ColbyDavis

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A Guide to Rational Investing

There's nothing I strongly disagree with with what you just said, but I think you are probably underestimating the heterogeneity of peoples' financial lives and the degree to which many people enjoy a personal touch.

Things like medicine and legal assistence need to be personalized because different people have >significantly different medical and legal issues, but investment?

Since I have started working in my current role I have been impressed with just how complex and particular an individual's financial situation can be, especially when dealing with high net worth individuals well into their career. Multiple accounts with different tax treatment, employee stock grants and options, insurance, inheritance, real estate holdings, dependents, charitable giving, trusts, required minimum distributions, loans and other financial obligations, etc. are all things I regularly encounter and deal with in considering portfolio construction. Add to this the fact that most people are very emotionally invested in and/or have ugh fields about their money and are prone to making foolish mistakes like selling at the bottom of a bear market (I've seen it from people who I know understand the efficient markets hypothesis) and you can see why there is a market for financial professionals who personally know their client and can hold them responsible to their financial goals. Not that everybody needs this, but I think younger people who have never had (or lost) a lot of money underestimate this aspect.

That said, I more or less agree with your point, and I think in a more competitive market there would be larger scale corporate consolidation in this market, along with law and medicine as well. One thing law, medicine, and finance all have in common is a system of occupational licensing and other cartelization policies in place that protect incumbents.

Betterment and WealthFront are trying to push our industry in that direction and have so far been quite successful for themselves. I would not be surprised, however, if after the next bear market their reputations take a hit when investors panic and hit the sell button when there's nobody there to talk them off the cliff. Maybe that won't happen. Time will tell.

I don't mean to imply that that all financial advisers are charlatans.

Thanks! =)

Part of the reason I got in the business I am in is because there is so much bullshit in the financial industry. I would like to try to bring a little more sanity to it, because I do think it is so important for our economy. This paper is part of my efforts to do so. I hope you appreciate it.

A Guide to Rational Investing

The age of the advisor matters not because of the skills he is or is not able to transfer to employees but because it may effect whether he wants to bring you on as a client in the first place. Most wealth management practices are owned by a single advisor or a small number of partners who are more concerned about maintaining their lifestyle than ensuring that their firm remains competitive in perpetuity. If a 55 year old advisor has an established practice working mostly with clients about her age who she likes, she is unlikely to take on a 25 year old from a different culture with few current assets just because the client can be expected to have a sizable portfolio after the advisor has already retired, even if doing so may theoretically increase the NPV of her firm. This is fairly common of private practice type industries like dentistry and law. Business owners are humans who like to form tribes, even if it means not being maximally efficient.

A Guide to Rational Investing

Vanguard may very well be better for you, and I am happy to tell people to take advantage of Vanguard if their fortunes are small or they don't want to spend a lot of time on their portfolio or hire an FA.

I want to quell the notion, however, that you're only worthwhile to a financial advisor if you have millions of dollars. The average FA is 50+ years old and so is generally more interested in how your portfolio looks right now than what it will look like in 20-30 years, but younger advisors are much more interested in the trajectory of your wealth. My firm has, and I have known other FAs who have, taken on younger clients with trivial amounts of current assets because they were dedicated to an aggressive savings plan.

A Guide to Rational Investing

This confuses me a little since the vast majority of the funds they invest in are Vanguard ETFs. Maybe you mean >something more specific that I'm missing?

Haha, ok. So you can just go buy a Vanguard target-date retirement fund and let the fund's internal structure take care of the asset allocation for you, or you can go talk to somebody at Vanguard who will either give you some straightforward advice about how to build your own portfolio for a one-time fee or build your portfolio for you for an ongoing fee, or go to Betterment where they will build you a portfolio out of Vanguard funds, or you can build it yourself using some of the insights you gleaned from this article. All of these are reasonable solutions.

A Guide to Rational Investing

I completely agree and would add that just because you know a lot about tech does not mean you are qualified to identify angel investment opportunities. Knowing a lot about accounting is probably just about as important. David Swensen, portfolio manager for the Yale endowment fund, and probably the most successful venture capital investor in the world, constantly stresses that only the top 10% or so of private equity funds have posted returns that have beaten small cap indexes and justified their costs and risks, and you're only going to have access to the top 10% of these funds if you have billions of dollars to work with.

A Guide to Rational Investing

Correlation doesn't imply causation. It is plausible that correlation actually goes in the way opposite than what you are >proposing: in wealthier nations people have more disposable money to play zero-sum games with.

