"Nobody knows Nothing"

Posted on April 24, 2010 at 10:06 AM PST by

“Nobody knows nothing” is a statement made by screenwriter William Goldman about the movie business. He meant that even after making movies for over 100 years, no one actually knows exactly how to make a successful movie. Sometimes sure things bomb. Sometimes long shots win big.

To draw a parallel, we assembled a few articles that describe how random investment success really is. For example, if you own actively managed mutual funds, you’ll retire with a lot less money than if you’d just bought, held and rebalanced the boring ETFs others and we recommend. This is a non-debatable fact that’s been proven over and over again.

But why do so many want to believe something that just isn’t true? Ivy League MBAs who are smart, motivated and work hard must be able to beat a dumb computer managing an ETF or an index, right? Wrong for two reasons. First, investment pros charge fees that are an impossible handicap to overcome. And second, unlike other professions like a surgeon, litigator, race car driver or a pilot where success can be accounted for by how well one manages risk, most professional investors who beat the market one year, are just plain lucky. They win for short periods of time because of random events, not skill or intelligence. Just luck. We all became acutely aware of this in 2008 when all the gurus somehow didn’t see it coming.

Consider it likely that the great professional investors may really be no better than the 4 finalists in the 8th round of a 1000 monkey coin-flipping contest. Yes, there will always be a winner. But why did the winner win? Did someone know something?

This point is made in an article in The New Yorker: “Blowing Up” by Malcolm Gladwell author of “The Tipping Point” and “Blink.” Gladwell interviewed Nassim Taleb, a professional options trader. Taleb’s book “The Black Swan” describes about how random events in the financial markets are common and unpredictable – essentially dismissing 90% of the value of professional investing.

“Wall Street was dedicated to the principle that skill and insight mattered in investing just as they did in surgery and golf and flying fighter jets…. For Taleb then, the question of why someone was a success in the financial marketplace was vexing. Taleb could do the arithmetic in his head…”

In another article in Fast Company, called “The Myth of Mutual Funds,” Chip and Dan Heath the authors of “Made To Stick,” explore why we don’t always want to believe the truth about investing. “Let’s pull off the Band-Aid quickly. You’ve come to believe that mutual funds are a smart place to put your money. They’re not. That’s the assessment of the smartest minds in finance, supported by a mountain of historical data. So two questions: How can this possibly be true? And why, in gleeful defiance of the data, do more people keep buying mutual funds every year?”

Last, read Moneywatch’s “Hedge Funds – Case Against, part 2” if you’re considering investing in one. Allan Roth writes some compelling pros and cons for doing so. He addresses the question: Are these fund managers lucky or smart? “If I had a dime for every time I’ve heard that hedge funds provide above market returns with lower risk, I’d be a very rich man. Every time I hear this claim, however, I ask for any evidence that supports it. I have had no takers to date, though maybe this column will change that. Unless you happen to have a few billion to invest (and give me a ring if you do), I’d steer clear of hedge funds as they provide too much risk with too little return.”