“You have no respect for cognitive reverie, you know that?” At the time I saw the movie, A Beautiful Mind, I had no idea what ‘reverie’ meant. However, when John Nash’s roommate retorted, “Yes, but…I have enormous respect for…beer,” I got that. And so did the John Nash character, because it drew him out of his daydreaming and toward the pub as he muttered, “I have respect for beer. I have respect for beer.”
My dad had enough respect for beer to make brewing it one of his hobbies. And like everything he did, he took the time and effort to become very good at it. He not only studied and experimented, but he also sought out experts. One such expert was in the process of turning his hobby into a small business. When my Dad found him, he was making beer in plastic buckets in a blue metal warehouse in my home town of Chico. Almost 40 years later that small brewery is still in business. You may have heard of it - it is called Sierra Nevada Brewery.
According to their website, Sierra Nevada beer was built on “…plenty of passion” and a commitment “…to pushing the boundaries of craft beer.” Within a year of the founding of Sierra Nevada, another firm was founded with a similar passion and commitment to pushing boundaries. You may not have heard of it - it’s called Dimensional Fund Advisors (DFA).
Last October, Wall Street Journal columnist Jason Zweig pointed out that DFA is “the fastest growing major mutual fund company in the U.S… [and it is] the sixth-largest…” Nevertheless the “…firm remains all but unknown to the general public…” Sometimes I joke that DFA’s unofficial motto is, “We’re the largest mutual fund company that no one has ever heard of - and we want to keep it that way. “
Their apparent aversion to marketing seems to extend to their recruitment of advisors as well. Unlike other mutual funds that are always recruiting advisers, DFA makes advisers find them. And once you find them, Zweig points out, they “…set up a daunting steeplechase that advisers still must hurdle before they can market their funds.” So, when I found them 25 years ago, I had to prove I was committed to and passionate about their “…bedrock belief,” as articulated by Zweig, “that active management practiced by traditional stock pickers is futile, if not an absurdity.” Based on this core belief and the fact that DFA’s founders are pioneers of index funds, one would expect them to be strict passive indexers. But, that’s not so. They realized there were ways to “...achieve better returns than plain index funds deliver.”
I don’t know how the founders of DFA came up with that cognitive reverie about returns, but I do know from the work of psychologist Jonathan Schooler that it wasn’t from combining respect for cognitive reverie with respect for beer. As I learned from the book Imagine: How Creativity Works, the type of daydreaming required for inspirational insights involves disciplined mind wandering. And while drinking beer “…induces a particularly intense state of mind wandering…” it’s not very disciplined because you become less aware of what you’re thinking. In other words, “You might solve a problem while drunk, but you probably won’t notice it.” So, it wasn’t beer that inspired them but, as they told Barron’s, it was the desire “…to apply the ideas” of Gene Fama at the Booth Chicago School of Business. Ideas that a press release from the school says, “…push forward the boundaries of research in finance.”
As I now know, cognitive reverie is thoughtful daydreaming that leads to profound insights. And it is these creative ideas that turn passion and a commitment to pushing boundaries, at Sierra Nevada and DFA, into great products for their clients. So, I drink Sierra Nevada Pale Ale. But more importantly, I recommend DFA funds because I have enormous respect for DFA. And that’s not the beer talking.
Then again, the Association for Psychological Science informs us that parenting any child isn't easy. A recent post, The Myth of Joyful Parenthood, states that "Raising children is hard and any parent who says differently is lying." And that isn't an unsubstantiated opinion, explains John Cloud in a Time Magazine article -- Kid Crazy. "Researchers have known for some time that parents are... more depressed than nonparents..." They're more depressed and stressed, writes author Jay Belsky, PhD, because of "...a fundamental truism about the world we inhabit: The future is uncertain. As a result, no parent...can know for certain what would be best for his or her...child..." Neither can investors know with certainty what is best for their portfolios. So, like parents, "investors hate uncertainty," points out Wall Street Journal columnist Jason Zweig. But certainty, which he defines as "...a state of clarity and predictability... doesn't exist, never has, and never will." However, "Our need for certainty in an endeavor as uncertain as raising children [or, I may add, investing for retirement] makes explicit 'how-to-parent' [or investment] strategies both seductive and dangerous," warns researcher and TED Talk sensation, Dr. Brené Brown.
Therefore, it is hard to resist "...seductive-sounding ideas that will supposedly enable you to beat the market," writes Zweig or be a "perfect" parent, Brown would add. But you must. That's why Brown says you have to "let it go" and Zweig says to "get over it." By doing that, Zweig explains you can then "...try to control the things that are controllable," which is mainly your behavior. So, Brown encourages parents to "Be what you want your kids to be" and Zweig admonishes investors to adhere "...to a set discipline... [to] prevent yourself from making impulsive decisions..."
