In investing, thinking doesn’t pay. Very simple diversification has for years delivered good risk-adjusted returns – often beating many professional fund managers. And in the last five years only 10 funds in Trustnet’s database have beaten my no-thought momentum portfolio. Granted, a slim majority of those funds have beaten the FTSE All-Share tracker funds in this time, but this owes more to those trackers being dragged down by big stocks under-performing than it does to fund managers’ ability: David Blake at Bayes Business School has shown that over the long-term most actively-managed funds underperform.
This, however, merely fits with other evidence that judgment is over-rated. Victor DeMiguel and colleagues at the London Business School has shown that simply dividing your wealth equally among assets can work as well as more sophisticated optimisation methods. In macroeconomic forecasting the yield curve tells us the probability of recession much better than do economists’ professional judgements. In psychology the late Robyn Dawes – following the work of Paul Meehl – has shown that even rough statistical methods outperform clinical judgments. And in management, Stanford University’s Nick Bloom has shown that quite simple methods can improve organisations’ performance. (Simple that is in intellectual terms; actually implementing them requires great political skill.) Mechanisms that give reliable cybernetic-type feedback of the sort advocated by Shann Turnbull can be better than managers’ strategic thinking.
All of which fits with a claim made by Gerd Gigerenzer at the Max Planck Institute – that simple rules of thumb often work better than sophisticated thinking.
Which poses the question. Given that simple rules work so well, why do we place so much value upon thought and judgment? There are some bad reasons, and one good.
One bad reason is a modern version of the ancient doctrine of signatures. Medieval men believed that cures resembled the ailment – that, for example, the toothwort plant was thought to cure toothache because its flowers looked like teeth. In the same way, we believe that because the world is complex we need complicated thoughts to navigate our way through it.
What this misses is that the world is too complex for us to understand, let alone predict. There is what the Canadian political scientist Thomas Homer-Dixon called an “ingenuity gap”: our limited cognition just isn’t equal to the world’s complexity. And being nearly right isn’t good enough. If you are crossing a bridge in the dark the fact that a few feet of it are missing is more than a minor inconvenience. The simple rule “don’t cross unknown bridges in the dark” serves you better.
Another bad reason is that although reliance upon judgment is bad investing it is good marketing. Telling your clients you have a rigorous and sophisticated investment process wins you more business than telling them “we just stick to a few simple rules that economists have known for years.”
Retail investors do something similar. Some of you think of investing as pitting your wits against “Mr Market.” Victories are then a boost not only to your bank balance but to your ego. Following old ideas about the merits of momentum or defensive stocks or the predictive power of the yield curve don’t give you such an ego boost.
There is, though, one good reason why we might value judgment rather than rules. It’s that the simple rules that have done well in the past might not continue to do so. If rising interest rates or fears of sustained inflation cause bonds and equities to sell off at the same time then simple diversification will fail. And it’s possible that investors have wised up to momentum’s out-performance and in doing so have raised the prices of momentum shares so far that future returns will be poor – as happened with small-cap stocks in the 1980s.
In such circumstances, simplicity will no longer work as well as it has in the past.
Whether judgment will work any better is, however, another matter. For it to do so markets will have to be inefficient either in the micro sense of individual stocks being mispriced or in the macro sense of the aggregate market being so. And what’s more, these mispricings must be detectable and exploitable.
Here, however, we run into a common misunderstanding. The old saying “you can’t beat the market” is ambiguous. It’s usually taken to mean that markets are smart and swiftly embody all available information. But it can mean something else – that markets are in fact inefficient but we lack the ability to identify and profit from such inefficiencies. Textbooks and investors have paid too little attention to this second interpretation.
