In the textbooks investing is a very rational process. Strategies are analyzed, portfolios are optimized and returns are positively related to risk. However in the real world there is the sticky issue that all along the way individual human beings are involved. Unfortunately those human beings are driven by any number of impulses. Two articles today highlight the way in which our desire to impress and invest like the best get in the way of good decision making. The first quote is from Eric Falkenstein at Falkenblog. He writes:
It’s interesting to note that in games there’s a profound dichotomy between the optimal tactics for beginners and experts. For example, Simon Ramo notes that among the very best tennis players, to win you need good winning shots; to be a good average player, you need to merely lower your failure rate. In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: beginners should focus on avoiding mistakes, experts on making great moves.
Yet if the distinguishing characteristic of an expert investor is whether they are being aggressive, then any aspiring expert is forced to be aggressive because this signals to others that he truly is an expert, and finance is all about getting other people to give you money to manage. Thus it should come as no surprise that if you give people advise to invest is simple index funds or to focus on low volatility stocks because you can do little damage, and save a couple percent a year, far too many will dismiss this advice.
Now contrast with the actions of a slew of university endowment officials who followed the lead of the Harvards and Yales of the world into alternative asset classes but did not end up generating the returns the Ivys were able to. James Stewart at NYTimes has the following quote:
“I feel that there was endowment envy, or maybe emulation is a better word,” Francis M. Kinniry Jr., a principal in Vanguard’s Investment Strategy Group, told me this week. “Everybody wanted to look like the Yales and Harvards of the world. But they were early. They were doing these techniques in the mid-1990s and late 1990s when equities looked overvalued, and alternative strategies could capture market imperfections. That’s no longer true. Those universities were forward-looking and deserve a lot of credit. But emulating that process three, five or seven years later is very problematic.”
Now many of these funds are stuck with mediocre (or worse) managers who are charging high fees and generating returns far outpaced by the equity and bond markets. The bottom line is that investors, both amateur and professional, are acting, often unconsciously, in a manner that first and foremost feeds their ego rather than their bottom line. Simple strategies, consistently applied have both the weight of history on their side and above all help remove the ego of managers from the process.