Investment Markets: Low Cost Index Funds Versus Active Management?

By Robert Wasilewski

Physicists and doctors are, in general, extremely bright people. However, even they often have a hard time fathoming how investment markets work.
This, of course, is not unique to physicists and doctors. But because they're so bright, it might be worthwhile to pick on them.
The reason for their shortfall is that most haven't taken a course in economics. One of the fundamental tenets in economics is that excess profits get competed away- and in a very short time if there are no barriers to entry.
Investment markets have minimal barriers to entry; if you think IBM is going higher, you can buy 100 shares online before you finish reading this sentence. This has implications on how fast prices adjust to news.

Value of Hard Work
Think about this: The physicist and the doctor get ahead in their careers by working hard and being smart. Reading plenty of academic papers, attending conferences to follow the latest research, writing academic papers, throwing in some brains and putting in the longer hours will get you ahead.
This is their life and model of how the world works, as it is for many people. The budding athlete, for example, hears this all the time: Just think and work hard and you'll be a better athlete.
Naturally then, people transfer this same logic to markets, to the world of investing in particular. Many physicists and doctors believe that by working hard and being smart it is possible to pick superior stocks and time the market. They naturally fall for the clever, persuasive person who shows them a system based on elaborate research techniques.
It's clear to them that undertaking massive amounts of research by very bright people must yield an advantage.

The Smartest Go
Down in Flames
With this in mind, let's revisit the saga of Long Term Capital Management (LTCM), the most infamous hedge fund in history. LTCM was founded by John Merriwether, the former head of risk arbitrage at Salomon Brothers, in 1994.
Just to be clear, to be the head risk arb guy at Salomon you have to be pretty sharp. But Merriwether added two Nobel Prize winning economists, Myron Scholes and Robert Merton, to his lineup, too.
He also brought along, from Salomon Brothers, several so-called "quant" guys whose brilliance was widely recognized in the investment community. They epitomized the meaning of "rocket scientist." It's probably safe to say that the IQs of the group assembled at LTCM rivaled that of mission control in Houston.
Their brilliance produced the state-of-the-art "value at risk" model. The model could calculate, at any point in time, the maximum that could be lost. Investors threw money at LTCM to invest in the best opportunities around the globe. By early 1998, they had to turn investors away.
That was a good thing. That's because later in the year they lost in excess of $4.5 billion during a very short period of time as the assets they held, along with their fabled value at risk model, went down the drain. Only a last-minute Federal Reserve-engineered bailout prevented a total disruption of the global markets.
It turned out that they didn't have all their bases covered. Russia defaulted on its debt and everything that was risky in the investment markets imploded; only Treasury debt went up in value.
In other words, investments that were supposed to rise when other investments dropped didn't rise. The smartest guys in the market had to be rescued, just like investment gurus at Bear Stearns, AIG, Merrill Lynch, etc., of more recent note had to be bailed out.
It makes one wonder and pause when handing more than 1% of assets per year to investment advisers who claim they have the "smarts" to time the market and pick stocks.

Stossel, ABC News and the Dartboard
Let's turn to John Stossel of ABC News. In 1992, on "20/20," he reported on an experiment whereby he threw darts at the stock pages to form a 20 stock portfolio and then compared the portfolio's performance with the recommendations from 10 large investment firms.
The results calculated by Zack's Investment Research of Chicago showed that, for the 12-month period, the portfolio constructed by randomly thrown darts outperformed nine of the 10 investment houses.
This is another awkward result. This doesn't fit the view of the world as understood by most people. How could this happen? How could someone who picks stocks at random by throwing a dart outperform the experts? What would be the chance of bringing somebody off the street and carrying out a more successful heart operation than 9 out of 10 heart surgeons?
These examples support the mountains of rigorous research that shows the lack of consistency and ability on the part of stock pickers and market timers to outperform the market.
It looks like Warren Buffet's advice to investors was exactly right: "The best way to own common stocks is through an index fund."

Robert Wasilewski is president of RW Investment Strategies in Glenwood. He can be reached at 443-896-4123 and via www.rwinvestmentstrategies.com.