Truth Vs. Ignorance: The Impactful Investment Manager Of Tomorrow
January 25, 2013
Page 1 of 3
Walking through the art studio at my son’s high school last year, I was drawn to a piece featuring a blindfolded woman trying to find an apple that she could not see in front of her. My son explained that this was the centerpiece in a series he was doing on “Truth vs. Ignorance.” Ignorance—that is, the lack of knowledge and/or insight—is often a contributor to prejudices, biases, and bad decisions, he said.
The piece resonated immediately. No matter what the decision to be made, the solution will almost assuredly be better if the decision is based on truth (knowledge) rather than ignorance. It is hard to make good decisions when you are unaware of—or unwilling to accept—the relevant facts and circumstances. This is certainly true for investment decisions, in part because their consequences have a direct impact on the economic options for the ultimate beneficiary.
All too often, investment professionals are unwilling or unable to pursue and act on knowledge that would lead to better investment outcomes for their clients. The investment management industry tends to emphasize product—and its invariably linked goal of beating the benchmark—over education and counseling. Leaders of tomorrow’s successful investment management organizations—those that will have lasting impact—need to foster a culture that values intellectual curiosity, the pursuit of knowledge, and the courage to communicate freely and openly, especially if the truths uncovered are at odds with conventional wisdom.
Ignorance is often used as a severely pejorative term. It shouldn’t be. Ignorance is merely a lack of knowledge, education, or awareness. By this definition, we must all live with the fact that we are ignorant in many areas, so ignorance in and of itself is not necessarily a problem. I and my colleagues would cheerfully acknowledge our ignorance of the latest innovations in medicine. Accordingly, we routinely seek the advice and counsel of doctors for medical issues. Merely seeking help from random medical professionals is not sufficient, however. I am likely to get better medical advice if I make the effort to learn something about my options, such as the credentials and specialties of the doctors under consideration. The key distinction is knowing when knowledge is necessary and, conversely, when a lack of knowledge is dangerous. As Benjamin Disraeli said, “To be conscious that you are ignorant of the facts is a great step to knowledge.”
While potentially not as serious for one’s health, ignorance in investing can have devastating consequences for individual portfolios and personal wealth. Too often, capital market participants have little knowledge of how markets work, how to make investment decisions, or how to manage their portfolios. For most, the standard operating procedure is to hire a collection of “good” managers in the hope of beating the benchmark. But this practice ignores the reality that alpha, the return attributable to skill, is incredibly scarce.
As an example, in 2010 Burt Malkiel analyzed the 358 equity mutual funds that were in existence in 1970.1 Remarkably, only 119—less than one in three—survived through 2009, with the rest presumably closed because of poor performance. Of the survivors, only five managed to produce net returns more than 2% per annum above the S&P 500. Talk about long odds—that’s less than 1.5% of the starting universe! But many assume that top quartile managers can add value far in excess of 2% per annum. Our own research shows that even with perfect clairvoyance of future profits discounted to today’s price, a portfolio weighted by Clairvoyant Value would produce excess returns of about 6% per annum, a figure routinely “achieved” in shorter term manager rankings, creating an almost irresistible siren’s song. To be sure, alpha may be achieved—but only for a scant few.