An incompetent investment advisor may leave you unable to ever retire.
The extreme high stakes of these decisions can lead to us making worse decisions in the first place. Combine that with the fact that, when it comes to expert services, it is very difficult for the customer to determine the value of what they are getting. When we visit a doctor, we have no way to know if they are prescribing unnecessary tests or prescriptions, we only know our ongoing state of health, and as we often do not even know what the other alternatives are, we can’t compare the outcome from the particular course of treatment.
Similarly, we don’t know how good our advisor’s recommendation for portfolio allocation is until it’s too late. He can show us fancy charts about how the portfolio has performed in different historical market conditions, but in the same breath, he’s obligated to tell us that “past performance is no guarantee of future results.” Investing is more an art than a science, because it is impossible to perform a repeatable experiment; financial markets constantly change and adapt to new information, including to the results of past experiments.
That is not to say that superior investors do not exist, but the sad fact is that most investors and advisors truly believe themselves to be better than average. The sad fact is, that even if everyone were honest with each other, we still wouldn’t know if we were competent investors ourselves, or if the people offering their advice were, either. Worse, the only measuring stick we have is past results, which, I’ll repeat, are no guarantee of future returns.
It’s enough to make you throw up your hands in frustration and go home. Which is exactly what people who advocate index investing suggest. Indexers basically ascribe to the theory that if you don’t know if you’re buying rotten fruit, buy the fruit that you know is only lightly bruised, and pay discount prices.
I’m a great fan of discount prices, but most people do not have enough saves that they can afford to accept the slightly-below-market (because of fees) returns promised by index funds, especially since we have very little idea what those market returns might be. Historically, stocks have returned around 10% depending on how you count, over the long haul. However, current valuations look more like those typically seen at market peaks, and investors who buy at market peaks typically have to wait a decade or more to get their money back. With this perspective, slightly-below market returns look much less appealing.
I feel that the biggest mistake we can make with our investments is to believe that we deserve a particular return, because that is what we need to reach our retirement goals. This belief leads to chasing returns; moving money to a new manager/stock/fund/asset class because it has had the returns that we thought we were going to get in the manager/stock/fund/asset class we thought we were in. This usually makes our problem worse. Recent performance is just about the worst reason to choose an investment or manager.
What is a good reason to choose an investment or investment manager?
- Because you are getting a good value: you should have an idea of what you are buying is worth, and be paying less than that. This should be an absolute valuation (“apples are worth $1 a pound”), not a relative valuation (“apples cost less per pound than oranges”,) because relative valuations lead to us buying the least rotten apple on offer, when we should just keep our money in our pocket and look at the oranges. When it comes to investment managers, most, in my opinion, are rotten apples. If you do not have the time and patience necessary to decide if a manager is as good as he thinks he is, you’re better off indexing your investments in a low fee, no-load life cycle fund. This is essentially what you’d be getting from most planners, and the bells and whistles some add on almost never justify the fees they charge. As far as I’m concerned, with most financial planners, you’re essentially paying for hand-holding. Following this logic, I first got into investing because I thought I could so better saving the 1-2% fees I would have been paying with an advisor and doing it myself.
When should you switch investments or managers?
- When the reasons you got in in the first place have changed. If you chose an investment manager because you thought he had a methodology that would beat the market over the long term, if you later found out that he was picking stocks that he heard recommended on Mad Money (I actually think Jim Cramer’s a very smart guy- if a bit hyper for my taste- but even the best guru’s picks cease to be useful when too many people follow them… and Cramer’s worse than most in this regard because he makes stock picking fun… The best investments tend to be ones it’s hard to get excited about… because that means no one else is excited, either.) On the other hand, if you chose a mutual fund because it has low fees, the time to switch is as soon as you find one with lower fees.