Wednesday, August 3, 2011

Working for a Negative Wage

Recent defenses of couch potato investing by Canadian Couch Potato and Canadian Capitalist left me wondering why so many people believe in active investing strategies. I think it may be partly due to the feeling that you will be successful if you work hard.

It may take some work to pick a passive investing strategy, but once started this approach is quite easy to maintain (which is why we call it “couch potato” investing). On the other hand, active investors work to try to beat the others who play the same game. Active stock pickers pore over company reports and calculate company valuations. For them investing is usually hard work.

The thing that goes contrary to our expectations about hard work is that active investors, on average, get lower returns than the market averages. It’s not that they don’t get enough benefit to justify the work they do; it’s that they actually make a negative wage for the hours they put in. At least this is true of the average person who invests his or her own money actively. Professional money managers get paid whether they perform well or not.

20 comments:

  1. Typo: You've got active twice in the last paragraph ("active investors, on average, get lower returns than active investors.")

    I'm a bit torn on the whole matter myself. For one thing, I'm not entirely an active or passive investor, having my portfolio split into the active half and the passive half (though the halves aren't quite equal, with the larger half belonging to the active part).

    I completely see the logic of passive investing for the average person, and that's all I recommend to people who ask what to do with their money.

    But at some level 1) I think that superior returns can be attained (e.g.: the superinvestors of Graham-and-Doddsville) and 2) I don't think that I am average. The problem of course is the Lake Wobegone effect: the average investor believes they are above average, and then makes mistakes.

    So that's why I have the passive portfolio. I hope to keep myself honest, and if active investing doesn't pan out, to switch completely to passive.

    Also, on the matter of hard work: for me, it's not really. At least for the moment it's just another thing I'm learning, a challenging game I enjoy trying to beat. My time is also nearly worthless at the moment. When I graduate and get a job, all that may change.

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  2. @Potato: Typo fixed -- thanks. I have no problem with people trying to see if they have what it takes to beat the market. What you have to do is set yourself a benchmark and do the work to see how you compare to that benchmark. I have little respect for active investors who don't even know how they fare compared to an appropriate index.

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  3. A little CAPM here. Passive investors earn beta returns. Active investors earn positive or negative alpha. Alpha is zero sum. Active investors losing money are losing it to other active investors. You can not argue with the math. If there are a hundred active investors and eighty of them lose money, the money they lost ends up in the hands of the other twenty.

    The debates about active investing can never be about that part of the math. They usually center about whether the twenty were better on investing or just plain lucky.

    To those who believe in luck and the Efficient Market Hypothesis, I have only two words. Warren Buffett.

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  4. @Ahmed: Alpha is zero sum before costs. After costs more active investors, on average, lose to passive investors. So, when 80 of 100 investors lose money, only some of their losses get picked up by the other 20. The activity of the entire 100 leaks money.

    Over a short period of time, 80/20 is the right ratio, but over longer periods the 20 shrinks.

    Weak forms of EMH make sense, but I believe that Buffett's record is skill, not luck. The problem is the millions of wanna-be Buffett's almost all of whom will fail.

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  5. @Michael,

    If the activity of the hundred leaks money, to whom does it leak money?

    I hope you are not lumping in day traders when you speak about active investors. Then you will end up making statements like commission costs will eat up your returns, which though they may be true for day traders, are not true for value investors who rarely trade.

    You have to be careful when speaking in generalities.

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  6. @Ahmed: Even value investors who rarely trade have higher turnover than passive investors. So, yes, I'm talking about commissions, spreads, and taxes. The average investor of the type you decribe will earn a small negative wage for his or her efforts, and day traders, on average, earn a large negative return for their efforts.

    I choose my words carefully. I'm speaking of averages. You claim that there are some better investors who succeed. This is true -- Buffett is an example. The problem is that the majority who try to beat indexes will fail.

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  7. @Michael,

    I have been an active investor for twenty years and this is my only source of income.

    You mention taxes. Once again you are making assumptions. My cumulative tax bill over the last twenty years is zero cents. The only income I have is dividends and capital gains. Dividends are sheltered by the Dividend Tax Credit and capital gains are deferred into the future. At some future time I will have to pay at the reduced capital gains tax rate but not in the present. So your assumption about taxes, while true for some people, is not true for everyone.

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  8. @Ahmed: You seem like a smart guy and I find these little back-and-forths puzzling. I'm saying that, on average, people who try to do what you do fail. That doesn't mean that there aren't some who succeed. I don't understand why you insist that my statements about averages must apply to everyone in a given group of investors.

