There is a never ending debate between Wall Street and Academics on whether markets are efficiently priced or not. While the debate is a bit too esoteric for most investors to care, understanding some basics about the debate can help investors make better investing decisions.
THE MOST BASIC VERSION OF MARKET EFFICIENCY
Essentially, academics believe that there are a lot of really smart people working in the financial markets everyday. Since there are so many people with so many resources, it is nearly impossible to do better than the average on a consistent basis.
This belief is supported by many studies which show that professional investors don't beat the market on average. Most studies find that professional investors under perform the market by 1%-2% each year. This finding leads many academics to recommend that investors simply put their money into index funds and forget about it. By doing this, investors avoid the costs of trading and of paying a professional for guidance, but there are some major problems with this recommendation.
THE REST OF THE STORY
The two huge problems with this recommendation are both based on the lack of investment experience and education that the average investor has. First of all, the average investor does not have the investment expertise to properly allocate their portfolio so that they have exposure to the asset classes they should and their risk is tailored to their tolerance.
Secondly, investors have very little confidence in their investment decisions which leads to buying and selling at precisely the wrong times. Studies show that investors under perform professional managers by a wide margin when left to their own devices. According to Morningstar, over the 20 years ending December 2008, the S&P 500 index averaged a gain of 8.4% a year. The average stock investor gained only 1.9% a year over that same period.
PROFESSIONAL ALLOCATION ASSUMING EFFICIENT MARKETS
Given this information, it is logical to assume that investors should seek professional guidance but focus on an advisor who keeps fees low and adds value for them in ways not related to stock picking such as:
- Portfolio allocation to help them gain the proper amount of exposure to each asset class
- Investment vehicle structure to help them put away the most money in the most tax efficient manner
- Tax efficient trading and harvesting
This is good advice and an investor would not go wrong with this approach. For many of Asset Advisors clients, this is the type of service we provide.
RISK TOLERANCE
One of the primary functions of any investment advisor is to determine the client's risk tolerance and ensure that the client's investments are appropriate given this tolerance. Below is a model that illustrates five hypothetical portfolios constructed by combining the asset classes available in the market in varying weights.
Many factors will affect which portfolio is appropriate for an individual investor including age, years to retirement, existing liabilities, and size of portfolio as well as others. Most advisors determine risk tolerance based on very few questions and very few inputs. Asset Advisors attempts to take this much further by asking more behavioral and psychological questions. This becomes critical during market downturns because investors ability to withstand the volatility in their portfolio is imperative to their success as an investor. It is much worse for an investor to sell during a downturn, miss the market upswing and buy again at a higher level than it is to own a less risky portfolio.
WHEN IS ACTIVE ASSET MANAGEMENT APPROPRIATE?
According to Asset Advisors view, active management is not a question of right or wrong but instead a question of risk tolerance. Some (but not most) active managers beat the market so it may be right for some investors to seek this increased return. However, choosing to pursue this option means the investor is not only taking on market risk, but also portfolio manager risk (the risk that their manager will under perform). Increased risk in a portfolio usually translates into increased volatility and increased uncertainty. This being the case, Asset Advisors only recommends active management for those clients on the high end of the risk tolerance scale.
The one exception to this rule occurs for clients who are seeking a high degree of diversification with lower market correlation. For these clients, a small portion of their portfolio will be invested in an active way to seek returns that will be less correlated to the market but positive in a significant way.