The process of becoming a smarter investor isn’t solely about intelligence; it’s about curiosity. I don’t think intelligence and curiosity are mutually exclusive. But I do think that while intelligence inspires one to acquire more facts, curiosity inspires one to ask more questions. When I think about this comparison and how it applies to the world of investing, asking more questions can be immediately beneficial.
I wrote last week that it’s very hard for an active manager to consistently outperform the market. I’m not saying that it’s impossible; it’s just very hard to do over a long timeframe. According to David Stein, author of Money for The Rest of Us, even skilled investment managers go through periods of underperformance and unskilled investment managers can get lucky with extended periods of outperformance. Part of the challenge in deciphering which investment managers are skilled from those that are not is finding a suitable way to compare them directly to each other or to a larger group (or universe) of similar managers over some set time period. The most common method is to compare the performance of a single manager to the average performance of a group of managers. But one of the problems with using the average or collective performance of a group or universe of managers is survivorship bias. Survivorship bias is the tendency to take at face value the performance of a group of investments over a specific time period without accounting for those investments that did not survive. Many investment managers that underperform, shutdown or merge with another investment manager, are not included in the investment pool, which in turn causes the performance of the remaining managers in the pool to appear better than it actually was.
In Jordan Ellenberg’s book, How Not to Be Wrong (1), he provides an example that sufficiently illustrates the dilemma of survivorship bias. The investment funds in Morningstar’s Large Blend category invest in big companies “that roughly represent those in the S&P 500.” According to Mr. Ellenberg, funds in this class grew an average of 10.8% per year between 1995 and 2004. He went on to say “that if you included the performance of the dead funds together with the surviving ones, the rate of return dropped to 8.9% per year (almost 200 basis points!).
In another example, David Stein outlines in his book, Money For The Rest of Us (2), that “each year, S&P Dow Jones Indices produces scorecards comparing active stock managers with market indices that approximate the managers’ particular investment strategy. These S&P Indices Versus Active (SPIVA) reports consistently show that most active managers around the world underperform passively managed benchmarks net of fees. For example, for the 15 years ending December 31, 2018, 92% of U.S. large cap stock funds trailed the S&P 500 Index, and 97% of small-company funds trailed the S&P 600 Index, a measure of U.S. small-company stocks. Morningstar produces a semiannual report that compares the performance of active managers relative to a composite of passively managed funds. The report shows that the vast majority of active managers underperform a comparable passively managed strategy net of fees of 10-, 15-, and 20-year periods.”
In 2012 I went back to school to get my MBA and one of the required courses was Corporate Finance. I was working as an investment advisor at Morgan Stanley at the time and I was excited about taking the course because I felt it would be additive to my career. About midway through the course we studied survivorship bias, its impact, and the historic record of mutual funds and their poor track record of beating the market. Prior to taking this course, I’d periodically questioned the value I was providing to clients because we both relied on readily available, public information. One of the takeaways from the course was that “if the market is efficient in the semistrong form, then no matter what publicly available information mutual fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole (3).”After studying this concept further, the question I asked myself was “What informational advantage could I, or any of my colleagues at that time, legally provide? Shortly after this course concluded, I decided to end my career in the public markets and pursue a career in the private markets. In the private markets, the market is truly inefficient, in that expertise and informational advantages are not equally shared, which I believe is of high value to investors without this access.
In conclusion, curiosity leads us to ask questions that help us discover the true drivers of the information we’re given, especially as it pertains to investment data. Two of the best tips I was given when I started my career in finance was 1). always question the assumptions and 2). always “READ THE FOOTNOTES” because that’s where the real information is.
Cheers – KM
(1) How Not To Be Wrong, Jordan Ellenberg
(2) Money For the Rest of Us, David Stein
(3) Corporate Finance, Core principles and applications – Ross, Westerfield, Jaffe & Jordan.