Which is why I said predictors, not correlates. There is plenty of research to support my claim; the source I cite points to some of it. Obviously teasing out the arrow of causality is difficult in large scale, trans-generational, international macroeconomic settings, but economists have done their best and the evidence supports the Solow growth model that Metus has brought up.

A Guide to Rational Investing

Good point. Again, these strategies don't always work, and their returns are more skewed and leptokurtic than broad market averages, which is probably at least part of the reason they work in the first place. An interesting thing about value and momentum though is that the two strategies have negatively correlated active returns, i.e. value tends to outperform when momentum is underperforming and vice versa, which allows for portfolio construction that can be less volatile than a broad index.

It is true that momentum hasn't been very strong in the US equity market since 2000. It has continued to work among global stocks in general, as well as in other asset classes. Though momentum might just be temporarily out of favor in the US I would generally expect this pattern to continue as the US equity market - and especially blue chip US companies - is the most efficient around. But the global capital markets are a very large place.

A Guide to Rational Investing

That sounds like usual risk aversion. How is that a bias?

Loss aversion is different than risk aversion, though they are related concepts, the shape of an agent's utility function under loss aversion can lead to inconsistent preferences.

Why in recent years? Why aren't these funds more common? And since you are talking about "rebalancing" in the next >paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?

I can only speculate as to what the average of all the millions of decisions that go into releasing an investment product and whether it gains popularity looks like. As to why in recent years, I think it mostly is a function of the rise of index strategies, the emergence of the ETF as a vehicle that is well-equipped to execute strategies like this, and the general fall in popularity of expensive, black-box, active management strategies.

Internally, these products rebalance according to some rules-based methodology. IMO the "active vs. passive" debate is a false dichotomy, the better scales to judge an investment by are "cheap" vs. "expensive" and "transparent/rules based" vs. "black box/dependent on skill." Some of the enhanced index funds are in fact cheaper than some of the "true" index funds on the market.

Externally, there is currently no such thing as target date retirement fund which tries to strategically target these factor premiums in a rules-based fashion, they are generally limited to single-asset classes and so will require some measure of asset allocation/portfolio management decision making.

I think there is a kind of "meta" risk you are not considering here: index funds are proven investment strategies, based >on empirical evidence and economic theory. The investment strategies you propose here are more uncertain. You link many studies in favor, but I don't have the expertise to evaluate their relevance, and I suppose this holds true >for pretty much anybody who isn't a professional investor. From the "outside view", the strategies you propose are inherently more risky than index fund investment.

I basically agree. And you may say the possible greater expected return from these strategies is compensation for this meta-risk. As I am quick to point out, these strategies do underperform from time to time, sometimes badly. It is during these periods that investors proclaim that "things are different now" and change course, often to their detriment. This epistemic factor can make the strategies more risky in practice.

I have laid out what I consider to be the best evidence to support my philosophy, much of it is Nobel-prize winning research (not that having Nobel laureates on your side is always profitable...) But how comfortable you feel evaluating that evidence or trusting me to present it in a fair manner is a question I can't answer for you. If you are doubtful, and I do not find that an unreasonable proposition, you would do well to use index funds and be done with it. More intrepid investors may have a different attitude.

A Guide to Rational Investing

I've obtained my leverage mostly through credit card stoozing, the act of taking advantage of low and 0% promotional credit card balance transfers and rolling the balances over as necessary. As I said at the talk and every time I bring this up, I do NOT recommend this unless you, like me, have an Asperger's level attention to financial minutiae. This is also a strategy that only is worthwhile while your net worth is relatively low. I started doing it in college and am now winding the strategy down, to be replaced with portfolio margin, which is cheaper and more scalable for people with more substantial assets to work with. You are right though that margin calls are a risk, however, so active portfolio monitoring and careful use of mean-variance optimization and other risk management techniques is essential. If you do not have the time or skills to employ these, or to use a financial advisor who is, then I cannot recommend it.

A Guide to Rational Investing

The online services Betterment and WealthFront explicitly state they hold the efficient markets hypothesis is true and invest exclusively in broad-market index funds. I consider their approach to be an alternative to using Vanguard, which is to say, they offer an excellent service and many people would be well to use them, but I believe more optimal investing is possible. In my opinion it is not really possible to scale a market-inefficiency-exploiting strategy to the level that Betterment and WealthFront are after.

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