Persistence is a quality that when found in people is usually admired. If a person’s goals and intentions can be judged as noble, then certainly a persistent effort to reach noble goals should be applauded. But what if the outcome of persistent efforts is merely random, and can be demonstrated to likely always be such, then should persistent efforts still be admired? This is not merely a philosophical question, it is a dilemma faced by investors pursuing the practical matter of building a portfolio for the undeniably noble causes of taking care of their families and securing their retirement.
The investment discipline of stock picking, also known as active management, is sometimes justified using the normative ethical position that it is the noble duty of an investment manager to beat the market. Indeed, some investment managers see their persistent efforts to create a return stream that is better than an index as meeting a moral obligation of the highest order. Perhaps without realizing it, these managers are embracing a “deontological” ethical philosophy. They are rejecting the idea that their efforts should be measured only by the consequences of their actions.
Over the last few decades, academic researchers have developed the statistical tools to measure the consequences of investment strategies. An article in the April, 2010 edition of The Journal of Finance http://www.hec.unil.ch/agoyal/docs/persistence_jof.pdf details those efforts and gives a history lesson for the uninitiated. The conclusion of this research is that even though investment managers achieve a wide variety of results, there is little to no evidence of any persistence in performance; active managers who have beaten the market are no more likely to beat the market in the future than anyone else. Therefore, we can reasonably see it as inevitable that active management will produce random results, and therefore fail to achieve a noble goal.
And yet some aspects of market performance are persistent. In the above referenced research, the authors had to statistically adjust out the positive and persistent effects that come from over-weighting small company stocks and value stocks. It was only after this was done that the uselessness of stock picking could be revealed. In the chart below from DFA funds you can see their research on the annual performance of small company stocks when compared to large stocks. The 3.58% average annual difference in returns is statistically significant and probably meaningful to most investors.
In the next chart from DFA Funds you can see that value stocks have performed 4.8% better when compared to growth stocks over the stated period. It doesn’t work every year, but the proper way to view both of these slides is by remembering that the whole of the stock market will sometimes fail to beat the return you could get from sitting in cash. However, in most years it does and that trend has not diminished over time.
This research is no secret. And so at Buckhead Investment Partners we are driven to create the best possible outcomes for our investors by applying this research to our clients’ portfolios. I guess that makes us “consequentialists”, which means that it is ultimately the results of these investment strategies that matter to us.
But then how harshly must we judge the investment professionals who spend their lives charging unnecessary fees to investors in an effort to achieve the impossible? Immanuel Kant, a famous deontologist no less, provides us with an opportunity to forgive. For Kant sees the measure of a person’s actions as being noble if they are intrinsically good as judged by intentions. And while we reject the idea that this can justify us chasing returns by picking stocks for our clients, it is only because the world is full of these statistically uninformed, but persistently hopeful, market participants that we have a robust stock market that is fairly priced for the rest of us. In other words, we can only depend on a certain market efficiency that makes our whole approach work precisely because of the existence of the “noble” stock pickers.
This communication contains general investing information that is not suitable for everyone and is subject to change without notice. Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass. The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security. Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors. Indices are not available for direct investment. The above charts do not represent actual portfolios. Buckhead Investment Partners is not affiliated with DFA Funds. For additional information about DFA Funds please see their website www.dfaus.com.