Star Wars fans come in all shapes and sizes. Sometimes they look like scruffy, twenty-something writers from a small island on the arse-end of the world. Other times they look like besuited, seventy-year-old billionaire fund managers from the American mid-west.
David Booth is co-founder of Dimensional Fund Advisors, which manages about $445 billion of investor cash. I didn’t get to ask him to weigh in on the Han vs Greedo controversy, but our conversation was still among the most life-changing I’ve ever had.
Before we get into the juicy stuff, a little background. I met Booth to interview him for a Fairfax Business Bureau article, in which he gave the following piece of advice to my readers:
You ought to be well-diversified, invest in low-cost strategies, and you don’t take more risk than you can tolerate.
OK, not exactly Earth-shattering if you already know something about investing. But the only reason this is conventional wisdom now is because of the decades of work put in by people like Booth.
You might describe them as Rebels, fighting on the front line of a revolution against a large and powerful Empire…
If you haven’t checked out the Beginner’s Guide to Investing, give it a quick read now—it’ll help you get acquainted with some basic concepts (what is a mutual fund, why is diversification important?) that aren’t explicitly explained in this piece.
Real Men Pick Stocks
The world was a very uncivilised place in the early 70s. People had to talk to each other at the bus stop, the selfie stick wouldn’t be invented for decades, and Star Wars was just a twinkle in George Lucas’ eye.
Around this time, the finance industry was confronted with an uncomfortable truth. Despite all their expertise, most mutual fund managers didn’t seem to be able to beat the average market return. A few bright sparks struck upon a revolutionary concept. Rather than trying to guess which companies or industries would do best, why not buy a little slice of every single one? Cutting out all the trading, research and analysis would trim costs to a fraction of a typical fund. By matching the proportion of each stock to its weighting on the index, investors would be more or less guaranteed to earn the average market return.
Booth helped set up one of the first index funds at Wells Fargo, and went on to co-found Dimensional based on advanced tweaks to the same underlying philosophy.1 It would be fair to say the new school of ‘passive’ investing wasn’t exactly a smash hit:
People said the stupidest things – ‘It’s un-American’. Trying to improve your investment returns is un-American? What they meant is, ‘Real guys out there pick stocks’.
The passive folks were underdogs for a long time, but as the years passed the research continued to mount up in their favour. We now know beyond a shadow of doubt that active stock-picking can’t live up to its marketing hype.
Special Snowflake Syndrome
Let’s say you’re struck with a flash of red-hot insight that tells you Apple stock is a screaming buy. You speed-dial your broker and load up on a big parcel of shares. By definition, the people selling their holdings to you have the equal and opposite opinion. Both the buyers and the sellers think they’re getting a ‘deal’, and that the other camp are suckers. Only one of them will be proven right. (Meanwhile, the broker is laughing all the way to the bank, clipping the ticket on both sides of the transaction.)
By chance, you’d expect to be right about half the time, and wrong the other half of the time. Of course, you know the odds don’t apply because you’re a special snowflake, way smarter than those idiots on the other end of the trade.
Are you, though?
The top investment firms have basements packed with Wharton School graduates, their brains hardwired into Reuters terminals and their eyes reflecting scrolling red and green numbers from the fourteen monitors surrounding each workstation. The bosses of the firm spend their Sunday mornings schmoozing top CEOs, exchanging mildly homophobic jokes as they tee off on the 18th hole. Their trading floors have the best proprietary trading software and the latest algorithms. Their bathroom stalls have the most septum-deviating amphetamines.
And yet… they can’t consistently beat the odds, either! No-one’s saying these guys and gals aren’t smart. They have multiple finance degrees and brains bulging out their ears. The problem is, they don’t have a monopoly on smarts.
The Efficient-Market Hypothesis
Booth was a research assistant to Eugene Fama during his time at the University of Chicago School of Business. When he founded Dimensional, he called up his old mentor and got him on board. The relationship they forged is still going strong after half a century, and Fama’s research has been central to the company’s success.
If Fama’s name rings any bells, it’s because he won the Nobel Prize a couple years back. The prize was in recognition of his most famous work, the efficient-market hypothesis, which helps us understand why dueling investment geniuses reach a stalemate.
In short, the ruthless efficiency of the market makes it impossible to consistently beat. All relevant information is immediately absorbed into stock prices. Other than actual insider trading, no-one in the publicly traded markets has much of an ‘edge’ over anyone else.2
The first principle is that you must not fool yourself – and you are the easiest person to fool.
— RICHARD FEYNMAN
The efficient-markets hypothesis went down about as smoothly as a cup of cold sick. It just felt wrong.
