Wise Investing Made Simple Review Part 3: Information and What To Do With It

February 1st, 2008

Wise Investing Made Simple Review Part 3: Information and What To Do With It

For the past several weeks, I’ve been working my way through the book Wise Investing Made Simple by Larry Swedroe. The first review covers chapters 1-8, the second review is chapters 9-16, and this review is chapters 17-22. Come back next week for the conclusion of the series!

Where we left off last week, Swedroe had addressed several myths in investing and shown how when examined, they didn’t hold water. This section of the book continues that theme, but takes a slightly different tack. Understanding information - what is useful and what is not - is important to being able to choose an investment strategy, and Swedroe looks at some little-discussed but important information as well as some much discussed that is widely misused and looks at what it all means.

Uniform Prudent Investor Act

According to Swedroe, this act is law in virtually all states. The act governs the investment activities of trustees and effectively makes passive investing the standard upon which all fiduciaries (basically, in my understanding, a fancy word for trustee) should be judged. It addressed diversification and cost control as important elements to prudent investing. So the question is, if it is law to use a passive investing strategy for those who have their money in trust for them to protect them, do we think we can come up with an even better strategy consistently? I don’t think I can.

Economic Forecasts and Market Forecasts

Economic forecasts are what market forecasts are based on. Looking at forecasts and leading investment research from 1970 to 1995, a number of key and disturbing points can be noted if you want to use forecasts to predict the future:

46 out of 48 economists missed correctly predicting the turning points in the economy
Economists forecasting skill is worse statistically than pure chance
No specific economic forecasters lead the pack in accuracy
Consensus forecasts offer little improvement

This is what is used to create market forecasts. Knowing this, it seems to me that market forecasts are a game of chance at best. In fact, Swedroe compares market forecasts to astrology (a guessing game) and says too many people treat them as astronomy (a science) instead.

What If Everyone Indexed?

This was one of my biggest questions going into the book. If passive investing is the winning strategy, and investing in index funds is a key component of passive investing, what would happen if the majority really did just invest in index funds? Would it actually work any longer?

The reality is that is unlikely to happen - institutions still only invest about 40% of assets as an average in passive strategies and individuals as a whole have about 90% of assets in stocks or actively managed funds. But even if that went to 100% passive (unlikely) there is still trading activity from the activity of individuals exercising stock options, liquidating estates, etc and companies buying and selling companies through mergers and acquisitions.

There’s also a story here about how the trend to passive investing happens. Basically, as a person has bad active management experience, they become more likely to go a passive investing route. Behavioral studies indicate that what initiates the change is bad experiences, not just recognizing that your active management success has been luck. That shifts the “competition” in active management to be tougher and tougher (as only successful investors stay with it). This means in most cases, it ends up better to not play the game but instead, benefit from the most successful setting the tone for the overall market.

Investing as Entertainment

Follow TV market gurus and pick their stock picks - they rise for a short time (as everyone watching buys them) and then just bottom out. This is basically the same as thinking you have specialized investing information because you watched a TV show which was nationally televised. There’s a quote I really liked here from Steve Forbes of Forbes magazine: “You make more money selling the advice than following it.”

So, overall, I learned that there is actually in our legal code an prudent investment strategy, and that economic and market forecasts are kind of like predicting the weather… sometimes it works (today we are supposed to have 3-10 inches of snow and that seems to be coming true) and sometimes it doesn’t (Tuesday we were also supposed to have 3-10 inches of snow and we ended up with a light dusting). Next week we’ll finish off the book by looking at the strategies and portfolios that Swedroe recommends.