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Note from the Editor: The following commentary is from our good friend Larry Swedroe. We share his thoughts on this topic as we take a brief break for the holidays. When we return, we will have our annual outlook for the upcoming year. Enjoy and have a safe holiday!
Today's Commentary: 12.20.04
The Conventional Wisdom: Playing the Loser's Game
by Larry Swedroe
There are two general theories about how markets work. The first, which is the conventional wisdom (because it is accepted by the vast majority of investors), is that there are smart people working hard that can uncover securities that have been somehow mispriced by the market. In the case of equities that means that there are people that can identify which stocks are under or overvalued, and there are also people that can identify when the bear is about to emerge from its hibernation (it's time to get out of the market) and when the bull is about to start another rampage (it's time to jump in and get fully invested). The former is the art of stock selection and the latter is the art of market timing. Together they form the art of active management.
Those that believe that active management is the strategy most likely to produce the best results can either select money managers themselves or hire professional advisors to perform that task for them. The do-it-yourself investor relies on services such as Morningstar's star rating system. Unfortunately, the evidence is overwhelming that by doing so the investor is highly unlikely to outperform proper benchmarks. As the following example illustrates, the alternative strategy of hiring professionals to perform the role of due diligence and selection, unfortunately, is also highly unlikely to produce benchmark-beating results.
Wall Street needs and wants you to play the game of active investing. They know that your odds of success are so low that it is not in your interest to play. But they need you to play so that they (not you) make the most money. They make it by charging outrageously high fees for active management that persistently delivers miserable performance. The financial media also want and need you to play so that you "tune in." That is how they (not you) make money. The only logical reason to play the game of active investing is that you place a very high entertainment value on the effort. For some people there might even be another reason‹they enjoy the bragging rights if they win. Of course you never hear when they lose.
Yes active investing is exciting. However, investing was never meant to be exciting. Wall Street and the media (who don't have your interests at heart) created that myth. Instead it is meant to be about providing you with the greatest odds of achieving your financial goals with the least amount of risk. That is what differentiates investing from speculating (gambling).
Many people get excitement from gambling on sporting events, horse races, or at the casino tables in Las Vegas. Prudent individuals, however, get entertainment value from gambling by betting only an infinitesimal fraction of their net worth on sporting events, etc. Similarly, even if you receive entertainment value from the pursuit of the "Holy Grail of Outperformance" you should not gamble more than a tiny fraction of the assets on which you wish to retire, or leave to you children or favorite charity, on active managers being able to overcome such great odds.
The Blue Money Report
Financial Commentary covering a wide range of topics concerning money, investing, and how it effects the average investor and their financial health.
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