Saturday, September 8, 2012

Are You a Better Investor Than Fund Managers?

Earlier this week, I came across an interesting study by Andriy Bodnaruk of the University of Notre Dame and Andrei Simonov of Michigan State University, entitled "Do Financial Experts Make Better Investment Decisions?"

The pair analyzed the personal portfolios of 84 Sweden-based fund managers and compared them those of  non-professional peers that had similar backgrounds as the fund managers.

Among their findings...
We find no evidence that financial experts are making better investment decisions than their less financially astute peers: they do not outperform, do not diversify their risks better, and do not exhibit lower behavioral biases...Our results demonstrate that day-to-day knowledge of financial markets does not improve investment decisions.
We find that financial experts do not exhibit superior security picking ability in their own portfolios. Private investments of fund managers perform on par with investments of investors similar to them in terms of age, gender, education level, income, and wealth. Even more striking, mutual funds managers’ investments perform worse than private investments of wealthiest 1% of investors. Moreover, non-MF-related investments of managers significantly underperform their MF-related investments. This suggests that a part of overall managerial performance should be credited to access to fund’s resources.
But not so fast -- the authors do insert important qualifiers as it pertains to the definition of fund managers' peers:
Our results can be best summarized in the following way: day-to-day knowledge of financial markets is of little value for investors with a high level of general intelligence – both managers and their peers are among the most educated and wealthy investors. It is plausible that marginal effect of financial expertise on investment decisions is trivial for these investors, but is of larger importance for less sophisticated individuals. Our results, nevertheless, provide important insights as they demonstrate that there are limits to the value added by financial expertise. 
In other words, financial literacy and a fair level of intelligence are still essential if you plan on investing on your own. You have to want to continuously learn about investing and keep up with your investments. Some people don't want to learn, and that's fine, but that group should probably outsource their investment management to professionals anyway.

Assuming that we have the requisite intelligence, knowledge, and motivation to manage our own investments, however, this study is indeed encouraging to individual investors.

If I've learned one thing in my investment career, it's this: superior investing results require superior decision-making skills. You can have access to all the information in the world, but at the end of the day the information isn't worth much if you're not using it to make better decisions. Great analysts don't necessarily make for great investors, and vice versa. Great analysts are great information gatherers and interpreters; great investors are great decision-makers.

After you've established a good foundation of investing knowledge, the next step is to understand investing psychology, behavioral finance, and risk. In fact, I've learned more about making smart investment decisions from these three books as I have in all the accounting and financial theory books I've read.

If you haven't read one or any of these, I can't recommend them enough. I find myself re-reading them again and again to let the lessons sink in.

The better you understand yourself -- what's behind your decision-making process, what triggers emotions, and the lessons learned from previous mistakes -- the better investor you'll be. I do believe that the non-financial professional with street smarts, self-awareness, and a solid financial foundation can achieve excellent long term returns.

Have a great weekend!


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