MAKING SENSE -- February 6, 2013 at 10:21 AM ET
What Good Do Money Management Firms Have to Offer?
When a feline can pick stocks better than a human, money manager Jon Shayne argues there are still very good reasons to have money management firms actively pick stocks and invest your money.
Photo by Tom Noser.
Paul Solman: Jon Shayne is not only our favorite wonky warbler in his musical avatar, Merle Hazard. He is also, as a well-known money manager, a trusted contributor to Making Sen$e, as one and then another of his recent interviews with British financial expert Andrew Smithers attest.
Here are Shayne's rather sober reflections on the life of a money manager and what he does every day: invest money.
When a Cat Can Pick Stocks Better Than Investors
Jon Shayne: The British Observer announced a few weeks ago that a cat named Orlando beat out three investment professionals, and one group of students, in a year-long, feline vs. human stock picking contest. Orlando won simply by nudging his cat toy at a grid to make his random picks.
As if that were not bad enough news for money managers like me, Paul Solman said recently that "most money management firms are parasites."
So, with my pride under threat from both a cat and Paul, maybe it is a good time to consider what, if anything, money management might be able to offer the world, other than dice-throwing, expert cat-toy-pushing or parasitism.
The Advantages of Index Funds
Now, let me first give Orlando and Paul their proper due by offering my positive assessment of index funds. The average investor will, by definition, get the average return, minus expenses. You can lock in an average return at very low cost by investing in an index fund or ETF. If you follow that route, you are going to find yourself in the top half of investors, once expenses are taken into account, with little fuss, and without having to take calls from an adviser who may try to sell you things. That is a good deal. Individuals, and even endowments and other institutional investors, can pursue indexing sensibly.
Vehicles like Vanguard's Target Retirement funds, which change their asset allocation based on the investor's target retirement date, are often even better for many investors. Combine a low-expense fund with good books like Jane Bryant Quinn's "Making the Most of Your Money Now," and maybe J.K. Lasser's "Your Income Tax," and you have outfitted yourself well, with little damage to your wallet.
What Is Left of the Case for Active Stock-Pickers?
The financial markets are generally quite efficient: Nearly all information is reflected in the market price of each asset. But they are not completely efficient. The business of money management should likely be a lot smaller and less lucrative than it is, but there actually is a role for it, cats (and cats in hats) notwithstanding.
You are not going to take anything a money manager says at face value -- nor should you -- so let me turn to Nate Silver, who recently demonstrated his statistical chops by using published polls to predict the outcome of the 2012 presidential election so well. His recent book, "The Signal and the Noise," is great. Chapter 11 is about financial markets.
To quote Silver (and the emphasis is his):
"In fact, efficient-market hypothesis is intrinsically somewhat self-defeating. If all investors believed the theory -- that they can't make any money from trading since the stock market is unbeatable -- there would be no one left to make trades and therefore no market at all ...
"The most workable solution to the paradox, identified by the Nobel Prize-winning economist Joseph Stiglitz and his colleague Sanford Grossman many years ago, is to allow some investors to make just a little bit of profit: just enough to adequately compensate them for the effort they put in ...
"The equilibrium proposed by Stiglitz is one in which some minimal profits are available to some investors. Efficient-market hypothesis can't literally be true ... It probably isn't the mutual funds that are beating Wall Street; they follow too conventional a strategy and sink or swim together. But some hedge funds (not most) very probably beat the market, and some proprietary trading desks at elite firms like Goldman Sachs almost certainly do ...
"Fischer Black estimated that markets are basically rational 90 percent of the time. The other 10 percent of the time, the noise traders dominate -- and they can go a little haywire. One way to look at this is that markets are usually very right but occasionally very wrong ...
"Some of the bubbles of recent years, particularly the housing bubble, were detected by enormous numbers of people well in advance. And tests like [Yale economist Robert] Shiller's P/E ratio have been quite reliable indicators of bubbles in the past."
Silver is very close to right. I would also add that some mutual funds are much less conventional than others, and thus have a higher chance of adding value. I see a little more room for adding value by long-term fundamental investing, Warren Buffett-style, than he does, but this is only a quibble. In short, he has read this about as right as he did the polls for the 2012 election.
And of course, even John Maynard Keynes did not think the market is wholly rational. After all, he said, "The market can stay irrational longer than you can stay solvent."
Keep in mind that even if markets were completely efficient, expected return would go up for those who assume more risk. You might need someone to counsel you about how much risk you can afford to take and how to factor in your Social Security benefits. If you and your spouse are fighting over money, hiring someone more objective to counsel you about spending and saving alone is very smart. I recommend hiring those who charge only by the hour and who do not accept any commissions. In other words, if you use a financial planner, fee-only is preferable to fee-based or commissioned.
Should One Invest Actively When Indexing Is So Attractive?
It can make sense for someone who actually enjoys the process or who is skittish about doing it himself/herself and needs someone to talk to. It helps if you think there is something at least a bit useful, socially, about a market-based system, much as the corner grocer can take some pride in feeding people even while trying to make a profit. I can hear a few readers laughing, but some investors do believe that markets have a role that is more beneficial than not.
And, frankly, as the investment writer and money manager John Train once put it, it probably helps to be, to some degree, misanthropic: If you are going to have any hope of earning back your expenses, and winding up with a net profit, you are going to find yourself buying what others hate, and selling what they love.
Not too many people actually enjoy that process, but for us cats who do -- us Nashville cats, in my case -- it can be a better fit than indexing.
Paul Solman: As an added bonus to this post, here is a reprise from the greatest hits of Merle Hazard, the alter ego of Jon Shayne. This song is a prescient ditty that came out a year before Wall St. crashed. "H-E-D-G-E" originally debuted in 2007.
You can kick back to the rest of Merle's oeuvre at merlehazard.com.
Jon Shayne is the Chief Manager of Shayne & Co., LLC, an investment management firm. The firm and Jon do not have own shares of Vanguard Target Retirement Funds in accounts they manage. However, they do have investments in other Vanguard funds.