## Tuesday, May 03, 2016 ... //

### Warren Buffett is right: investment consultancy doesn't work

Dupes pay lots of fees to dummies

Warren Buffett has been a classic value investor who was buying assets when they were undevalued and selling them later. This is obviously an activity that is good for the investor if he can really do it; and by this kind of a behavior, investors such as Buffett are actually doing an extremely helpful and essential service for the market – they are setting the price.

This should be contrasted with the technical investors who are trying to spot the "momentum". These investors don't have a clue about the actual value of a company and they don't positively contribute to the market process of discovering the right price. They contribute noise – and they help to grow bubbles when they act as collective bulls; and they help to cause dramatic crashes when they act as collective bears.

Aside from the technical investors, one also has the noisy investors who just do basically random things – often with other people's money – and they claim that it's better than doing nothing. During the weekend, Warren Buffett made a wonderful monologue about the uselessness of the noise investment consultants:

Warren Buffett’s Epic Rant Against Wall Street
I couldn't agree more with him. The seven-hour video is available. Things are interesting after 2:42:20 (data showing why hedge funds don't work).

His company's vice-chairman Charlie Munger pointed out that the Berkshire investors have been able to beat the S&P 500 index in recent decades. But these were a lucky few and that has really been the only argument against Buffett's main claim that the best strategy at every moment is simply to buy an index fund and all the investment consultants who constantly advise doing something special are basically charlatans whose only purpose is to suck a nontrivial part of the wealth from their clients.

There are lots of people employed as investment consultants and most of them can't boast any successful and sustainable overall record. But they're living out of a few percent of the clients' money every year and they have to display some activity. So they invent many kinds of very special recommendations – in this year, you should better focus on this asset class and not that one, and so on – and they are gradually adjusting these specific recommendations every year. They would feel painful if they just said "it's always right to simply buy an index fund" so they prefer to construct more complex stories although all the added value and complexity is bogus.

As Buffett points out, it just doesn't work. In the best sustainable case, these recommendations are random; but the client still loses relatively to the passive investor because he pays several percent from this wealth in annual fees.

Nevertheless, as Buffett observed, there are lots of people – and funds and organizations – that believe that when they have a lot of money, they simply must be able to hire someone who can beat the market i.e. get a higher percentage gain in a year or several years than the S&P 500 index, for example. I know very well that this is a widespread belief, also bought by a relative of mine whom I will call M2.

All these consultants and fund managers etc. must know what they are doing, M2 believes, and so do tons of the people who have been talking to Warren Buffett. He gave all of them all the explanations – backed by his unusually good investment record – and mathematical arguments why one is losing money by trusting the investment consultants (and managers of hedge funds). But the result is that after they stop talking to Buffett, they go out and hire an investment consultant for big bucks. Buffett can't believe what he sees but the lesson is obvious: the human stupidity is infinite and whenever people act as if their stupidity were just finite, they are only pretending.

The inability of these smart pants to systematically beat the market has several basic aspects:
• many and maybe most of them really have no clue and when they pick special stocks etc., they are just guessing; also, sadly, this group of total charlatans isn't clearly separated from the more promising ones
• even those that have some quasi-rational reasons can't beat the market because other consultants in this group (and this group is very large – the industry is crowded) could have already beaten them, so the expected change of the price may already be built-in (or the motion may have been overshot) and the hypothesized profit from the strategy is therefore annihilated (or reversed in sign)
• by moving the assets, one often loses the time when the average change of the price of stocks is also expected to be positive
• the fees that the client pays to the adviser make sure that the client is worse off.
Concerning the last point, Buffett made a bet against someone who has argued that some active funds-of-funds would beat S&P 500 in 2007-2015, even if the fees are subtracted from the profit (as the client sees it). The result? S&P 500 grew by 66%, the fund-of-funds by 22%. No contest, Buffett won the bet. But note that most of the edge, 44%, may actually be attributed to the fees paid to the managers (over a decade). In the long run, aside from the fees, what the active (but at least somewhat non-stupid) and passive people do is about equally effective.

These are some of the reasons why the investment consultancy is a classic pseudoscience, a form of shamanism. The consultants dress well, behave in a friendly way, live in materially satisfied conditions, but something is missing because their clients aren't really beating the market.

The irrational character of the consultants is clearest in the group #1. They just have no clue and the specific recommendations are basically fabricated, copied from other people who have no clue, or determined by superstitious methods that are basically equivalent to horoscopes. But even when the methodology is more sound, as in the group #2, the reasons to think that one will systematically beat the markets are basically non-existent.

You know, the main problem is that the consultants as a group of people collectively advise a large percentage of the clients. So even if they had some ideas by which they could beat the market, they still have to compete with each other. (Decades ago when professional speculators and consultants didn't affect the markets much, the situation may have been different and good for the few and their strategies because lots of "almost guaranteed" imperfections of the market could have been isolated. But the times have changed.) If the consultants collectively knew that it's a good idea to buy a stock, and the price of the stock would really go up in the following year, those who would know it faster than others would earn more than others.

Except that near the beginning of this upward curve, it isn't clear that the "early buyers" were right. And later, when it's clear, it may already be too late to buy. In fact, the upward motion may have already overshot, and it often does overshoot, so the existence of the upward motion – the vindication of the early buyers – may be a reason not to buy anymore. Your investment consultant is likely to be placed randomly in this ensemble, so the probability of an extra income and extra loss is about the same.

