When I was a child, every county fair and carnival had a snake oil salesman. These remarkable fellows persuaded otherwise sensible citizens to suspend disbelief long enough to sell a product of zero value, that claimed an exhausting list of miraculous cures and benefits without any evidence whatsoever that the product was either safe or effective. The lack of any evidence was no deterrent. Testimonials, anecdotes and plain old lies kept the small-town public coming. And of course, when the product failed to deliver the salesman was long gone.
TUTORIAL: Investing 101
A faint imitation of the snake oil salesman persists in health food stores where labeling a vegetable or substance natural or organic greatly increases profits. True snake oil salesmen have all migrated to Wall Street where they merrily sell active management to a new generation of the small-town public. (To learn more, see Just How Smart Is Wall Street?)
The recent market unpleasantness has provided active managers with opportunities to question each of the tenants of modern financial theory. Few enjoyed the 18 months of downturn during the 2008-2009 market disruption. To say the least, it was disconcerting. Many investors were feeling burned, bruised and battered. It's natural to reconsider your assumptions after a traumatic experience. But, you could certainly learn just the wrong lessons. There are plenty of folks out there that will help lead you astray.
Active management claims to deliver additional benefits (the ever allusive alpha) through either individual security selection or market timing. While conclusive truth in the securities markets is impossible to find, the overwhelming evidence suggests that active management reliably generates increased costs, taxes and risks while reducing returns. It is, however, highly profitable, and as long as investors will buy, the snake oil salesman is always happy to oblige. (To learn more, see Active Management: Is It Working For You?)
Modern financial theory is the enemy of the active manager. Passive strategies capturing the benefits of efficient markets, long-term buy and hold and Modern Portfolio Theory (MPT) with global diversification are safe, economical and effective ways to profit from the long-term growth of the world's markets. As investors adopt these methods, the active manager's market share and profits are threatened. It should come as no surprise that they will fight back to preserve their empires.
We may divide them into three categories: thieves, fools and charlatans.
The Madoffs of the world simply stole money. Fools actually believe that they have some special insight that a few billion of their closest friends have missed. And charlatans see no reason to give up a good gig.
Whatever they are, their siren song has variations of Wall Street's Three Big Lies:
Modern Portfolio Theory Is Dead
Oh, really? Or, do you just not understand it? The guts of MPT are that investors are risk averse, and that appropriate diversification reduces risk to its lowest possible amount at any desired return target. Naive diversification simply buys a collection of assets, reducing the possibility that an adverse event in a single holding will decimate the entire portfolio. It's better than no diversification at all, but, diversification is best accomplished by using asset classes with low correlations to one another. (To learn more, see Asset Allocation: One Decision To Rule Them All.)
But, when you take diversification as far as it can go, market risk remains. That's the risk that cannot be diversified away. In other words, MPT is a tool to manage risk towards an optimum result. It never claimed to eliminate risk. In fact, MPT software predicts that events of this magnitude will happen with some frequency. Unfortunately, they can't predict when they will happen. (For additional reading into MPT, take a look at Modern Portfolio Theory: Why It's Still Hip.)
Of course, eliminating risk eliminates the possibility of increasing returns. Market risk is the engine that generates returns above the zero-risk level. If you want higher returns than Treasury Bills or certificates of deposits (CDs), you simply have to accept the risk. (For further reading on Treasury Bills and certificates of deposits, see How To Compare Yields On Different Bonds and Are CDs Good Protection For The Bear Market?)
Market risk appeared with a vengeance during late 2007, all of 2008 and part of 2009. While this was the single worst market decline since the Depression, the fact that risk manifested itself does not negate the benefits of MPT. Investors that utilize MPT can expect to substantially lower risk over the market cycle, leading to higher terminal values or a higher probability of success whatever their objectives. (To learn more about the Depression, see What Caused The Great Depression?)
The corollary to the MPT is the dead claim is that correlations are moving together. Of course, correlations are variable just as expected return and risk vary over time. There was never an assumption that correlations were fixed. We expect them to increase and decrease over time in a random pattern. There is little data to support the idea that markets are systematically and irrevocably moving towards a complete linkage. As long as there is any correlation less than perfect, investors will receive a diversification benefit.
No one disputes that during times of financial panic, correlations will increase. During 2007-2008's market unpleasantness, there was almost no place to hide in the world's equity markets. However, after the panic abated, markets began to diverge again.
Diversification Is Dead
We will happily stipulate that during 2007 to 2009, diversification did little to improve results in the short term. However, longer term results show a distinct benefit. Global diversification eliminates the possibility of having all your funds in the worst performing asset class. For the decade, you would have had to look pretty far to find an asset class worse than the S&P 500 (domestic large companies). Every other asset class had positive returns and a diversified portfolio held up surprisingly well. (For a quick beginner's guide to diversification, read Introduction To Investment Diversification.)
Buy and Hold is Dead
This is the steady refrain of the active manager whether he advocates individual security selection or market timing. I agree that buy and hold is the absolute worst way to manage a portfolio … unless you consider all the rest. The evidence that active management will systematically increase costs, risks and tax exposures and reduce returns is clear beyond a reasonable doubt. Nevertheless, active managers will continue to peddle their snake oil as long as investors will buy. (Weigh the pros and cons of buy and hold, read Buy-And-Hold Investing Vs. Market Timing.)
Someone always wins the lottery, and there is always someone that predicts a market event. They get lots of attention from the media after the fact. But, winning the lottery or being right once is not a sign of genius. And media attention certainly attracts lots of new assets to the lucky few that got it right.
You can follow the snake oil salesman if you wish. After all, just because it's never worked before doesn't mean it can't ever work. Or, you can follow the research. It's always worked before and offers you the best chance of a successful investment experience.