Home > The stock market, Understanding Investors > Why New Year’s resolutions often fail: A guest post by Kees Koedijk and Alfred Slager

Why New Year’s resolutions often fail: A guest post by Kees Koedijk and Alfred Slager

Thanks to Kees Koedijk and Alfred Slager for this guest post. Visit their blog here.

Top 10 stocks and funds to invest in for 2011 circulate widely. It’s a recurring theme with a predictable storyline at the end of the year. The analyst: “Well, we indicated that stock XYZ should be the best performing one this year, and it should have been the case, but it has not for good reasons.” Analysts then borrow the “deus ex machina”  plot device from the theatre (literally, “God out of the machine”), in which  a seemingly inextricable problem is suddenly and abruptly solved with the unexpected intervention of some new character. For analysts this usually boils down to central banks not behaving like they should, politicians meddling with economics or misplaced optimism or pessimism of consumers or companies.

So unless the investing public suffers from collective amnesia with a yearly cycle, the real merit of predicting is not the prediction itself. Maybe it’s a form of mating game in the investment industry. The analyst, bank or mutual fund signals with his prediction to the investor that he knows the intricate details of financial markets, and is therefore fully in control of the risks attached to an investment. And once you’re in control of the risks, then there is actually no risk attached, is there? An elegant way to play into investor’s permanent desire for free investment lunches, an important theme in Meir Statman’s insightful book “What Investors Really Want”.

Maybe institutional investors and pension trustees should be given a second chance for better New Year’s resolutions. If they’re smart, they won’t focus on predictions, but on understanding why predictions continually fail, and how to benefit from this insight. This requires delving more into the beliefs behind the economic theories, and how they affect your investment decisions, the central theme of our recently published book Investment Beliefs. A Positive Approach to Institutional Investing. The problem at hand is quite simple. Despite all the research done and money spent in the financial industry, diverging views persist in economics and finance. A solid theory, broad dataset and sound research methods should be able to resolve ongoing debates and lead to accurate predictions. Economists and researchers surely put an enormous effort into research, but resolving debates tends to move slowly. Economics and finance are tough subjects to investigate. Why is this?

A historic perspective comes in handy. Investing theory and practice have developed dramatically over the past five decades, yet as Andrew Lo argues, there still is no objective framework around for viewing capital markets and deciding how to apply these insights for investment purposes. Active management, passive management, absolute return strategies – all are different views of capital markets that happily co-exist. Yet none can be pinpointed as the right one. Theories in investments and finance simply do not have the same degree of confidence as theories in physical sciences. The main theories have not been road tested; basic premises are not conclusive. For example, is there any agreement on whether financial market pricing is efficient; the basis for passive management? Research findings are inconclusive. There is an increasing amount of evidence on “anomalies”, unexplained gaps between predictions and realizations. However, no workable alternative for the underlying theory has been formulated that can be put to good use on a large scale. Moreover, few investors are actually able to exploit these “anomalies” and turn them into higher returns.

So in the meantime, students and investment managers learn that efficient pricing exists, but observe and act otherwise in practice. Believers in inefficient markets usually invest in what they perceive as undervalued stocks, sectors or assets, and do appreciate market-timing. In a brilliant stroke of marketing, they have labeled themselves as “active” managers, ideally positioned for investors who want to be in control and want to win. Believers in efficient markets on the other hand focus on buying the index against the lowest costs possible: costs are after all a certain drag on your returns, while the free investment lunches pictured by the active managers have yet to materialize.

This discussion suggests that the smart, rational money is on passive investing. The reality is the other way around. The overwhelming share of equities is invested by active managers. Our experience is however that pension funds would make fundamentally different choices if they were aware of the uncertainties behind the economic and finance theories – after all, it boils down to what you believe in. We call this investment beliefs: an explicit view on how to interpret, and approach a debate in the financial markets. We covered active versus passive management as a noteworthy investment belief, but there are many other beliefs out there: on sustainability, risk premium, investment horizon, risk management- to name a few.

Investors simply have to deal with the fact that many debates never really reach a firm conclusion and keep haunting them. Proponents of active management have just as much ammunition in the form of anecdotal evidence or research to prove their case to sympathizers of passive management as the other way round. There is no single objective truth in the financial markets, just an accumulation of learning by doing and adapting to new realities. Investment beliefs address this uncertainty and make it manageable – not predictable.

So, chances are that the predictions will once again miss the mark. This shouldn’t worry investors, and certainly not prevent us from filling out the sweepstakes. The process of arriving at a prediction might well be more important than the prediction itself. Wouldn’t that be a great way to actually realize a New Year’s resolution?

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