Diary of a Financier

Robert Shiller on the Active vs Passive debate & investment advisory

In Idiosyncrasy on Mon 31 Mar 2014 at 05:44

When asked if he tells investors that they can pick winners in the stock market or go to index funds, Robert Shiller told the WSJ:

“I tell people to get an investment adviser. That makes sense to me…

“The question is often whether it’s possible for anyone to pick stocks, and I think it is. It’s a competitive game. It’s like some people can play in a chess tournament really well, but I’m not recommending you go into a chess tournament if you are not trained in that, or you will lose. So for most people, trying to pick among major investments might be a mistake because it’s an overpopulated market. It’s hard. You have to be realistic about how savvy you are.

“But if you are thinking about buying real estate and renting it out, fixing it up and selling it, that’s the kind of market that’s less populated by experts. And for someone who knows the town, that’s doing business, I’m not going to tell someone not to do that.”

The Wall Street Journal¹


First, let me say I fully agree. The game is rigged against the part-time, individual investor. The more naive the investor, the more experts stand to gain.

Because of this, capital markets are in no way comparable to casinos. In gambling, the law-of-large-numbers factually asserts that the house’s winning percentage will migrate toward its expected value (probability) given a large enough sample size (number of trials). Reciprocally, casino-goers’ winning percentages are rather inescapable too.  Therefore, most blackjack dealers are always willing to talk neophytes through the rules of the game or let a passerby proffer advice to a player, because the probabilities are what they are, and skill makes so little difference at a casino that it doesn’t materially affect the bottom line.

On the other hand, you have capital markets, where broker/dealers are the house, making their winnings on every game. They’re intermediaries who win 99% of the time via skimming — either adding a commission atop a transaction or wedging a spread between buyers’ cost and sellers’ price.

There’s nothing nefarious about that though — it’s just the cost of doing business.  But, while they’re almost always winning, B/Ds can always win bigger (i.e. higher commissions or wider spreads) if they’re transacting with a naive client. For example, how can any retail bond buyer know when his broker’s adding an extra quarter-point sales credit to the muni CUSIP they’re discussing?

Advisors or RIAs can bilk clients with high fee product too. Insurance and annuities are a go-to. There are more implicit costs associated with RIA relationship also. For example, RIAs themselves are clients of broker/dealers’ institutional trading desks. B/Ds sell them product (like a bond or stock) for which there’s a built-in cost (spread or commission to compensate the B/D). RIAs then pass on that cost to their own clients in the form of a higher cost basis. They have a structural disadvantage in that they need to tap a line into Wall Street, and that comes at a cost.

The higher volume, the lower that cost, so some RIAs concentrate their platforms on fewer product offerings, which marries them to certain fund families or strategies. That means these RIAs can be slow to change and can’t customize their service to every client’s needs. (And no, “high net worth investors” are not a niche specialty.)

Finally, there are both tangible and opportunity costs associated with the non-advisor alternative like low cost or passive/index investing.  This is just skimming the surface, but here goes: unless a US-based equity investor buys-and-holds a vehicle like $SPY forever (or $AGG for a bond-buyer), they’re participating in active management.

First off, the S&P 500 itself is an actively managed index, curated by the people at Standard & Poors.  Even if we were to give that a pass, humans are irrational creatures who suffer from cognitive foibles.  I’ve never seen anyone capable of sitting idly by while the market tanks 50% in a bear market.  Amateurs always sell near the bottom, then miss the recovery retracement — especially those in index funds.

Further, the asset allocation choice itself — if even strategic (as opposed to tactical) — is an active approach, as are choices like when to rebalance, reinvest, and contribute more to account balances.

Therefore, the key is to find a broker or advisor you trust — so cliche, but so hard to enact in practice:

  1. Go with someone you know personally or, if you must, someone to whom you’ve been referred, because they’re less likely to try and “win bigger” at your expense.
  2. Go with someone who has a relatively open architecture platform and the resources (i.e. intellectual capital or a team of specialists) to deploy everything with expertise, because you don’t want your square peg getting jammed into a round hole or your darts thrown blindly at the board.
  3. Ask questions to ascertain the status of these key tenets (1 & 2) in your relationship with an investment professional.


I digress… back to Mr. Shiller. While I concur with his comments above, I find it funny that we’re inclined to nod in agreement whenever an academic uses an accessible metaphor or simile — as if it were some scientific data proxy. Mr. Shiller likens [personal] investment to the skillful game of chess, and the comparison resonates with us. Yet, wouldn’t we agree all the same if he compared investing to something like solitaire — the latter, on the contrary, conveying a game of more random outcomes, reliant on far more luck than skill.

Undoubtedly a brilliant academic, Mr. Shiller gathered a Nobel Prize in Economics in 2013. He’s also been a great beneficiary of onlookers’ cognitive biases like the Survivorship Bias and the Halo Effect, due to his forecasts of irrational exuberance with a timely book of the same title in 2000 (regarding the Tech Bubble), then a revised edition in 2005 (regarding housing).  Were he strictly an economist, I’d laud him for both calls.  But, he holds himself out as more — as an investor.  In that case, his 2005 call on housing was almost 3-years too early and 350 S&P points (30%) too low.

To wit, in rich irony and a testament to the Halo Effect, Mr. Shiller doesn’t even take his own advice:

Q: Do you think of yourself as someone smart enough to pick winners in the stock market?

A: Well, I actually think I’m smart enough to pick winners.


¹Full interview here



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