Saturday, October 3, 2015

Not Quite Peter Lynch and Neither is Your Expert

Earlier this week I had a chance to spend some time with an estimated 200 professional investors (pros) at an institutional investment conference.(1) The pros were there to listen to and engage in Q&A with the senior management from well known and widely followed companies in the gaming industry that included MGM, BYD and WYNN, among others. The pros represent the largest and most sophisticated institutions in the markets. The pros were mostly men without ties who updated company models-notes on their laptops while listening to the company executives speak about issues of the day within their companies and industry. This gathering was closed to the public and had the typical look and feel of similar events with the companies selling their scripted stories designed to put forth the message they want to tell the pros (i.e. the market). The pros in turn, listened for any hint of new information that might impact their company models and forward looking assumptions.

Company executives know the drill here as conferences like this occur year round with the pros. The pros (who know the drill as well) are a highly educated, talented and hardworking group of individuals who possess high level analytical skills were there as part of their ongoing effort to figure out the potential future value of these companies by focusing on any new information that might impact the value of company debt and equity. The pros know the detailed company stories, numbers and models far better than individual investors can imagine. Their collective model assumptions and opinions represent what is known as the "consensus" which drives stock and bond prices of these companies. In other words. the decisions and actions of this group act as a key price setting mechanism for debt and equity issued by the companies who presented this day.

If you do not understand this already, you need to understand the pros set the market price as you and I, as individual investors do not. The other thing you must understand is that this crowd is smarter than you and I. In other words "fuggedaboutit" if you think you can beat the pros (i.e. market) over time using less sophisticated thought processes, strategies and analytical techniques.

The relevant point here is that the majority of this talented group cannot beat the market despite industry expertise, access to the companies and the skill they possess. In August 1975 Charles Ellis wrote a now famous article for the "Financial Analysts Journal" titled "The Loser's Game."(2) In the introduction the article Ellis wrote the following:

"Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market averages."

His point was that the professionals were not beating the market as the market was beating them. This remains true today as the overwhelming majority of active fund managers (i.e. the experts) do not beat the market despite their superb skill level. The question here today is that if the probability of the pros beating the market in any given year today is 10% or less and lower for consecutive years, what is the probability you can beat the market over time based on your skill level? The answer is near zero to zero. On this point Ellis argues that the premise professional money managers can beat the market is false. Ditto for the overwhelming majority of individual investors in spite of psychological resistance to this reality by some.

So one of the basic questions you the investor must answer is do you want your money to be actively or passively managed? In other words, if you and your professional guru(s) cannot beat the market, join it. If you do, the odds are that you will beat 90% or more of professional money managers as well as your own performance as an active investor.

The advantage of passive investing is low cost diversification compared to active management, among other factors. Passive investing has been around for a while and has taken off since the 2008 financial crises as most managers (i.e. experts) have not kept up with the market. Warren Buffett also recommends this approach. It is also worth noting that in this day and age, the related strategy of smart beta funds have emerged that have some combined characteristics of both passive and active investing but may impose higher fess than purely passive investment options. There are a number of sponsors that offer passive and smart beta instruments and lot's of information available today on these important topics. I include some sources below related to passive investing as a starting point.

Passive investing is an important strategy and one that deserves serious consideration. If this concept is new to you, I would start with Charles Ellis's book, "Winning The Loser's Game."(3) Even if it is not, I strongly recommend the book. I would also spend time on the Vanguard website and in John Bogle's writings on this subject as well as the "Wealthfront"(4) website.

I have been and remain both an active and passive investor. Peter Lynch of Fidelity beat the market for 11 out of his 13 years as an active professional investor and made Magellan one of the most successful funds in history. His record is near impossible to beat by most professional or individual investors.

(1) Deutsche Bank and UBS Gaming Investment Forum, September 28, 2015.
(2) Charles D. Ellis, "The Loser's Game," The Financial Analysts Journal, July/August 1975.
(3) Charles D. Ellis, "Winning the Loser's Game, Timeless Strategies for Successful Investing," Sixth Edition, July 9, 2013.

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