As Booth explains, it rubs against the grain of our psychology. We’re conditioned to think that if you work harder or smarter than the next guy, you can beat him. It’s a core part of American culture—right up there with apple pie and assault rifles—but while hard work pays off in many fields, it’s not so useful in markets.
In fact, the exact opposite may be true: the best investor is almost certainly the lazy one who commits to a low-cost fund, sets up an automatic payment, and ignores it for several decades. Fidelity once studied its best-performing investors to try and discover the secret to their success… as it turned out, they had all either forgotten about their accounts, or were dead.
Booth peppers the conversation with references to Daniel Kahneman, a psychologist who won the Nobel3 after more-or-less establishing the field of behavioural economics. He recommends I read Thinking, Fast and Slow, in which Kahneman lays bare all the ways we meat-sacks are hopelessly irrational.
(In a stroke of serendipity, my flatmate happens to have a copy on hand. This becomes one of the best books I read in 2016, and possibly my entire life.)
Behavioural economics goes a long way towards explaining why we don’t want to believe the efficient-market hypothesis. We have an amazing ability to ignore concrete facts and probabilities, and maintain the delusion that we are special snowflakes.
People tend to remember their big wins and discount their blunders. They start to tell themselves stories. When they beat the market, it’s because they’re a genius! When they fail, it was just bad luck, or someone else’s fault.
Experts are just human in the end. They are dazzled by their own brilliance and hate to be wrong.
— DANIEL KAHNEMAN
It’s incredibly difficult to step back and be honest with ourselves about this. Now imagine how much harder it is for ‘professionals’, who have shaped their entire identity and livelihoods around the ability to make accurate predictions.
Kahneman references the work of Philip Tetlock, who gathered 80,000 predictions from people who made their living as political and economic commentators and advisors and asked them to rate the probability of certain events occurring.
The results were devastating. The experts did worse than if they’d assigned equal odds to every event. Those who knew more in their specific area did slightly better than those who knew less. However, the most knowledgable people were often the most unreliable, because they had an inflated opinion of their own skill.
Tetlock concluded experts were no better at making predictions than, say, an attentive reader of the New York Times. Amusingly, the one thing they were expert at was avoiding admitting they were wrong. Even when forced to do so, they had lots of excuses – the timing was wrong, it was because of an unforeseeable event, or they were wrong but for the right reasons.
Swinging For the Fences
A few lucky gambles can crown a reckless leader with a halo of prescience and boldness.
— DANIEL KAHNEMAN
Some fund managers do beat the market for a long time—but we should expect this, entirely by chance. Let’s say we held a national coin-flipping contest. After 10 flips, one in 1000 people would have managed to call every single one correctly.
Now imagine those lucky few being interviewed by breathless breakfast TV hosts, and telling the adoring public it’s all about the precise flick of the wrist. Aspiring flippers would queue up to buy the inevitable best-selling book, Flip Me Off, and pay exorbitant sums for one-on-one coaching sessions with the master coin-tossers.
This is exactly what happens in the real world. Investors stampede towards managers who have performed well, especially if they have a run of wins on the board. What they fail to understand is that in the stock-picking game, past success does not predict future returns. The person who flipped 10 heads in a row still has the same 50-50 chance of getting the next one wrong.
The pack behaviour of investors incentivises fund managers to swing for the fences, increasing the chances that they beat the market in spectacular fashion. The more outrageously they behave, the bigger the performance bonuses they collect.
Survivorship bias ensures we only hear from those who have taken a gamble and won. They’re the talk of the investing community, and do lots of important interviews with the financial press. Of course, they’re equally likely to fail disastrously, but the losers don’t tend to self-promote as much.
If I knew a certain fund manager was going to sock that baseball right out of the park, I’d give them all my money in a heartbeat. The point is that I don’t know, and neither does anyone else.
Taking the Warren Buffett Test
Whenever the active versus passive debate flares up, someone always asks: ‘Yeah, well, what about Warren Buffett then?’
Warren Buffett is a legend. I love him. He plans to give away 99 per cent of his tremendous wealth. He lives a simple and frugal life. He rocks a cardigan like no-one else, and his favourite meal is a cheeseburger and coke. I will sing Warren Buffett’s praises in a separate post.
What Warren Buffett is not is a genius stock-picker.
He makes a killing through juicy private deals which are completely out of reach of the average investor. Like, six billion dollar deals with three billion in preference rights and a guaranteed dividend. Like, lobbying the government to bail out the banks, then carving off a huge piece of the action.
Remember, the efficient-market hypothesis says prices fully reflect all available information. When it comes to publicly listed companies, everyone has access to the same data. Outside the public markets, information asymmetries can be exploited. If you’re an angel investor, a private equity firm, or a crony capitalist, you can make buckets of cash based on what you know and who you know.
