Why passive investing through index funds helps when one lacks expertise
Posted by: Uma Shashikant on May 21, 2018, 06.30 AM IST
How should an institutional investor, who is not an expert in investments, make decisions? Many institutions such as religious trusts, sports, arts and recreational associations, housing societies, educational bodies like schools and colleges routinely have to manage money. They have a corpus to use and surpluses to invest from time to time. Many of them do not move beyond bank deposits. Some of them invest in liquid funds or short-term debt funds. But most prefer to be conservative. The reason they cite is that they do not have the expertise.
Expertise is an interesting idea. For years, social scientists and psychologists have defined, tested and attempted to describe the concept. Expertise invokes awe and admiration. When a player swings the racquet to win set after set; when a chess player walks past a table and mentions a fantastic move in seconds; or when a doctor makes a diagnosis almost effortlessly, most of us accept that these people are highly skilled in what they have chosen to do.
If we are unable to perform a task such that the outcome is consistently superior each time, we think we do not have the expertise for it. But is it really possible for someone to achieve that level of performance? How does one develop that high order skill? Studies of expertise explains it mostly as the ability to recognize patterns. An expert chess player, an airplane pilot or a doctor or nurse, have thousands of patterns of possible outcomes stored in their head from years of performing a task in a given sequence.
When they see a situation, they pick up the cues and are able to refer back to these patterns instantaneously and pull out the one that would work, with minimal effort. Their talent lies in being able to evaluate their choice and make modifications on the fly, progressively deepening their application of their knowledge and skill. There is an informed intuition that has developed with experience that supports their superior performance.
How does such expertise come about? Research offers two primary conditions.
One: People have to acquire adequate experience in a high validity environment. Two: there must be adequate opportunity to learn from these experiences.
A high validity environment is one where cues that enable decision making occur regularly and result in a predictable and observable outcome every time. The second condition is important in this process. As the cues are observed and applied, there is the opportunity to see how the decision plays out and learn continuously. Chess masters are a classic example of experts who are able to see the cues, act on them and learn as they play.
Investing is not a classic example of expertise in action. There are two reasons why it is so. First, the environment in which investment decisions are made offers very low validity. With the same set of factors and variables, one set believes a stock is good enough to buy while another believes it is good enough to sell. Price can either rise or fall and one of the two sets cannot explain how that came about. The possibility that the outcomes can turn out to be different each time, makes invest ..
Second, in an environment where validity of a decision cannot be objectively measured or anticipated, uninformed intuition comes into play. This is what we know as thumb rules or short cuts. Investing decisions run the risk of being made based on incomplete or invalid memories from the past. There is a huge volume of literature that documents the behavioural biases we suffer from when we have to make investment decisions.
It is not as if all investing success is luck. Expertise in investing involves not just the hard work of analysis and interpretation, but also the conscious ability to keep incorrect intuitions out. Both these activities are tough and take a great amount of practice, high level of engagement and selfregulatory checks to succeed. Even then there is no assurance that the outcome will always be favourable, because the investing environment is too complex to be predictable.
A completely unexpected market event can throw the best bets into complete disarray.
Are the institutional investors who keep away from the equity investing right after all? Should they remain skeptical about acquiring the required expertise?
Expertise in investing is not about dealing with the uncertainties of the macroeconomic environment and the unpredictable outcomes it brings. It is about being able to recognise incorrect intuitions based on short cuts and rules of thumb, from informed intuitions that come with experience.
What we know about the difficulty in acquiring investing expertise does not undermine those who pursue it as a profession. It translates into a practical problem of inconsistency for those who choose investments.
There are investments that do spectacularly better than the others; there are funds that are in the top of their game; and there are multi bagger stocks that offer eye-popping returns. But there is no fool proof method to select the best at all times The problem for the institutional investor is not the lack of expertise in investing; the problem is in defending an investment choice and being accountable for inconsistent performance.
The solution is disarmingly simple. Whenever decisions have to be made in a low validity environment, where the same set of cues can lead to varying outcomes, and where the difference between informed and uninformed intuition is a blur, algorithms have outperformed human effort. A formula-based passive decision making approach simplifies the decision, while also ironing out the outliers. This is why passive indexing is a great choice for institutional investors, whose main area of work is not money management.
There are funds and stocks that do better than the index. But the probability that investors will correctly pick those funds and those stocks, much in advance is low. They may fail even more when they have to work limited predictive capability. They will tend to lean on rules of thumb and short cuts that lead to risky outcomes and mistake luck for skill.
In every situation of limited expertise in investing, selection and performance evaluation, investing in the index offers a superior choice. It is far better than failing to invest in equity assuming lack of expertise