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In praise of idleness

In praise of idleness

For a long time, I've advised investors to be less active with their portfolios. I'm pleased, therefore, to see at least one professional fund manager doing well by being lazy. Steve Edmondson, head of Nevada's state pension fund, claims to do little all day and with good results. This poses the question: why aren't investors, both professional and amateur, lazier?

Let's first sharpen the question by remembering that there are small benefits and possibly high costs to active trading. The costs are not merely the cost of trading. They also include the danger that we'll trade not upon genuine information but upon mere noise, and so buy overpriced assets.

And the benefits are small. Common sense tells us that big profit opportunities shouldn't come along that often. Even if you believe that markets are irrational, it would be odd if they threw up easy ways of making money all the time. What's more, investing, like so many things, is subject to diminishing returns. Randolph Cohen at Harvard Business School has shown that even average fund managers have a handful of ideas that beat the market but beyond these their stock-picks add no value.

The fact that most fund managers don't beat the market, and that the few who do such as Terry Smith or Warren Buffett tend to be buy-and-hold investors, tells us that activity often doesn't pay.

This is not to recommend complete inertia. You'll need to rebalance portfolios occasionally - although the fact that running your winners often pays off tells us not to do so very often. And there's a good case for following the 10-month average rule or for some version of variance management whereby you cut equity exposure when volatility rises and raise it when volatility falls.

Nevertheless, there is a case for doing very little. So why do so many investors do more?

One reason is overconfidence. We overestimate our ability to spot underpriced stocks and so trade unnecessarily. In a classic paper Brad Barber and Terrance Odean showed that this costs retail investors millions of pounds.

A second reason is the action bias. How often have you seen a football team concede a penalty and thought, 'the goalkeeper would have saved that if he'd stood still'? A team of Israeli economists have confirmed this impression. They show that top league goalkeepers would indeed have saved more if they had stayed still.

So why do they dive? It's because there is a norm in favour of doing so: the keeper who stays still looks sillier if he concedes than one who dives. Similarly, the busy investor looks and feels more sensible than the lazy one, even if he isn't.

This urge to do something is magnified by the herding instinct. If everyone else is doing something, we feel compelled to emulate them. As Maynard Keynes said, "it is better for one's reputation to fail conventionally than to succeed unconventionally". Mr Edmondson is brave to depart from the conventional approach, and braver still to confess to doing so.

But I wonder: might there be something else - a lack of agency failure and excess of intrinsic motivation?

A lot of economics is concerned with the agency problem: how to ensure that agents such as fund managers or bosses act in the interests of principals such as investors. In the real world, this problem is diminished by intrinsic motivations: professional ethics or a sense of obligation cause agents to behave well even when incentives or oversight are imperfect.

Usually, such motives are laudable. In this case, however, they might do damage. Fund managers feel obliged to do things even if inactivity would serve their clients better. Playing computer games or watching cricket while at work is unprofessional, and good fund managers would feel guilty about doing so even if this would avoid losses for their clients.

Blaise Pascal might have exaggerated somewhat when he said that "all of humanity's problems stem from man's inability to sit quietly in a room alone". But his words contain much truth - even though there are strong reasons for that inability.

MORE FROM CHRIS DILLOW...

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Chris blogs at http://stumblingandmumbling.typepad.com

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By Chris Dillow,
04 January 2017

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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