The Lively Management Delusion: Respect the Wisdom of the Crowd


“My basic point here is that neither the Financial Analysts as an entire nor the investment funds as an entire can expect to ‘beat the market,’ because in a big sense they (otherwise you) are the market . . . the greater the general influence of Financial Analysts on investment and speculative decisions the less becomes the mathematical possibility of the general results being higher than the market’s.” — Benjamin Graham

An everlasting principle of monetary history is that past solutions often plant the seeds of future problems. Among the many least-expected examples of this phenomena were the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts mandated extensive financial disclosures by publicly traded corporations and outlawed market manipulation and insider trading. Prior to their passage, Wall Street stock operators routinely profited by cheating markets quite than outsmarting them.

To be clear, these regulations were desperately needed to scrub up US securities markets. After they were passed, skillful securities evaluation, quite than market manipulation and insider trading, was largely the one technique to beat the market. After all, truly above-the-mean securities evaluation was and stays exceedingly rare.

But that hasn’t kept capital from flooding into actively managed mutual funds — even after the primary index funds launched within the Nineteen Seventies. Under pressure to distinguish their products, fund managers introduced a slew of investment strategies covering various asset classes and sub-asset classes. Increased complexity, specialization, and robust marketing budgets convinced the general public that skilled managers could add value to their investment portfolios beyond what they might otherwise obtain by investing in a diversified portfolio of stocks. Few paid attention when the SEC noted that the common professionally managed portfolio underperformed broad indexes before fees in an exhaustive 1940 study.

For greater than 80 years, the indisputable fact that few lively managers add value has been validated by quite a few research papers published by government agencies, including the SEC, and such Nobel laureates as William Sharpe and Eugene Fama, in addition to the experience of Warren Buffett, David Swensen, Charles Ellis, and other highly regarded practitioners. Despite a preponderance of evidence, many investors proceed to reject the undeniable truth that only a few are able to consistently outperforming an affordable index fund. Outside a small and shrinking group of extraordinarily talented investors, lively management is a waste of time and money.

The Extraordinary Wisdom of the Crowd

So, why is the lively management delusion so persistent? One theory is that it stems from a general lack of information as to why lively strategies are doomed to failure normally. The first reason — but actually not the just one — is summed up by the “wisdom of crowds,” a mathematical concept Francis Galton first introduced in 1907. Galton described how tons of of individuals at a livestock fair tried to guess the burden of an ox. The common of the 787 submissions was 1,198 kilos, which missed the ox’s actual weight by only 9 kilos, and was more accurate than 90% of the person guesses. So, 9 out of 10 participants underperformed the market.

Galton’s contest was not an anomaly. The wisdom of crowds demonstrates that making a better-than-average estimate of an uncertain value becomes harder because the variety of estimates increases. This is applicable to weight-guessing contests, GDP growth forecasts, asset class return assumptions, stock price estimates, etc. If participants have access to the identical information, the entire estimates above the actual amount are likely to cancel out those below it, and the common comes remarkably near the true number.

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The outcomes of a contest at Riverdale High School in Portland, Oregon, illustrated below, display this principle. Participants tried to guess the variety of jellybeans in a jar. Their average guess was 1,180, which wasn’t removed from the actual total of 1,283. But out of 71 guesses, only 3 students (fewer than 5%) beat the common. Anders Nielsen got here closest with 1,296.

Average Participant Guess by Variety of Participants

Chart showing Average Participant Guess by Number of Participants

The Seed of the Lively Management Delusion

Speculators prior to 1934 understood the wisdom of crowds intuitively, which is one reason why they relied so heavily on insider trading and market manipulation. Even within the late 1800s, market efficiency was a formidable obstacle to outperformance. The famed stock operator Daniel Drew captured this sentiment when he reportedly commented, “To speckilate [sic] in Wall Street when you are no longer an insider, is like buying cows by candlelight.

The Great Depression-era securities acts improved market integrity in the US, but in addition they sowed the seed of the lively management delusion. As corporations were forced to release troves of monetary information that few could interpret, markets became temporarily inefficient. Those like Benjamin Graham who understood the right way to sift through and apply this recent data had a competitive advantage.

But as more investment professionals emulated Graham’s methods and more trained financial analysts brought their skills to bear, the market became more efficient and the potential for outperformance more distant. In truth, Graham accelerated this process by publishing his techniques and methods and thus weakened his competitive advantage. His book Security Evaluation even became a bestseller.

After a time, Graham concluded that beating the market was now not a viable goal for the overwhelming majority of monetary analysts. That didn’t mean that he had lost faith of their value; he just knew with mathematical certainty that outperformance was too tall an order for many. Despite his indisputable logic, his warning was largely ignored. By the Nineteen Sixties, too many investment firms and investment professionals had staked their businesses and livelihoods on beating the market.

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Letting Go of the Fear of Obsolescence

The flawed belief that we will beat the market persists to today. What’s worse, it has spread to institutional consulting and other sectors. Many firms base their entire value proposition on their manager selection skills and asset allocation strategies. Yet these are subject to the identical constraints as Galton’s weight-guessing contest. For instance, average estimates of asset class return assumptions — which are freely available — are more likely to be more accurate than those provided by individual firms using comparable time horizons. The identical holds for manager selection, only the outcomes are quite a bit worse. The common alternative of an asset manager could also be higher than most individual selections, but by definition, even the common is a losing bet. That’s, the common manager is anticipated to underperform an index fund because most asset managers underperform index funds.

To enhance client outcomes, investment consultants and advisers must come to terms with this reality. But over the past several a long time, most have only intensified their quixotic quest for outperformance. Their collective failure has saddled clients with portfolios which are overly diversified, laden with unnecessary lively manager fees, and unnecessarily invested in expensive alternative asset classes that may only add value to a small subset of highly expert investors. The consequence is subpar performance, higher fees, and dear neglect of more vital financial challenges.

Why can’t advisers and consultants accept the reality about outperformance? Because they fear it’ll result in their obsolescence. It’s an important irony, due to this fact, that the other is true. Once we let go of the outperformance obsession, we will add extraordinary value for our clients. Clients need us to hone their investment objectives, calibrate their risk tolerance, optimize the deployment of their capital, and maintain strategic continuity. By spending less time on unnecessary tweaks of portfolio allocations, the constant hiring and firing of managers, and unnecessary forays into esoteric asset classes, we will higher serve our clients by specializing in what really matters.

Step one is to acknowledge and respect the wisdom of crowds. Only then can advisers and their clients join Benjamin Graham as elite investors.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the creator’s employer.

Image credit: ©Getty Images / mattjeacock

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