Buffett’s style of investing is literally impossible for a regular person to imitate. He not only acknowledges this, he wants his estate to be transferred to a passive index fund when he dies.
If you’re still on the fence, I’ve come up with a foolproof test:
- Look in the mirror.
- Is Warren Buffett looking back at you?
- If the answer is ‘no’, don’t try and pick stocks.
(If the answer is ‘yes’, holy shit! Thanks for stopping by Wazza mate, love your work.)
If you see fraud and do not say fraud, you are a fraud.
— NASSIM TALEB
Imagine we woke up tomorrow morning to find all the writers in the world had been replaced with a giant room full of monkeys pounding away on typewriters. Our richest literature and most stirring poetry would be replaced with random strings of asgj.3r4t$djks;s1jk>.
Human civilisation would suffer an immeasurably huge loss.
Now, imagine all the active fund managers and investment gurus had been replaced with monkeys, who picked stocks by flinging their shit at the business pages of the newspaper.
Human civilisation would be… pretty much the same? The monkeys might even do a better job, because instead of jaw-dropping performance fees they’d be paid peanuts.
I’ve drawn hoots of outrage using variations of this analogy in the financial press. Why pick on the investment crowd, given other ‘expert’ forecasters in politics and economics are similarly useless? The vital distinction is that the investment soothsayers actually take people’s money—and how!
Active funds charge higher fees than passive funds, because they incur higher costs in brokerage, research and analysis. Fair enough. However, the managers also take fat bonuses when they beat their benchmarks (as a reward for their genius insights). For some strange reason, they never dock their own pay when they underperform.
Let’s recap: we have an industry that invests people’s money based on predictions, pays itself juicy fees whatever happens, and has scanty evidence to back up its marketing claims. The whole thing reeks of snake-oil.
Desperately trying to protect your livelihood is a natural urge, but it’s a sad spectacle. I’ve seen several smart people I previously respected tying themselves in knots trying to defend something indefensible.
As Upton Sinclair noted, it’s impossible to get someone to understand something when their salary depends on their not understanding it.
Why We Should All Thank Active Investors
If you go by the numbers alone, the active vs passive fight is the equivalent of the Klitschko brothers taking turns whaling on a tired old palooka. If you look at the big picture, it’s much more evenly matched. Team Passive has the weight of research behind every punch, but Team Active has psychology and history on their side. As long as there’s huge amounts of money involved, they’ll never throw in the towel.
Long may they fight!
My monkeys-on-typewriters analogy isn’t quite right. The hubris of stock-pickers really does provide a valuable service: not for any individual client or investor, but for the collective good of the market.
Stock-pickers read the balance sheets, consult the entrails, and cast the I Ching before they place their bets. Individually, it’s noise, but collectively, it generates a signal. Index investors can then wander in and just copy whatever the general consensus is. Critics worry that if that everyone adopts this freeloader approach, there’ll be no-one to scrutinise companies in the first place.
This is the strongest argument the active folks have left, but I still think it’s hogwash. There will always be people willing to swing for the fences, to gamble, or to exploit what they see as an information asymmetry. If the pendulum swings too far towards passive, there’ll be a counter-swing back. But we’re nowhere near that point yet, and we might never get there.
The other reason it’s hogwash is that all those big passive investors aren’t sitting on their hands. Sure, they don’t choose where to allocate cash, but they do take their responsibilities seriously.
I put these concerns to Michelle Edkins, managing director of corporate governance at BlackRock (the biggest investor in the world). She told me BlackRock casts shareholder votes on behalf of its clients 100 per cent of the time in major markets. That’s more than 15,000 company meetings a year. Edkins’ team frequently opposes underperforming directors standing for re-election, and gets hands-on with leadership teams in need of a stern word.
Passive investing might actually be the saving grace for good governance. If active investors don’t like what a company’s management is doing, they sell out and wash their hands of it. Long term investors have no choice but to buckle down and fix the problem.
From the Beginner’s Guide to Investing:
Passive funds tick all the boxes: Enormous diversification, different levels of risk to match your preferences, rock-bottom fees, low barriers to entry, and the ability to set up an automatic drip-feed.
It’s hard to go past Vanguard, a non-profit with a staggering $5.6 trillion of assets under management. Depending on which index or indices you choose to track, your cash is spread across thousands of companies, markets and industries. This huge diversification comes with fees as low as 0.05 per cent, which is 20 times cheaper than your typical active fund.
Here’s a quick reminder of why fees matter:
Vanguard and the other passive giants are based in the US. If you live elsewhere, you might run into a few complications around exchange rates, custodial fees, and tax. The best option is often to find a middleman which channels your investment into Vanguard funds while optimising for local conditions (in my home country of New Zealand, Superlife or Smartshares provide such a service).
