The 'Lake Wobegon Effect' Of Investing

by: Lowell Herr

Given a sufficiently large population of investors, the laws of probability will produce a group of money managers whose investment performance will exceed the broad market average over any time frame. Is this skill or just luck? Identify any well known successful investor and stake them with a $100,000 in cash. Will they be able to reproduce outstanding results over the next 20 to 40 years? This question is not to denigrate the investing skills of top money managers, but it is worth pondering to those who claim to be able to "beat the market." Is anyone able to identify the next Michael Price, Warren Buffett, Peter Lynch, or John Templeton?

Index investors are grateful that the majority of investors continue to make investment decisions using a style known as active management. Active managers provide liquidity in the market and this serves a useful purpose to those investors who tilt toward a passive style of investing. Active managers operate under the assumption they can "beat the market." And the laws of probability prove some to be right in their reasoning. While I call this the "Lake Wobegon Effect" it is also known as the "Dunning-Kruger Effect." In other words, the majority of investors think they are above average. Once more, is there confusion between skill and luck?

William F. Sharpe makes a compelling argument in his simple four-page article that active investors, on average, cannot outperform passive investors. Check out his "The Arithmetic of Active Management" article. I suspect Sharpe used 'arithmetic' in the title to imply anyone with an 8th grade education will be able to understand his arguments.

Quoting Sharpe in the above article. "If 'active' and 'passive' management styles are defined in sensible ways, it must be the case that

1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

These two points are the thesis of Sharpe's article.

In a recent Seeking Alpha article, I listed my top 12 investment books. The underlying theme in each of these books is index investing. As expected, the cry for active management arose and the name Benjamin Graham was frequently mentioned as the father of value investing and the teacher of many famous investors who studied his approach. None of Graham's books made my top list even though I consider them valuable reading.

Late in life Graham changed his attitude toward active management, at least for some investors. Here are a few links to some of his remarks.

Benjamin Graham and index funds.

Benjamin Graham and the Wisdom of Index Funds.

While I have a bias toward a particular investment style, the choice to be an active or index investor is up to each individual. If one is convinced they are smarter than the market, go for it. If one takes the active path, here are a few check points or "roadside markers" I employ when using the active management style.

1. Use software to track the Internal Rate of Return (IRR) of the portfolio. Professional mangers handling multiple accounts will likely use Time-Weighted Return methods.

2. Set up an appropriate benchmark for the portfolio. You cannot manage what you do not measure. Here is a link to benchmark guidelines.

3. Develop a customized benchmark for the portfolio as the S&P 500, frequently used, is an inappropriate benchmark for most portfolios. For example, if bonds make up a sizable percentage of the portfolio, a bond benchmark should be part of the calculus.

4. Determine what risk one is taking to achieve performance results. My preference is to use either the Sortino Ratio (SR) or a modification of SR known as the Retirement Ratio. These risk ratios do not penalize volatility to the upside or when the manager is outperforming the benchmark.

If you are using a professional money manager to handle your portfolio, what kind of performance records are provided? What are they using as the benchmark and is risk reported?

Outside of the mutual fund industry it is nearly impossible to come up with portfolio performance results. Even if the data were available, it would be a monumental task to come up with reliable conclusions as most portfolio to portfolio comparisons make little sense. Risk requirements vary, launch dates differ, and portfolio size allows for different opportunities.

While individual investors have many advantages over mutual fund managers, it behooves individuals to examine professional results. If the pros have difficulty beating the market, can the small investor do it? For a good look at actively managed mutual funds, read Richard A. Ferri's book, "The Power of Passive Investing: More Wealth With Less Work." The results are an eye opener.

I've come to the conclusion that only the individual investor can answer the question as to which style, active or passive, is the best investing approach. Regardless which path is selected, one needs to carefully monitor performance and risk while using an appropriate portfolio benchmark.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.