Investors should heed both pieces of advice and try to emulate the behavior of disciplined role models like Warren Buffett. That means not only knowing what he does but also doing it. "Only when you combine sound intellect with emotional discipline do you get rational behavior," Buffett maintains. For him to nurture such intellect and discipline, he told CNBC, "I do more reading and thinking, and make less impulsive decisions than most people in business." It's something "All of you can do," he points out, "but I guarantee not many of you will do it." And that's the reason why so many investors make the same mistakes over and over.
As humorist Franklin P. Jones observed, "Experience enables you to recognize a mistake when you make it again." Regrettably, there is more truth than humor in that statement. It's true because, "...it turns out that our brains are hardwired to get us into investing trouble," laments Zweig. In other words, nature has cross-wired our brains in such a way that we believe that the world is more predictable and controllable than what logic, observable facts, or past experiences would suggest. Because of that, neither parents nor investors can let go of the belief that perfection (or near perfection) is possible. And that's not very smart, is it? Ya think!
My wife and I, along with a daughter and son-in-law, were in a London pub when a World Cup soccer match between Great Britain and Sweden was about to start. In preparation for the telecast, the waitresses were busy replacing glass mugs with plastic cups -- for everyone but us. When I asked one of them “Why?” she replied, “You’re Americans. You can keep your glasses, but the local football fans tend to get a little excited and throw their glasses at the telly.”
While I never did see anything thrown, I did see a lot of excitement. The first goal generated a roar worthy of the three lions crest on the team’s jerseys. In the celebration that followed, a passionate fan next to my wife grabbed her and kissed her. When I stood to protest, the Brit bear hugged me and planted his stiff upper lip squarely on mine.
Being kissed was not surprising but the source was unexpected. Similarly, Michael Johnson recently wrote in the Financial Times that another report documenting the futility of active investing was not surprising “…but the source was unexpected.” That’s because it was a dispassionate British agency, not some passionate advocate for passive investing. And that’s why he claims their research is so “…robust, independent and damning… [And why it] skewers any justification that active fund management of listed assets is worth the candle.” It’s a waste of time and money, he says, since “Ludicrously expensive talent is deployed [by investment firms] in the pointless pursuit of continually trying to outperform one another. Worse, it is a giant negative-sum game in which the savers pay the price, their hard-won capital persistently eroded by recurring charges and fees.”
In his book on prudent investing, The Prudent Investor Act: A Guide to Understanding, W. Scott Simon describes this pointless pursuit in more detail. He explains that active investment buy-sell decisions are “…little more than side bets…” on the direction of the stock market. A highly educated and well-trained analyst at one prestigious financial institution “…places a buy bet on the same stock…” another equally well educated and trained analyst at another institution places a sell bet on. And since losing bets are always offset by winning bets, he quotes Steven R. Thorley’s conclusion that, “…simple arithmetic dictates that beating stock-index benchmarks is a zero sum game before costs and a negative sum game after costs.”
So, surprisingly simple arithmetic and mountains of data collected by an unexpected and unbiased source prove that, on average, the additional returns generated by active management are not sufficient to overcome the additional costs. And while some managers will beat the indexes and their peers, it is virtually impossible to identify those managers in advance. As Johnson points out, “a stunningly small number of funds beat their peers on a regular basis, but the crucial point is that at the start of any three-year period, no one knows which funds they will be. Hindsight being useless, this is active fund management’s Achilles heel, and the crux of the debate.”
The debate is over. Johnson concludes that active investment management is “…a web of meaningless terminology, pseudoscience and sales patter…costs are controllable but, by and large, investment performance is not.” So, just as prudent waitresses replaced glass mugs with plastic cups, the British government’s report recommends that prudent investors replace active fund management with “…passive fund management.” It will probably reduce costs and increase performance, but it will not be exciting. Sports is exciting but good investing is not. As Warren Buffett explains “…excitement and expenses are [investors’] enemies.” And that’s why when an investment broker passionately explains the advantages of some great active strategy, you should dispassionately tell him to “kiss off.”
“That makes the victory all the sweeter.” Those were the words of my best friend who was rubbing salt into my wounds. Jim and I live 2,500 miles apart, but we get together once a year for a golf grudge match. We play for quarters, but the real prize is the “thrill of victory” and the joy of watching the loser suffer the “agony of defeat.” In this case, I had just mentioned how much it hurt to lose. But, instead of responding with sympathy, he reveled in his victory and gloated over my defeat.
Even though Jim has a lower handicap than I do, I refuse to take any strokes. So he beats me more often than not which, from a financial perspective, means I’m playing a loser’s game. However, my occasional win is exhilarating. I remember my first victory. It ended with me one-up, so I won a quarter. A couple of dozen years later, I still have that quarter. I painted it red and use it to mark my ball for our annual matches. And I guarantee you, he knows what that red quarter represents and he hates it.