Viva la Revolución
Remember how the swinging dicks running the industry back in the 1970s thought index investing was for sissies? Half a century later, Booth would have pretty good cause to be smug.
For one thing, he’s a billionaire. For another, the revolution has been won. These days, more than 50 per cent of new investments made in the United States are under passive management. Just to put the cherry on top, those nice Swedish folks finally gave old mate Fama the big gong in recognition of the research underpinning the whole movement.
Booth’s personal fortune is about $1.8 billion. He never needs to work again, and hasn’t needed to for a very long time. So what gets him out of bed in the morning?
You look at how people actually behave, and it’s inconsistent with the way they oughta behave. I think we can have a bit of a voice in changing that. It sounds corny, but we want to help improve people’s lives.
Trust in the Force, You Must
At this point Booth and I have been talking for more than an hour, and I’m starting to get uncomfortable. I’ve got a guilty conscience, and I need to make a confession.
It all comes out: I know this stuff intellectually, but I don’t put it into practice. I preach one thing to my readers, and then do the exact opposite. I’m not like them—I’m an up-and-coming financial reporter, spending my days attending company meetings, talking to analysts, interviewing CEOs, and trawling through balance sheets. I’m a stock-picking Real Man! In short, I’m the poster child for irrationality.
Booth takes it in his stride:
OK. Remember in The Empire Strikes Back, when Luke is training with Yoda? He doesn’t fully believe in the power of the Force, and that’s what holds him back from becoming a Jedi. You’re Luke Skywalker, and I’m Yoda. You have to trust in the Force, Luke.
Like stock-picking, the dark side of the Force is seductive. It’s exciting, stimulating, and powerful. It creates intense emotions: greed, fear, anger. By contrast, the light side leads to serenity—acceptance of fate and the things outside our control.
On a recent rewatch of Empire, I couldn’t help but notice this scene where Luke asks Yoda how he can tell the light side from the dark:
A year after meeting Booth, I’ve started to come over to the light side. I’ve read Thinking, Fast and Slow, and other behavioural economics primers. I’m starkly aware of all the mental gymnastics I’ve had to perform to justify my own irrational choices.
Sometimes just knowing something isn’t enough to change your behaviour. When a self-made billionaire gives you money advice, you give him your undivided attention. When said billionaire’s business partner is a Nobel prize-winning economist, the persuasion battle is halfway won. When he drives home the point with a Star Wars analogy, well—he might as well have brought the Death Star to a knife fight.
This is one of those situations where a little knowledge can be a dangerous thing, so drink deep or taste not that Pierian spring. I suspect this was my downfall. If I was, say, a crime reporter instead of a finance guy, I might have happily followed the passive investing path from the outset, and saved myself a lot of grief (e.g. my $10,000 investing mistake).
If you want to invest actively, you’ll need to put in thousands of hours of diligent research, learning and trial and error—and you’ll almost certainly do worse than if you’d never bothered in the first place. With that in mind, I’m not going to recommend any investing-specific books.
The public library will loan you these books for free. If you’d rather buy them, the affiliate links on this page send a few pennies to support this site, at no extra cost to you (read more here).
Thinking, Fast and Slow is great for the reasons mentioned earlier, and for the general insights it provides into the quirks of the mind. It’s a handy stepping stone to the ‘rationalist’ community—people who actively try to overcome their messy monkey brains, and search for objective truths. Predictably Irrational is another good read which covers similar ground.
UPDATE: with delicious irony, Kahneman was way too overconfident, and parts of this book haven’t held up well. Read it alongside a critical recap, like this one from Jason Collins.
The Black Swan by Nassim Taleb had a big influence on Kahneman, and touches on investing in several interesting ways. I’ve adopted one of Taleb’s strategies, which I’ll write about separately.
UPDATE: Here’s The Barbell Strategy for Investing
The broader theme of the book is our failure to predict rare events of great magnitude, how we can prepare ourselves to withstand these ‘Black Swans’, and how to position ourselves to take advantage of the positive ones.
- Dimensional bears no resemblance to traditional, active fund managers, but it’s not strictly passive either. It designs its own indices, often of smaller-cap stocks, and minimises transaction costs by sitting on bids or offers throughout the day and waiting for someone to cross the spread, rather than automatically doing business at the market close.
- The strongest of the three ‘forms’ of the efficient-market hypothesis holds that not even inside information can give an investor an advantage.
- To head off the pedants: no, Kahneman, Samuelson, Fama and the other dismal scientists technically didn’t win Nobel Prizes, but this essay was putting me at risk of carpal tunnel without having to type ‘Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1970’ multiple times over.