In case you were wondering how you should invest your retirement savings (assuming you’re fortunate enough to still have some), yet another study demonstrates that low cost index funds are the way to go:
Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. So in a miserable year for stocks, index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.
That, at least, is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. He presented his results in the Feb. 1 issue of Economics & Portfolio Strategy, a newsletter for institutional investors published by Peter L. Bernstein Inc.
Why are index funds so effective? Here’s a related question: Why are most mutual funds and hedge funds so ineffective? The answer, I think, gets back to our mistaken belief that the market can be beat in the first place:
Think about the stock market, which is a classic example of a “random walk,” since the past movement of any particular stock cannot be used to predict its future movement. The inherent randomness of the market was first proposed by the economist Eugene Fama, in the early 1960′s. Fama looked at decades of stock market data in order to prove that no amount of knowledge or rational analysis could help you figure out what would happen next. All of the esoteric tools used by investors to make sense of the market were pure nonsense. Wall Street was like a slot machine.
The danger of the stock market, however, is that sometimes its erratic fluctuations can actually look predictable, at least in the short-term. Our brain is determined to solve the flux, but most of the time there is nothing to solve. And so our we flail against the stochasticity, searching for lucrative patterns. Instead of seeing the randomness, we naturally come up with explanations to explain it away. We see meaningful trends where there are only meaningless streaks. “People enjoy investing in the market and gambling in a casino for the same reason that they see Snoopy in the clouds,” says Read Montague. “When the brain is exposed to anything random, like a slot machine or the shape of a cloud, it automatically imposes a pattern onto the noise. But that isn’t Snoopy, and you haven’t found the secret pattern in the stock market.”
I recently wrote an article for the London Times in which I confessed my own investing errors and discussed some recent research into why financial bubbles are such a recurring theme of economic history:
I am a sucker for financial bubbles. The first stock I bought was Cisco Systems, in early 2000. It was the height of the dot-com bubble and Cisco was about to become the most valuable company in the world. Naturally my investment crashed too.
I’d like to say that I learnt from my dot-com disaster, but I didn’t. In late 2006 I began investing in blue-chip financial stocks, such as Citibank and Bank of America. At the time these companies were reporting record profits as they expanded into the sub-prime mortgage business. We all know how that turned out.
If there’s any consolation from my losses it’s that I wasn’t the only one. The current economic crisis is a by-product of collective failure, an example of terrible decision-making on a huge scale. Banks gave out loans to people who shouldn’t have taken them, consumers got used to spending money they didn’t have, regulators failed to regulate, and investors, appeased by ephemeral profits, failed to ask hard questions.
In retrospect we can see the profound foolishness of this behaviour. Yet it’s worth remembering that this is not the first time that the markets have gone haywire. The history of finance is largely a history of financial bubbles, from the tulip mania of 17th-century Holland to the South Sea Bubble of 18th-century England. Do we never learn? And, if not, why not?