If you can’t understand why two supposedly nice guys would get such pleasure from crushing another human being, then you are apparently not competitive. Obviously, Jim and I are fierce competitors which, interestingly, is how Nate Silver described Eugene Fama in his book, The Signal and The Noise.
Eugene Fama is a 2013 recipient of the Nobel Prize in Economics who is best known for his efficient-market hypothesis. Silver explains that Fama got interested in finance after taking “…a job working for a professor who ran a stock market forecasting service.” The job stimulated his competitive juices and he was, early on, thrilled by his ability to “…identify statistical patterns that suggested the stock market was highly predictable and [that] an investor could make a fortune by exploiting them.” However, the competitive Fama was crushed when he saw that his strategies didn’t “…perform in the real world.”
“Equally frustrated and fascinated by the experience,” Silver says, “Fama… enrolled in the University of Chicago’s Graduate School of Business.” In his studies he received some consolation for his agonizing inability to beat the market by discovering that nobody else could either. This discovery formed the core of his 1965 thesis in which Silver explains, Fama leaned “…on a mix of statistics and sarcasm to claim that much of the conventional wisdom about how stocks behave was pure baloney.”
Unfortunately, the established investment community is only now learning how to separate the baloney from the truth. In what John Morgan in Moneynews describes as a “watershed moment”, the California Public Employees’ Retirement System, the second-largest pension fund in the United States, “…is considering a switch to an all-passive investment portfolio.” “It’s sort of an exclamation mark on a trend that most are aware of,” says Chris McIsaac, of The Vanguard Group.
The trend is toward passive indexing because beating markets is not necessary for the strategy to work. Silver explains why that is important by quoting former trader, Henry Blodget; “…in the stock market the competition is fierce... The average trader…has ample credentials, a high IQ, and a fair amount of experience… How could you beat that?” You can’t. And since you’re playing for a lot more than quarters, you should avoid the competitive investment game altogether. Because unlike golf, it’s a game that Fama discovered nobody wins. And that’s why Blodget warns: “Don’t Play the Losers’ Game.”
When asked about the benefits of being a celebrity, Henry Kissinger replied, “Now, when I’m at a party and bore someone, they think it’s their fault.” Kissinger definitely isn’t shy. If he were, he would still think it was his fault, no matter how famous he was. Reading about shyness on Wikipedia just confirmed what I already know; “Shyness usually involves… discomfort in social situations *and+…may include crippling physical manifestations, in many cases leading *the sufferer+ to feel that they are boring…”
I’ve always suspected I was boring. Why else, when I rang the doorbell at Don’s house, would one of his sisters rush to the door, throw it open, instantly have her expression of excitement turn to indifference, and then add insult to injury by yelling, “It’s only Guerdon.” But it wasn’t until I was in second grade that I found out, along with the rest of my classmates, that I was shy. I never understood why my teacher always had me take the attendance sheet to the office and always chose me to run errands to other classrooms, but I found out in a painful way. Once when I was gone on one of those errands a student asked why she always sent me. She explained, “Guerdon is so shy, that he will not talk to or even look at adults, so I am sending him on errands to force him to interact with adults.” It was at that time a label was attached to my fears and my classmates never let me forget it.
As an adult, I am still plagued by shyness and my awkwardness has kept me from developing good interpersonal skills, which means I haven’t lost my ability to bore people. While the feelings of apprehension have lessened, I haven’t been able to entirely escape the captivity caused by my anxiety in social settings. However, as much as I hate to be imprisoned by my insecurities, there is one area where I am not concerned about being boring, and that’s in investment management.
The White Rabbit, in Alice in Wonderland, probably gave the best investment advice ever when he said, “Don't just do something, stand there...” In his book, The Brilliance of Boring Investing, Marshall McAlister writes, “It is a paradox…the portfolio process that requires less [activity]…can actually deliver the best long-term returns.” This investment process, which is known as passive asset allocation, is designed to create less trading, less taxes, less cost, less volatility, less illiquidity, less opaqueness and less concentration. And this “less” of passive investing is usually more than the “more” of the alternative (active investing) because the “more” is usually more costs, taxes, and volatility instead of more returns.
However, doing less is the most difficult thing for investors to do. As Allan Roth explains in his article Dare to Be Dull Investing, “It’s hard to strike out for dull and boring, when our emotions, along with the media and Wall Street, are singing the siren’s song of what the economy will be doing and where to invest. Fantasies of outsmarting the market (active investing) are the rocks the sirens entice us to wreck our ships on, and naturally, our advisors are willing to charge us handsomely to try and do it.”
Unlike Henry Kissinger, people know it is my fault when a conversation with me bores them. And while it would be nice to be fascinating, I realize that when it comes to investing, dull is a virtue. Active investing and complex investment strategies may appear more exciting, but it’s the less appealing passive investing style that has delivered better long-term results. That’s why, when you really get to know passive investing, you’ll realize that boring is beautiful.