Stordahl Capital Management’s Evidence-Based Investment Insights: Insight #3: Financial Gurus and Other Fantastic Creatures
Welcome to the next installment in our series of SCM’s Evidence-Based Investment Insights: Financial Gurus and Other Fantastic Creatures.
In our last piece, “Ignoring the Siren Song of Daily Market Pricing,” we explored how price-setting occurs in capital markets and why investors should avoid reacting to breaking news. The cost and competitive hurdles are just too high. Now, let’s explain why you’re also ill-advised to seek a pinch-hitting expert to compete for you.
In his “Berkshire Hathaway 2017 Shareholders Letter,” Warren Buffett described his take on the price paid to active “experts”:
“Performance comes, performance goes. Fees never falter.”
Instead, Buffett suggests:
“Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with every bit of Wall Street jargon. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals.”
Group Intelligence Wins Again
As we covered in “You, the Market, and the Prices You Pay,” independently thinking groups (like capital markets) are usually better at arriving at accurate answers than even the most intelligent individuals in the group. That’s partly because their wisdom is already bundled into prices, which adjust with fierce speed and relative accuracy to any breaking news.
Thus, even experts specializing in analyzing business, economic, geopolitical, or any other market-related information face the same challenges you do if they try to forecast future prices. They must still attempt to predict the unpredictable successfully. Like anyone else, they cannot foresee the news itself, let alone the reactions to unexpected news that is unknown. Particularly after the costs involved in trying, outmaneuvering prices set by group intelligence usually remains a prohibitively tall hurdle.
The Proof is in the Pudding
But maybe you know of an extraordinary stockbroker, fund manager, or media guru who strikes you as among the elite few who are up to the challenge. Perhaps they have a stellar track record, impeccable credentials, a secret sauce, or brand-name recognition. Can you rely on their latest forecasts?
Let’s set aside market theory for a moment and consider what has been working. The bottom line is if investors could depend on expert stock-picking or market-timing forecasters, we should expect to see credible evidence of it, with more “winners” than random chance would explain.
Not only is such data lacking, the body of evidence to the contrary is overwhelming. Each season’s crop of star performers often fails to survive, the fund goes out of business or is merged with another fund, let alone persistently beat comparable market returns moving forward.
Plus, the best way to profit from a guru’s stellar track record requires you to jump on their bandwagon while they’re still on a hot roll so you, too, can profit from their future success. Without a time-travel machine, this is once again a daunting challenge.
To cite one of many sources, Morningstar publishes a semiannual “Active vs Passive Investment Management Barometer Report,” comparing actively managed funds to their passively managed peers. In its Midyear 2023 Report, there was some relatively good news for active investors. For the 12 months from June 2022–June 2023, Morningstar found, “Fifty-seven percent of active strategies survived and beat their average passive counterpart … well above their 43% success rate in calendar year 2022.”
Of course, if 57% of active strategies survived and beat the market for the 12 months ending June 2023, a relatively hefty 43% of them did not.
Thus, even the brief pop was not a resounding success. Nor do we expect it to be long-lived. As Morningstar also reported:
“Actively managed funds’ recent surge did little to change their long-term track record against their passive peers. Just one out of every four active strategies survived and beat their average passive counterpart over the 10 years through June 2023.”
Dimensional Fund Advisors found similar results in its independent analysis. Looking at the 10-year performance for U.S.-domiciled stock funds through year-end 2022, they found only 27% of an initial 2,954 funds survived and outperformed their benchmarks.
Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking.
Among the earliest such studies is Michael Jensen’s 1967 Journal of Finance paper, “The Performance of Mutual Funds in the Period 1945–1964.” He concluded, there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”
More recently, Eugene Fama and Kenneth French published a 2010 Journal of Finance study, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” demonstrating that “the high costs of active management show up intact as lower returns to investors.”
In 2016, a pair of professors from the University of North Florida published “A Review of Studies in Mutual Fund Performance, Timing and Persistence,” scrutinizing more than 60 of the “more widely cited works” on fund performance. They concluded: “The basic results have not changed; it appears that: (1) mutual funds underperform the ‘market;’ (2) fund managers in aggregate are incapable of timing the market; and (3) mutual fund investors are ill-advised to invest based on prior fund performance.”
Yet another study, “Mutual fund performance at long horizons,” appeared in the January 2023 Journal of Financial Economics. Its authors concluded that fund managers still struggled to outperform the market (as proxied by the S&P 500). They estimated “an aggregate wealth loss to mutual fund investors of $1.02 trillion,” based on long-horizon mutual fund underperformance. In a separate commentary, the authors wrote, “This wealth loss reflects the combined effect of mutual fund fees and investors’ timing decisions.”
Your Take-Home
So far, in our Evidence-Based Investment Insights series, we’ve been assessing common investment challenges.
Fortunately, there’s a way to invest that lets you nimbly sidestep rather than face these stumbling blocks: You can allow the market to do what it does best on your behalf. Next, we’ll introduce the strategies involved, starting with what some have described as investment’s only free lunch: diversification.
If you want to discuss this concept further, we offer a complimentary 15-minute call to answer your questions and to share how we can help.
This information should not be construed as investment, tax, or legal advice. This commentary reflects the personal opinions, viewpoints, and analyses of the Stordahl Capital Management, Inc. employees providing such comments and should not be regarded as a description of advisory services provided by Stordahl Capital Management, Inc. or performance returns of any Stordahl Capital Management Inc. Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this piece constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Accessing websites through links directs you away from our website. Stordahl Capital Management is not responsible for errors or omissions in the material on third-party websites and does not necessarily approve of or endorse the information provided. Users who gain access to third-party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from the use of those websites. Please note that trading instructions through email, fax, or voicemail will not be taken. Your identity and timely retrieval of instructions cannot be guaranteed. Stordahl Capital Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.