Academics Question Stock Investing

The Standard & Poor’s 500 index has soared 27 percent since October! These times of strong market gains are the brass ring for a large swath of well-educated, well-off Americans.

But recent academic research on three topics – value investing, the record of individual investors, and the usefulness of investment advisers – raises serious questions about buying individual stocks or actively invested stock funds.

The upshot of this research, it seems, was neatly summed up by Nobel Prize-winning economist Daniel Kahneman’s bestseller, “Thinking, Fast and Slow:” stock picking “is more like rolling the dice than like playing poker.”

The papers are complex (though not difficult to read), so here are synopses and links to them:

  • A paper by four finance professors at Goethe Universität in Frankfurt is brutal to individual investors, who “exhibit negative skill.” Analyzing nearly 9,000 online brokerage accounts in Germany, they concluded that most investors don’t outperform the stock market – “and if they do it is mere luck.” Enough said.
  • Wisely, you may think, nearly three out of four investors consult an investment adviser. It’s well-known that advisers who earn commissions based on what they sell face a clear conflict. The issue is: how do they handle it?
  • Harvard professor Sendhil Mullainathan, special adviser to the federal Consumer Financial Protection Bureau, sent research “auditors” into the field to impersonate prospective customers and evaluate the investment advice they received. Mullainathan and his co-authors concluded that such advice “is not in the best interest of the clients.” Further, an adviser sometimes “pushes clients towards funds with higher expected fees with little change in portfolio diversification.”

  • “Value investors” are the “grown-ups,” buying stocks “for less than they are worth” and unswayed by irrationality. But is that enough?
  • Aswath Damodaran’s paper analyzes value investing – passive, contrarian, and active – an area of expertise for which the New York University professor is a minor celebrity. He doesn’t say it’s a failed strategy, but he does warn that success, for the contrarians, “may prove illusive.” And he makes clear that “beating the market is always difficult to do, even for a good value investor.” Here’s the rub: the paper is written for investment managers.

    Note, however, that the paper is probably a value investors’ dream reading material. It is replete with history, interesting observations about Warren Buffett, nifty charts, and qualifiers.

Amid this tepid, even damning, research, Squared Away invites readers to explain why the investing craze never dies. Do readers go for active investing or for passive mutual funds – and why?

4 Responses to Academics Question Stock Investing

  1. Rob Elder says:

    I, too, enjoy reading academic research, a sure sign of excessive wonkiness. For a more fluid explanation of these issues, I strongly recommend “Winning the Loser’s Game,” by Charles Ellis and “Bogle on Mutual Funds,” by the Vanguard founder, both of which set me on the right path years ago. More recently, David Swensen at Yale deconstructed much of the fund industry in “Unconventional Success.” Read one or all and you’ll have more knowledge than most financial professionals.

  2. The fundamentals of investing have never been taught to a broker. RIAs (Registered investment advisers) are normally those that have used the series 7. Diversification is not taught nor is correlated to standard deviation, and on and on. Risk is NOT addressed except in the most sophomoric terms. They are given superficial marketing and then are told to sell stuff.

    If you do not know diversification (by the numbers), you cannot determine risk. If you cannot determine risk, you cannot determine suitability.

    Certainly the consumers know even less. They buy individual stocks hoping for Nirvana, but this is not necessary for Kahneman to detail. Anyone who has just, even lightly, analyzed investors is well aware of the general illiteracy and financial illiteracy of the 99 percent (not a misprint).

    But it is not going to change. As author of “Financial Planning Fiduciary Standards under Dodd Frank,” I can assure anyone that suitability and fiduciary are mere words used to assuage consumers and journalists into some level of comfort.

    Frankly, the focus on returns is not the real key to success. It is about risk, but it is rarely addressed anywhere. A risk of loss can be determined for almost any portfolio, but it requires a personal financial calculator.

    Errold F Moody Jr
    Life and Disability Insurance Analyst
    Registered Investment Adviser

  3. Warren Flick says:

    Rob has good advice. Add Burton Malkiel’s, “A Random Walk Down Wall Street” (New York: W.W. Norton & Company, 2011) to the list. Malkiel first published the book in 1973, and I believe the current edition is the 10th revision. A diversified portfolio of stocks, bonds, real estate, and foreign investments, all in low-cost mutual funds or perhaps ETFs is a good basic approach for millions of investors.

  4. JP Smith says:

    One possibility that the post did not cover was that equity investing was a losing game “no matter what assets you pick.” Zerohedge had a recent post on that topic – interest in equities peaked years ago and has been declining ever since.