Active Investing And The Scientific Method

Warren MacKenzie Recently I observed a wealthy individual choose an indexing investment strategy which I expect will underperform the actively managed alternative he was considering by about 1% to 2% per annum. Over the next 20 years, this could mean $10 million in lost income and capital accumulation. This got me thinking about the difference between two methods of decision-making: the “scientific method” used in medicine and other sciences, and the “emotional method” which is frequently used to make investment decisions.

One of the tenets of the scientific method is to develop a hypothesis about something and then set out a method to test the hypothesis to see if it’s true. One way to determine if the hypothesis is true is to identify the things that cannot happen if it is true. For example, if the hypothesis is that the application of a new flame retardant paint will prevent fires, the hypothesis is proved wrong if the material burns just as quickly with or without the paint.

If an investor were to use the scientific method to test the theory that index investing is always the best strategy, an important step would be to identify any conditions that, if they exist, would mean that the theory cannot be true. For example, if one could find a group of active managers who beat the benchmark indexes over a period of 10 years, then the theory is wrong. Yet the wealthy individual I mentioned above did not use the scientific method to reach his decision and he didn’t consider any facts that would prove his theory wrong. He made what I believe was the wrong decision based on gut instinct and emotion. So, I asked myself: why do otherwise logical investors behave in this way?

I concluded that investors make the wrong decisions for various reasons. They may be tired of the decision-making process and just want to get it over with. They may be unwilling to do the hard work of examining different strategies. They may lack confidence they’ll be able to make the right decision even if they have all the facts. They may discount the advice of the advisor if they suspect that he or she has a conflict of interest.

When investors start heading down one path, they also don’t want to complicate their life by considering other alternatives. They’ll often ignore any facts that may contradict what they believe or have been taught (i.e. confirmation bias).

In this case, the individual chose a passive portfolio of index funds and ETFs. The alternative was a portfolio of active managers with a 10-year track record of beating a passive composite benchmark—and the qualitative and quantitative attributes that support an expectation of future long-term outperformance. His decision was based on a recent New York Times article and some general comments by Warren Buffett. He refused to consider any facts that contradicted his understanding of the benefits of the strategy he was leaning towards.

The New York Times article reported that over ten years, no active manager had consistently beaten a passive index. People who did not understand the article took it to mean that no manager has outperformed the index over 10 years. What the report actually said was that no manager had beaten the index each and every year for 10 years in a row. An investment manager might have had an average annual return of 12% compared to the index of 10%, but if there was one year out of the 10 that it underperformed the index, then the writer felt correct in saying that no manager could consistently (in every single year) beat the index. The reality is that any reasonable person would choose an investment that earned an average of 12% (with lower volatility) compared to an investment that averaged 10% with higher volatility, even if one year out of 10 the chosen investment underperforms the index.

Investors should know that there is a reasonable explanation for Warren Buffett’s suggestion that a passive portfolio is best for most investors. Buffett is considered to be the greatest investor of all time. He is an active investor who seeks out companies he believes are undervalued. He obviously believes that an active investing strategy works if one can exercise a skillful and disciplined approach. I think Buffet’s reason for recommending passive investments may simply be that for the average investor, this is the best strategy.

As Buffett suggests, investors are generally better off with index funds for a number of reasons:

Most financial advisors who try to pick stocks will underperform a passive index;
Retail mutual funds generally underperform the index;
Retail mutual fund fees are high and not fully disclosed;
Most investors don’t follow a disciplined rebalancing strategy;
Investors don’t receive performance reports that compare actual results with the appropriate benchmarks, reports that would thereby enable them to make wise decisions;
Investment mandates are not rebalanced to enable the investor to mostly be in the proper asset and to be able to “buy low and sell high”; and,
Most investors don’t know how to determine if the performance of different money managers is based on luck or skill.

With all these negatives, investors are usually better off with a cheap passive investment portfolio.

We all know that there are exceptions to most common-sense rules. If the rule is true most of the time, it’s wise to follow the advice. It’s even better if you’re wise enough to know when you can make an exception to the general rule.

With investing, the general rule is to use index funds or ETFs unless you have reason to believe that you have access to managers who have a long-term history of outperforming compared to the index. Some financial professionals who adhere to the fiduciary standard and who put client’s interest first are able to tilt the odds of success in clients’ favour by:

Designing “goals-based” portfolios which are designed to achieve goals while taking no more risk than is necessary;

Avoiding the conflict of interest that exists when professional investment managers pass judgment of their own performance;

Proactively negotiating low fees on the client’s behalf;

Using their experience to select “best in class/most appropriate” investment managers for each different investment mandate;

Using a well-researched rebalancing method to rebalance the portfolio when the asset mix is sufficiently out of whack; and,

Delivering performance reports which compare results to the proper benchmarks.

So, if the person wants advice and has enough capital to work with a qualified financial professional, I think that based on the hard evidence Buffet would agree that in these cases the active approach is better.

Investors should also be confident enough to ask for an explanation of any facts that seem to contradict the theory they want to believe. If you see a black swan you should question the common belief that all swans are white. And, when you see a portfolio of active investment managers who have (after all fees) beaten the composite benchmark over the last 10 years, you should question the statement that no managers can consistently beat a passive benchmark.

Why would investors ignore clear and incontrovertible facts that contradict the solution they’re leaning toward? Part of the reason may be that they simply do not believe these “facts” and they’re not willing to investigate to find out if they are true. To examine any contradictory facts they may have to restart the whole decision making process—and investors just don’t want to do this. Also, they’ve not calculated the long-term cost of underperformance (which in this case was over $10 million). At this point it seems that any decision is better than the uncertainty they’ve been going through.

In this case, by not questioning contradictory facts, the individual didn’t understand that when Buffett talks about how mutual fund managers usually underperform the index, he’s talking about high-fee retail mutual funds, not truly active “institutional funds” where the fee may be lower than the fee for an ETF. I believe Buffett would also have a different view in cases where the institutional funds are chosen by portfolio managers who have conducted extensive due diligence and who understand the investment strategy employed by the active managers.

Sensible investing starts with being brave enough to trust your common sense and to question facts that contradict your preliminary conclusions.

Bottom line? In all walks of life it takes courage to address facts which contradict our pet theories. No one likes to be proven wrong and by examining the facts we may prove ourselves to be wrong. Ignoring any facts that contradict our beliefs will save time and mental energy; however, if we question contradictory facts we’ll get a better understanding of the situation and we’ll usually make better investment decisions.

Warren MacKenzie, CPA, CA, CIMA is a Principal and Stewardship Counsellor with HighView Financial Group. HighView is an experienced boutique investment counselling firm, dedicated to developing sustainable wealth solutions for Canadian families and foundations. Email: wmackenzie@highviewfin.com Tel: 416.640.0550