Outstandingly Mediocre

Because he believes – quite rightly – that investing is hard, Tadas Viskanta, author of the fine new book Abnormal Returns and the indispensable blog of the same name, is clear that we should approach the task of investing with great humility and with modest goals. That’s because we can’t begin to think we can know (much less control) the markets with any degree of certainty and because we do such a poor job of controlling ourselves.  As a consequence, in his view, the best that most investors can hope to achieve is “investment mediocrity.” Indeed, Tadas sees that not as “settling” somehow, but as a worthy goal. 

How then should we define investment mediocrity? I would suggest that it is market returns. I recognize that we all like to win, that we all like to think we’re well above average and that we’d all like to be rich.  Those behavioral factors all tend to entice us into trying to beat the market.  But the probabilities say we won’t, especially in the secular bear market we have been suffering through since 2000.

The 2012 Quantitative Analysis of Investor Behavior from DALBAR was released recently and, yet again, it reflects comprehensive investor incompetence and irrationality.  For 2011, the QAIB showed that equity investors lost 5.73 percent as compared to the S&P 500′s gain (with dividends) of 2.12 percent.  Over 20 years, the average equity investor earned 3.49 percent per year compared to the S&P’s 7.81 percent — an annual underperformance of a whopping 4.32 percent.

As The Capital Speculator pointed out recently (consistent with my findings in The Value Project), the evidence in favor of passive management (most typically indexing, which by definition provides market returns) is surprisingly compelling. TCS correctly concludes that chasing alpha demands a lot of extra time and effort for an uncertain (unlikely?) payoff. It’s easy to claim that “market returns” are inadequate (for example, The Reformed Broker does so here), but astonishingly few (including even the always entertaining and frequently insightful Josh) provide reason to think that they can do any better.  Mediocrity is pretty darn good.

Passive investing is predicated upon the efficient markets hypothesis.  To oversimplify, that hypothesis asserts that because asset prices reflect all relevant information and that investors act rationally on that information, it is impossible to “beat the market” over time except by being extremely lucky.  The evidence supporting this idea is surprisingly strong as a practical matter even though aspects of it are easy to falsify.

Most significantly, and consistent with the QAIB’s findings, active managers generally fail to beat their benchmark indices.  Indeed, in 2010, only about 25% of active managers outperformed and 2011 was even worse.  Data from Morningstar shows that among 4,100 funds that invest in large-cap stocks, only 17% beat the S&P 500 for the year (strictly speaking, all index funds underperformed the market because of costs; however, for these purposes I will treat index funds as having matched the performance of “the market”). That is the smallest percentage since 1997.  Moreover, according to Bianco Research, 48% of equity mutual funds underperformed their benchmarks by more than 250 basis points. For example, the Fidelity Magellan Fund underperformed the S&P 500 by close to 14%. That’s an astonishingly bad year.  Even worse, those few active managers that do outperform in any given year have a very hard time (more here) keeping up the good work. 

Hedge funds – despite (and in part because of) enormous fees – have also badly underperformed, and they are the most active of active managers.  Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved simply by investing in Treasury bills. Hedge funds are prone to the same inconsistencies as more traditional managers too. Legendary hedge fund investor John Paulson generated returns of up to 600% by betting against mortgages in 2008 as the market crashed, but got crushed by huge losses in 2011. Many a great Wall Street career has been made with one great call in a row.

The Global Market Index (GMI — see here) —a passive, unmanaged but well diversified mix of all the major asset classes weighted by market values — has outperformed nearly everything else over the past decade, providing a 6.0 percent annualized total return for the 10 years ending December 31, 2011. That puts GMI in the 89th percentile relative to the roughly 1,200 multi-asset class funds with at least 10 years of history (and thus makes it an even better performer overall than the 89th percentile suggests once survivorship bias is factored in). GMI’s rebalanced and equal-weighted counterparts did even better. In retrospect, most investors would have been thrilled to receive 6 percent annualized over the past ten years.

At a minimum, this data demonstrates that (a) the vast majority of investors would benefit – and most would greatly benefit – from investment mediocrity; and (b) any portfolio including actively managed components must be carefully considered and supported, especially when the advisor is a fiduciary.

For most people, investment mediocrity would be a major upgrade.  So before you get carried away trying to beat the market, begin with a more reasonable, indeed worthy objective: mediocrity.  It isn’t at all a bad thing to proclaim that your investing is outstandingly mediocre.

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10 thoughts on “Outstandingly Mediocre

  1. Nicely said: “[T]he vast majority of investors would benefit – and most would greatly benefit – from investment mediocrity” — amazing but true. It’s also amazing that the majority of investment advisers and active investment managers do consistently underperform their benchmarks over the long run and short run, even before fees are consider. After fees, the comparison gets worse.

    This makes a great case for almost all investors to use a diversified, low-fee, passive portfolio. Something like a Lazy Portfolio, regularly re-balanced, fits the bill nicely:

    To quote Tadas Viskanta’s eight-word investing philosophy: ““Diversify widely, rebalance regularly, minimize costs: rinse, repeat.” Almost everyone would do well to do that.

    Now, that being said, the reality is that the Efficient Markets Hypothesis is not correct. Individual securities are routinely mis-priced and some of those who are disciplined enough to make a study of this arena and follow one of the schools of Graham-Dodd investment theory as a vocation have consistently beat the market indices and other investors, e.g. the so-called “Superinvestors of Graham-And-Doddsville” and their acolytes (Buffet/Munger, Seth Klarman, Walter Schloss, Christopher Browne, Bill Miller, etc.)

    Of course, the problem is that no one is as smart or disciplined as they think they are.

    • Excellent points all. As I have noted numerous times, the EMH is easy to falsify, but the market remains exceedingly difficult to beat.

      For my views as to when and how one might integrate active management into one’s portfolio, check out “The Value Project.”

      • Well, there is a lot of meat there in your seven “The Value Project” posts. Thanks for the referral.

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  3. Nicely put. I disagree with one comment:

    “Passive investing is predicated upon the efficient markets hypothesis.”

    I think the argument for passive investing may equally be premised upon the idea that, while markets are inefficient, human behavioral quirks preven most of us from exploiting those inefficiencies.

    • The EMH has a variety of iterations. You have recited a newer one (as it has become increasingly difficult to claim — in light of behavioral finance most prominently — that that the market is efficient). The key point, however, is that the market is exceedingly difficult to beat.

      Thanks for reading.

  4. Good article except for the word mediocrity. Passive is more outstanding than mediocre.
    1) http://www.merriam-webster.com/…/mediocre – of moderate or low quality, value, ability, or performance : ordinary, so-so
    2) Passive investor returns are market returns less (low) fees/costs
    3) Average active investor returns are LESS than market returns DUE to higher fees/costs
    4) Hence passive is better than average active, thus better than mediocre
    Again, right conclusions in this article, but the wording is misleading. I also appreciated that the topic is raised by someone combining both active and passive approaches. No contradiction. I do it myself.
    But the better title would be Outstandingly Advisable.

    Best wishes,

    • I used “investment mediocrity” because that is the expression used by Tadas Viskanta in his new book. Personally, I think “mediocre” is a bit too negative but that “outstanding” is too positive. But I don’t have a great alternative.

      Thanks for reading.

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