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THIS YEAR SAW THE passing of two giants of the investment world. The first was Harry Markowitz, who in the 1950s developed a concept now known as Modern Portfolio Theory. His key insight was one that today we view as so fundamental that it’s easy to take it for granted: Markowitz was the first to articulate and quantify the importance of diversification. He later won a Nobel Prize for his work.
This year also saw the passing of Charlie Munger. In contrast to Markowitz, Munger viewed diversification as ”balderdash” and dismissed it as “a rule for those who don’t know anything.” In his more than 50-year collaboration with Warren Buffett, Munger assiduously avoided diversification, opting instead for big bets on a small number of holdings.
Though they held opposite views, Markowitz and Munger were both revered for their contributions to the world of investing. Their legacies are a reminder that, when it comes to personal finance, no one has a monopoly on the “right” answer. There’s always more to learn. On that note, as the year draws to a close, I thought it would be useful to revisit some of the research I’ve shared in my articles over the past year.
Tactical error. Among the many debates in personal finance, one seems never-ending: the argument over active versus passive investing. On the one hand, the data seem conclusive—that passive is the better way to go—but new research often uncovers nuances worth understanding. This year, a study by Morningstar provided color on one such nuance.
When it comes to actively managed funds, Morningstar found that some are far worse than others. In particular, Morningstar detailed how one fund type is in a category all its own: tactical funds. These funds have delivered results so poor that Morningstar described them this way: “They came. They saw. They incinerated half their funds’ potential returns.”
What’s a tactical fund? Unlike a typical mutual fund, which is usually limited to a single asset class, managers of tactical funds have the freedom to adjust their portfolio’s asset allocation in response to economic forecasts. The challenge, of course, is that forecasting the direction of the entire economy is far more difficult than trying to forecast where a particular company or industry might be headed.
Morningstar found that ordinary single-asset-class actively managed funds don’t do so badly before fees. It’s only after fees that they tend to underperform. By contrast, tactical funds have delivered terrible results by any yardstick.
The lesson: I don’t recommend any type of actively managed fund, but—if you’re going to go that route—it’s important to know which fund types represent the third rail. It’s also important to avoid the mistake tactical managers seem to make. You want to tune out market commentators and the day’s headlines, and instead maintain a steady asset allocation.
Information overload. Why is active management so challenging? One answer lies in a CIA report titled “Do You Really Need More Information?” The report reveals a key irony in investment research: It turns out that investment managers who take the time to really do their homework are actually doing themselves—and their investors—a disservice. That’s because, in many realms, gathering more information tends to make forecasts less accurate. To add insult to injury, more information does accomplish one thing: It makes us more confident in these less-accurate judgments.
This difficulty is a key reason I’m in the passive investing camp. The reality, however, is that personal finance still involves innumerable other decisions. Financial planning, in other words, is about more than just choosing mutual funds. As much as we try to be evidence-based in making financial decisions, there’s a fundamental obstacle: All data are about the past, while all decisions are about the future. We can try to be logical in making decisions. But in the end, decision-making still involves some amount of guesswork.
That’s where Harvard professor Cass Sunstein’s new book, Decisions about Decisions, may be of interest. Sunstein highlights a subtle point about decision-making: Though the two terms might sound synonymous, there’s a difference between picking and choosing. In Sunstein’s framework, some decisions lend themselves to choosing—that is, making careful, research-based decisions. But other decisions don’t benefit from gathering facts and data. In those cases, investors simply need to pick an option and not deliberate. By understanding the difference, investors can better allocate their time and energy.
Weighty issues. One area where the data have been immensely frustrating for investors: international diversification. Look at a long-term chart, and you’ll see a clear benefit to diversifying your stock portfolio outside the U.S. But for an investor who’s held international stocks in recent years, it’s felt more like the incinerator Morningstar described. International stocks have lagged in virtually every year since 2008. Despite that, investment manager Cliff Asness, in a paper published this year, argues that it still makes sense to diversify. The paper’s title: “Not Crazy.”
I agree with Asness. But this debate gets at a larger, recurring challenge in finance: At what point do we know that things have permanently changed—that we can’t expect reversion to the mean and that, therefore, historical data are only leading us astray? Without the benefit of hindsight, we can’t answer that question definitively. But there’s value in simply being aware that it’s a question. That knowledge can help us avoid being too confident in our opinions and thus it can help us avoid going too far out on a limb with any particular decision.