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  9. @Michael,

    To me telling people not to try because most people fail is like telling a group of students not to try to become honor students because most students will not become honor students. Which of course is true.

    I do understand where you are coming from though. When I first studied commodities, I found that 85% lose their money in the first year and only 15% survive to continue trading in future years. So I asked myself after much study: Have I discovered what the skill is that these 15% have? The answer was no. So I stayed away from commodity trading.

    It was not the odds that kept me away but simply realizing that I didn't have the requisite skills to become a commodity trader.

    So as an investor, here is how I respond to people who question me about whether they would be successful as value investors:

    If I hand you an annual report and black out any reference to the price of a stock. Can you calculate its intrinsic value. And if you can, and the price of the stock is 30% below the intrinsic value you have calculated, do you have the courage of conviction to buy in with serious money. If yes, then you will be successful in the long run. If yes and you still lose money, if means you do not have the skill to determine a stock's intrinsic value. Because by definition, value will out and stocks will trend back to their true values, even though it may take some time.

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  10. Most people KNOW that the average guy cannot beat the market.

    But most investors believe they represent the exception to the rule. Using logic to convince them - does not work.

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  11. @Ahmed: Your analogy about students working hard doesn't work very well because when students work harder, on average, they get better marks. However, when investors go from doing (almost) nothing by indexing to doing the work of active investing, on average they get worse results.

    I have no problem with people testing themselves as stock pickers. If one of my sons was determined to do this I'd advise him to invest his real money passively and try stock picking on paper.

    @Mark: Many of my colleagues who thought they were great investors through the tech boom learned expensive lessons.

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  12. I do believe that there are those who are truly skilled in stock picking. I also know I'm no Warren Buffett and I don't have the time or temperament to become one. Therefore, I'm mostly indexed.

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  13. Great post. It is counter intuitive that working harder at something can give poorer results, but it is true for many things, including investing, fitness (one needs rest between workouts), and even studying (one's often better off getting some sleep before an exam versus pulling an all nighter). I've learned each of these lessons the hard way.

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  14. @Blitzer: I can still remember the reasoning: I don't have to study now because I have lots of time. Later it's I don't have to study right now because I can pull an all-nighter. Then it's I can't pull an all-nighter because I need some sleep.

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  15. Been there, done that. We are our own worst enemy.

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  16. There are very few people who have the ability to beat the S&P or Dow through skill and not luck. For the vast majority it is far better to be a defensive investor. In other words, balancing bonds and well diversified stocks. No expert assistance needed.

    The only way to skilfully do better than the markets is through timing (really, who can time the markets), buying a growth opportunity (but you need to see it as a growth opportunity before anyone else, and even the venture capital experts don't provide outsixed returns to their limited partners), or buying something for less than it's worth (and this requires the ability to find them before the masses and then value them correctly).

    I think professional advisors who promise any more than competancy, conservatism and sober second thought are misleading their clients.

    In summary, most people should buy the right indexes and go sailing on the weekends. Others need to be sure they know what kind of active investor they are and must be sure to have the skills necessary.

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  17. @Mark: You make a number of excellent points, particularly about what advisors should promise and about sailing on weekends (or whatever your favourite activity is). I found it a relief when I started throwing out stacks of company financials.

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  18. @Michael: Don't forget that the "average" investor is not the same as the "median" investor or the "typical" investor. The typical intelligent, informed, experienced enterprising investor (as Benjamin Graham calls them) may indeed beat the market for all we know. They may be drowned out by (1) idiots, (2) shortsighted fund managers trying to meet quarterly targets, and/or (3) fund managers who have no choice but to buy high and sell low because that's when the idiots (see #1) tend to buy and sell fund units.

    I'm not arguing that this is true. But I think it's a valid theory that could reconcile the seemingly contradictory statements that, on the one hand, the average active investor lags the indexes, and on the other hand, that some enterprising investors seem to do well over a long period of time.

    I deal with this conundrum by avoiding it. I didn't choose indexing because I'm unable to beat the market. I chose it because I'm unwilling to try. Too much brainpower in our society is devoted to financial navel-gazing already. (I know that's an ironic thing to say for someone with a personal finance blog...)

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  19. @Patrick: I suspect that the median and mode investors actually underperform the average investor. My main message is that it's not good enough to be smart. You have to be better than the (dollar-weighted) average active investor by enough to overcome the added costs of active investing. Most people (or more precisely dollars) who try to outperform must fail. These should be sobering facts for investors. No doubt there are some great investors who understand all of this well and can outperform.

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