Asset management is an extremely competitive industry that offers extraordinary wealth building opportunities to those managers who are successful in generating market beating returns, or at least in bringing in large amounts of assets to manage. This opportunity draws lots of really smart people to the business. The problem is that the average performance of these really talented people is likely to be near market average returns before subtracting fees, and below market returns net of fees. Meanwhile, individual investors can achieve something very close to market returns by investing in low-cost passively managed index funds. This apparent paradox, that an amateur can outperform the average pro, is due to the fact that tremendous competition makes it extremely difficult to consistently beat the market.

Active managers resist this theory. They point to examples of investors that have consistently outperformed the overall market for years (Warren Buffett being one example). Besides, if there were no gains to be achieved through market analysis and security analysis, why do so many people pursue these activities? Cynics might respond that these activities are pursued in part because customers are easily duped into paying large fees for them, even if they do not on average produce value.

Behavioral finance says that the academic theory of the Efficient Markets Hypothesis (EMH) is wrong because people are not rational. They are subject to waves of optimism and pessimism, they are overconfident, they extrapolate recent results, they tend to hold onto losing investments too long and sell winning investments too soon. These “errors” of judgement lead to terrible investment performance by individual investors.

On its face, this theory suggests the opportunity for active management – to take the other side to the losing trades of the individual investor, or at least to help the individual out by keeping him from making mistakes. Of course, in order to add value the active manager must not be susceptible to these well documented errors and biases.

Even without assuming superior ability to outwit the market, one implication of behavioral finance is to question the efficiency of traditional indexes of market return. Most indexes, like the SP500, are so-called market capitalization weighted indexes. This means that the share of each stock in the index is its proportionate value weighting (i.e., the weight for Apple is the market value of Apple divided by the sum of the market values of all SP 500 stocks). Market capitalization (or “market cap”) weights are prescribed by traditional financial theory. The “market portfolio” is a market cap weighted index of all traded stocks. But if stock prices do not “fully reflect available information” as assumed by the EMH, then we can conclude that stocks are, at times, either over- or under-valued. The effect of market cap weights is to concentrate too much weight on over-valued stocks and place too little weight on under-valued stocks. The consequence is that you will be more susceptible to asset price bubbles and will tend to underperform indexes that are not based on market cap.

To avoid this source of underperformance, you might want to use other methods to build indexes and index funds. The simplest is “equal weight” where each of N stocks has weight 1/N. Alternatively, you can build portfolios by weighting fundamentals like company sales, or profits or book value. This is called “fundamental indexing.” Notice that the theory does not assume that the asset manager can identify which stocks are over and under-valued, just that market cap weightings are not efficient.

One of the leading proponents of fundamental indexing is Robert Arnott who has conducted research studies to show that fundamentally indexed portfolios have out-performed market cap weighted portfolios. Arnott is also a financial entrepreneur who has introduced the RAFI (Research Affiliates Fundamental Indexes) set of fundamentally indexed funds.

Perhaps not surprisingly, one critic of fundamental indexing is John Bogle. He points out that financial theory supports market cap weighting and claims that fundamental indexing is simply another version of tilting your portfolio toward value stocks or small stocks, and that any additional return that you may achieve is balanced by greater riskiness of the portfolio.

It turns out that this dynamic – identification of a market beating strategy, and then realization that it entails heightened risk – seems to come up a lot. Researchers have identified historical market beating returns in small stocks, in value stocks, in momentum strategies (buying stocks that have been moving up and selling those that have been moving down), by using leverage, in selling liquidity (buying illiquid securities and selling liquid securities), in being short options (selling volatility) and numerous other strategies. Generally, the flip side of the higher average return is that the potential downside risk of the strategy in a difficult environment may be extremely large. This is one of the fundamental lessons of financial economics.

Bottom line

So what should you do? Take a deep breath and try to focus on the important stuff. The first step is to develop an overall financial plan, featuring a feasible spending plan given your current income, likely future income, current age, desired retirement age and current financial wealth.   The second step is to manage your investment portfolio in a coherent way. Keeping it simple, you should have three objectives. First, take advantage of the equity risk premium by holding broad equity exposure. Second, maintain a safety net in the form of a low-risk bond portfolio. Third, take advantage of any special skills or talent that you might have (this talent could be security analysis and selection, or market forecasting and time, or manager selection). The first two objectives can be achieved through a core portfolio consisting of broadly diversified stock and bond funds. The percentage in equities should depend on your tolerance for risk. The third objective is to increase return by using your special skill; that is, if you have a special skill. You can do this by running an active portfolio in addition to the core portfolio. The size of the active portfolio relative to the core portfolio should depend on the confidence that you have in your special skill. For most of us, the active portfolio percentage should be very small.

Can you do this by yourself? Sure you can. But most people will probably decide to employ outside expertise in one or more of these steps. Just be sure to keep an eye on the fees.