Investors, in fact, have faced a similar challenge with value stocks. According to Dimensional Fund Advisors, between 1927 and 2021, value stocks outperformed their growth peers by more than four percentage points a year, on average. But in recent years, value has felt like a losing battle. Despite cautions that their valuations are too rich, growth stocks have dominated the market for most of the past 15 years. Today, some of these companies carry market capitalizations in the trillions, and many have argued they’re riding a knife’s edge. Still, they’ve continued to climb in price.
Because of this phenomenon, commentators have been cautioning for years that the S&P 500 Index has become dangerously top-heavy, and yet it’s only become more so. In fact, in 2023, 72% of stocks in the S&P 500 have underperformed the overall index. The lesson: Yes, there’s value in paying attention to the market and listening to what observers have to say. But ultimately, we need to recognize that no prognosticator can know exactly how things will turn out.
Finance professor James Choi provides a useful perspective on this topic in a paper titled “Popular Personal Financial Advice versus the Professors.” He looked first at some of the well-known findings in the finance literature. For comparison, he then looked at how investment practitioners actually operate. Among the topics Choi explored: debt, international diversification and mental accounting.
On many of these topics, Choi found a disconnect between professors and practitioners. But he wasn’t so quick to criticize the practitioners. In many cases, he found that the way finance theory was employed in the real world wasn’t entirely unreasonable, even if it wasn’t entirely by the book. The lesson: There’s value in following the research, but we should view it as just one element of the mosaic, and not gospel truth.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X (Twitter) @AdamMGrossman and check out his earlier articles.
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Excellent article. Even in an area where I thought I was an expert, my investments did only OK. So I am almost uniformly a “passive” guy.
But that also causes me to avoid the international arena entirely, except for investments outside the US that are made by American companies and included as a part of their stock performance. International is not simply “international’ – it is a really collection of wildly different individual countries outside the United States. I don’t think I can ever know enough to make an informed decision about investing here. There are many enormously important factors beyond most investors’ reasonable comprehesion – culture, market structures, relative wealth and income growth, ability to compete, political stability (or instability), the possibilities of armed conflict, business and governmental corruption, the integrity of capital markets and stock exchanges, and so much more. And the analyst support for companies outside the US gets thinner and more speculative, too. SO, why should I just take a flyer with my hard-earned money? I like America. And IMHO America will continue to be the country that drives the planet for the immediate future (unless you feel comfortable putting some of your money in China!) So, while I can’t truly say I am sticking with what I know, I can say I’m sticking with something I feel comfortable with (and that has rewarded that choice for me.)
Adam, thanks for another great read. I’m having trouble, though, reconciling these two sentences:
According to Dimensional Fund Advisors, between 1927 and 2021, value stocks outperformed their growth peers by more than four percentage points a year, on average.
Despite cautions that their valuations are too rich, growth stocks have dominated the market for most of the past 15 years.
Maybe Value greatly outperformed in the earlier years of that range, and so, on average, it outperformed Growth over the entire span even though it lagged the last 15 years?
Hi Andrew – Yes, that’s exactly right. Value stocks don’t garner much attention, but they have delivered some impressive performance. In large part, that’s specifically because they don’t garner much attention and thus tend not to become too overpriced. The challenge, though, as always: Past performance does not guarantee future results!
And for that reason their dividend yields have remained more attractive 🙂
Adam, thanks for clarifying that for me.
Adam, great article to end the year. Thanks for all your contributions this year.
Happy New Year.
Thank you, Rick. Happy new year!
“Despite cautions that their valuations are too rich, growth stocks have dominated the market for most of the past 15 years. Today, some of these companies carry market capitalizations in the trillions, and many have argued they’re riding a knife’s edge. Still, they’ve continued to climb in price.”
This coincides with the period of low interest rates. If interest rates stay at 5%, then eventually growth stocks will come down and value stocks will take off. The market continues to believe in the low-interest-rate fairy, even though there are many indications that she has vanished for good.
This website is absolutely wonderful and much thanks to Adam and Happy New Year. I just watched some interviews at the Bogleheads Conference 2023; quite interesting and worth a look. Keep up the great work
Thank you, Kenneth. Best wishes for 2024!
Nice piece to round out the year, thanks Adam.
Housel asserts a lot of financial debate is people with different time horizons playing different games talking past each other. His advice: few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are.
Thank you, David. Thanks for all your great comments this year, and wishing you a happy new year!
Thanks, Adam. Best wishes for a happy and healthy 2024