This is the last essay in this series. In part one of this series, we examined whether investing is a game. In part two of this series we examined the question of whether investing is a negative-, zero-, or positive-sum game. In part three we focused on how much of the investing game is luck or skill. In this segment, we will examine the question of whether it makes sense to have someone more skilled play the game on our behalf. If you have not read the prior essays, please read them first, in order.
There are numerous ways to have someone else “play the investment game” on our behalf. We can pay a full-service broker to choose stocks and other securities for us to buy and sell. We can purchase an actively-managed mutual fund and have a professional money manager choose a group of stocks or bonds for us. We can pay an investment advisor or portfolio manager to do the choosing. We can subscribe to a newsletter produced by the guru of the day and buy and sell the stocks he recommends. In all of these cases, we incur expenses. From a very broad perspective, these expenses are a zero-sum game. Whatever we pay, someone else collects. But for the investor, this is clearly a drag on performance. The key question is, can the “wisdom” imparted by the finance professional compensate for its cost?
To simplify one of the key messages of the previous essays, owning stocks and bonds is a positive-sum game; trading stocks and bonds is a negative-sum game. So if you are willing to pay someone else to play the game for you, are you paying him to own your stocks and bonds or to trade your stocks and bonds? Paying someone else to merely own stocks and bonds does not seem like a good use of money. Where is the value added? Almost any investor can hold something for a long time and collect interest payments, dividends, or capital gains. You don’t need the services of a “professional” if the primary source of your profits is the long-term appreciation of financial assets.
So that means that paying someone to play the game means paying someone to trade stocks and bonds on your behalf. As discussed previously, the odds are stacked against anyone who tries this, since this is a negative-sum game even before the extra costs are taken into account. If there were no trading costs, it would be a zero-sum game. But adding in trading costs makes it a negative-sum game. Then you have to add in the fees you pay someone else to trade on your behalf. Only an uninformed (or perhaps delusional) optimist would assume that he will beat these odds on a consistent basis.
Myriad studies reconfirm the difficulty of achieving better-than-average performance. In a recent front-page article in the Wall St. Journal on December 24, 2011, the authors cite a Bank of America-Merrill Lynch report that only 23% of U.S. stock managers were outperforming the large-cap benchmark for the year. These odds make slot machines, roulette, and even state lotteries look like a good deal in comparison. Note also that these managers are among the best-paid professionals in any industry, have vast amounts of experience, and have state-of-the-art resources at their disposal. But since they are, in essence, competing with themselves and incurring costs along the way, a majority can never win.
For a moment, put yourself in the position of an investment professional. You can try to make money the difficult way and attempt to be a better-than-average securities chooser. Or you can do it an easier way and collect money from others and insulate your income from the ups and downs of the market. All you need to do is to keep your clients satisfied to the point at which they don’t abandon your services and you are assured of a great compensation. Your clients don’t have to be happy, just not dissatisfied to the point where they will seek out an alternative. You can spend your time gathering and retaining clients, a far easier task than figuring out how to outthink the professionals who dominate trading in today’s markets. Why try to play the negative-sum game of trading stocks and bonds when you can play a totally different game and collect a toll from those who don’t understand how the process is not designed for their benefit?
The “standard” compensation scheme for investment professionals is a “heads I win, tails you lose” proposition. Consider the fees that investors pay to own the largest mutual fund, the Pimco Total Return Fund. It has over $240 billion dollars in assets and charges an annual expense fee of 0.46%. This adds up to more than one billion dollars a year, most of which is pure profit for the sponsor. The fund has performed poorly this year, underperforming more than 90% of its peers and trailing its benchmark by several percentage points (which is significant for a bond fund). In most other industries, a poorly performing manager would not be so richly rewarded. But in the actively-managed mutual fund business, the fund holders pay the price and the fund management company still collects its billion-dollar fees. As I have stated in previous posts, investors are slowly figuring this out and more money is being invested via low-cost index funds than ever before. But we still have a long way to go before the compensation in the industry reflects the true value added.
Last year, IBM produced a study that identified how hundreds of billions of dollars are paid annually in excess fees for actively-managed long-only funds that fail to beat their benchmark (see Industry ‘overpaid by $1,300 billion’ in the 4/4/2011 Financial Times). Similar amounts of money are spent in fees for wealth management and advisory services that fail to deliver promised above-benchmark returns. This unearned compensation is great if you are on the receiving end and have low ethical standards, but not so great if you are the one who is furnishing a portion of these proceeds.
The investment industry is taking proceeds from the positive-sum portions of the game from naïve investors and churning that money by trading amongst themselves in a negative-sum game in a futile attempt to be in the minority of winners. The solution for the self-directed individual investor is obvious: focus on playing the positive-sum game. Keep payments to non-value-adding outsiders to a minimum. Own stocks and bonds for the long term. Do not play the shorter-term and negative-sum game of trading stocks and bonds. It can be very expensive to pay someone else to play either part of this game for you, and it is not necessary if you have the proper education.