The Folly Of So-Called 'Best Practices'

Summary

• So-called "Best Practices" are in fact common practices.
• Antiquated and inferior approaches are routinely misidentified as "Best Practices".
• We really should continually seek better ways – true "Best Practices."

Knowledge must continually be renewed by ceaseless effort.

- Albert Einstein

So-called "Best Practices" are in fact common practices. This isn't just semantics; it's bad practice. Nevin Adams says that "Best practices that are not common practices are merely someone's unpopular opinion." In other words, a true "Best Practice" doesn't stay that way for long because presumably the industry adopts it very quickly so it enters into the mainstream of common practices.

Nevin is correct, but not about the time it takes for investors to recognize a better way - a true Best Practice.

Modern Portfolio Theory ((MPT)) was 30-years-old before it was even discussed. The Black-Scholes Option Pricing Model took decades, largely because no one would publish their groundbreaking paper. Dr. Frank Sortino's leading edge active-passive optimizations have remained a secret for 40 years, although some are doing work in this area. In other words, there are in fact "Best Practices" that have not yet become common practices.

In the meantime, antiquated and inferior approaches are routinely identified as "Best Practices." Without naming names, there is at least one large organization for investment advisors that publishes best practices. These standards recommend the use of peer groups, and go to great extent to elaborate on time periods. You need to look at peer group rankings over various time periods. These standards also recommend an "appropriate benchmark" that could be an off-the-shelf index.

Indexes and peer groups are far from being "Best Practices." In fact they are known to be "Worst Practices" because we know they have failed. I have contributed several articles to Seeking Alpha on this subject, including:

• Rewards for Saving Active Management
• New Definition of Investment Manager Success
• Yin and Yang of Change, about Hedge Fund Evaluation
• New Era for Financial Advisors. Dealing with DOL Fiduciary Rules
• Alpha on Steroids
• Hedge Fund Peer Groups are Hazardous to Your Wealth
• What Investors Really Want from Their Advisors

The Moral

We can all sit around and tell ourselves how smart we are to use "Best Practices", but we really should continually seek better ways. Please read the Einstein quote that leads off this article.

Analyst’s Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Ronald Surz]

These are great comments. Very enlightening. Thanks.

From my experience in the consulting profession, the old ways continue on because of momentum, laziness and self interests.

Momentum and laziness: We’re all hardwired to resist change.

Self interests:
Active investment managers prefer the status quo because savvy salespeople can always find an index and/or peer group that they have outperformed. Have you ever met a manager who ranks below median?
Advisors like the old ways because they have told their clients that these ways are the right ways, and have invested in them. Also, pay-to-play is a way of life in the investment business that engenders old ways.

[djoseph]

In their earlier stages, many new practices, procedures or approaches in medicine turn out to be not so good or very bad. That is just the manner in which research works. Experienced doctors are often risk averse, due to their experience. They wish to wait until more "real world data" have been accumulated before changing their approaches. In other words, they don't wish to experiment on their patients. Does there come a point where real data on efficacy have emerged, and some doctors still refuse to change? Indeed. Why does this happen? You can think of the same reasons I can: lack of energy, disinterest/boredom with the profession, emotional problems related to personal issues or drug/EtOH misuse, etc and etc. The goal is balance. As Hegel wrote, the world progresses as follows: thesis, antithesis, synthesis (balance). It can sometimes be hard to know just where we are on that continuum.

[Adam Hoffman, CFA]

DJoseph-->

Part of the problem in medicine is that doctors are no longer "doctors". They are just workers on an assembly line that have to follow the Standards of Practice (SOP) of the hospital, insurance companies, and their malpractice insurance. Let's take for example, a doctor knows with 100% certainty that the patient has ABC disease. The doctor will still order the "regular and accepted" tests of 1,2, and 3 to confirm ABC disease to adhere to the SOP of the insurance company as well as to follow "best practices" in-order to not put their livelihood at risk. Remember, at the end of the day that Doctor has bills that need to be paid and he/she doesn't want to jeopardize their income.

If the doctor deviates from the SOPs, they risk the ability to get paid from insurance and increased risk of a malpractice suit.

Same issues are present in financial advice / planning. Let's take for example a person that will exhaust their portfolio in 5 years. The safe bet for the advisor is too keep the money invested conservatively to make sure it will last 5 years. However, the money will still run out in 5 years. The alternative is to put the money into "high risk" investments and "hope" for great returns to extend the life of the portfolio with the risk that the portfolio could run out prior to 5 years. What is the best option? For the client, it might be going the low risk or the high risk route. For the advisor, the low risk / conservative path is the choice to make. Otherwise, it might be viewed by a regulator or the attorney suing you that the advisor "experimented" on the client since a non-traditional or accepted approach was taken.

Adam Hoffman, CFA, CAIA

[TabbyKatz]

@Adam H. - You have hit a nail on the head. The old adage about never being faulted for recommending IBM holds true for FA's. It is much easier and presents less liability to recommend ETFs and mutual funds in line with MPT and asset allocation tenets than to provide active, dynamic, on-going management.

[BubbaJM]

I do relate and agree with your ideas about "best practices" being attributed incorrectly to those which are fed to us by certain authoritative institutions. I've seen similar phenomena in my medical career...often when newer procedures are known to be superior by a few... It still can take many years before these ideas are accepted, or even know by the majority. There also seems to be a certain "stickiness" to old beliefs,..they die hard and slowly. I presume that this may even partially relate to the reason for the momentum effect in stocks, as well as so many other areas. I would have to admit however, that even though realizing that current beliefs of "Best practice" may not actually be the best... Trying to determine what is actually "best" can prove to be very difficult.

[BeAnBeAn]

Why are people reluctant in the medical field to adopt new and better ways? Is it just the typical apprehensive mindset to try new things out of fear of personal liability if something could possibly go wrong, even though the benefits have been strongly demonstrated?

[BubbaJM]

There are multiple reasons for this... (that I believe are in effect) ...none of which have to do with any "conspiracy" to try and suppress information. You have to realize the world is a big place..(huge actually). Information takes more time to spread than we realize (even today with internet access). The whole world is not working on the same problems, in the same way, at the same time. It is usually the case that in different parts of the world, different methods are being developed for the same problem. Many of these you will not even become aware of until many years after one group has perfected their procedure or formula. Yet at the same time a different method is evolving somewhere else. And so on. They all have different advantages, different risks...some of which take many years of analysis before even determining which method is better. I used to think most medical procedures were the same and standard at all hospitals....until I actually had been working at multiple hospitals. There are some differences between all. Visit another country and more differences still. Then doctors, hospital staffs, committees have to form and try to identify best procedures. Do you think everyone agrees?...just look at the number of different opinions on "best financial advice" here on seeking alpha. And besides all this, there are the normal human concerns of politics and money that play into all organizations, committees, hospitals, etc... sometimes it is subtle enough that people don't even realize it plays a role. Different people often believe their own ways are best... Most people (myself included) aren't even aware of all the alternatives out there. Like yourself I used to believe things were simpler, that everyone in a field knew exactly what the best practice even was. Now I believe differently. I'm sure it is the same way in many fields besides medicine.