Similar comments also hold if computer programs are used for the trading. Even if they could do it well, they must still work with the incredibly high noise in the financial markets. And the computers must also compete with other computers. There's no good reason to think that the algorithmic consultants and funds are particularly likely to beat the market – and for many years, the data indicated that these strategies lose to the market.

My point #3 is largely negative about "daily trading" etc. It's a tempting game but at the end, it's unlikely that it allows anyone to beat the market, too. Whenever you buy or sell, you pay a certain percentage of the sum in fees. It's easy to calculate how much you're losing if your profits and losses otherwise cancel.

But aside from the fees, you also pay for the "missed opportunity". Imagine that you buy and sell a stock at random moments and you own it 50% of the time. If the expected annual growth is 10%, your growth will only be 5% because you owed it 50% of the time. (All these values are mean values and in the real world, the rest may be considered a noise centered around zero.) So you lose 5% a year. You may lose additional percentages due to the fees.

At the end, some strategies when you buy and sell often may turn out to be worse than the passive investment even if they look like good transactions immediately after you do them. It must have happened to you that you bought a stock for 48 (whatever the currency is) and sold it for 80 – before you saw it rising above 100 (this was about Fortuna, a bookmaker, in Czech crowns). You could have held it, too – you would be better off. Later, the company went back from 100 to 80 but if you sold it at a rather random moment in the following months, the average selling price would still be better i.e. higher than 80. So the idea that "it was great you sold it at 80" looked sensible immediately after the sale but with the hindsight, the opinion changes.

And finally, the fees. Fees for transactions make the daily trading bad. And the fees for the fund managers or consultants are perhaps worse. As I said, almost all the lost money of the clients of the financial advisers and consultants is lost in the fees. And as Buffett said, almost all the income that the investment consultants have earned was earned for their salesmanship skills in selling pieces of šit as gold, not for actual helpful ideas.

But let me return to the main point of Buffett's monologue. It's the widespread people's superstition that if your total amount of money is very large, you may also get a higher percentage. It sounds sensible to the laymen – including lots of the people in pension funds etc. – because "a bigger amount" sounds like "richer" and "richer" should imply "better methods" and therefore "higher yields (as percentages)".

Except that if this were right, a bunch of very poor investors could always combine their money and they could collectively behave as a billionaire, too. If one billionaire is capable of hiring the folks and finding the "better methods" that produce the "higher yields", the group of 100,000 poor investors must be able to do the same because their total assets are equally high! But the collectivization simply isn't making things better, so being "richer in the absolute sense" can't increase the yields (as a percentage per year), either. You may imagine that all money that all people and organizations invest are "unified" and their owners want to do "better than the average" which is a contradiction because the average of $\{X\}$ is $X$ and it isn't higher than $X$.

Those people who talk to Buffett pretend to be polite when Buffett tells them all these important things but as their subsequent acts demonstrate, they don't really understand the things he is saying at all.

I have mentioned my relative M2. He's been doing daily trading for some 5 years and despite these good years for the stocks (except for the last one, approximately), the money reserved for the stocks have dropped by some 30%. OK, a lot of these things is about good luck and things we can't affect. But some beliefs by M2 just look so incredibly irrational and stupid – but I also believe that many people actually share similar beliefs – that I want to discuss them now.

First, M2 only trusts stocks whose absolute price is in a particular range, something like CZK 600; \$1=CZK 24, if you need to know. (Sadly, the best stock of this type that he has held costs CZK 450 now so the "CZK 600 is great" rule stopped working whether one likes it or not, and I am sure he doesn't like it.) Stocks that cost CZK 1,000 or more are already too expensive and stocks below CZK 300 are already too cheap etc. It is not possible to find any sensible or semi-sensible answer to the question "why exactly 600 is supposed to be the right number".

So I tell him: M2, the absolute price of the stock doesn't mean anything. One may very well divide a stock to 10 or 100 pieces (and companies are actually doing such things sometimes) or, on the contrary, merge 10 stocks to one, and the absolute price of one stock changes, the number of stocks one owns changes in the opposite direction, and everything is the same. It's just like in the joke about the blonde and the pizza, I continue. A waiter asks: "Would you like the pizza to be cut to 4 slices or 8 slices, Madam?" – "Only 4 because 8 would be too many for me to eat." M2 laughs but he clearly doesn't get it at all (he doesn't understand that his reasoning is exactly as irrational as the blonde's reasoning) because in a minute or next time, I hear exactly the same story about the only right price around CZK 600.

This belief of M2 has many manifestations and all of them suggest that he just can't be getting the notion of the "percentage". For example, M2 says: it's totally silly to buy a company whose stock is CZK 12,000 (cigarette maker Philip Morris CZ, if you need to know), because the same change of the price (like CZK 50) only means a small profit for me. So I say, M2, companies of the same kind have the same typical change of their price expressed as a percentage. So when a stock worth CZK 600 changes typically by CZK 10 a day, a CZK 12,000 will typically change by CZK 200 per day. It's proportionality. After all these years, M2 clearly doesn't get it and seems proud about this fact (although M2 was recently tempted to buy the Big Tobacco, too).

M2 also believes that a big company is safe, despite the 30% drop of the "biggest" company that he trades (and owns) most often. Now, this is also largely irrational, I think. A big company may be "too big to fail" so that the government may decide to save its very existence etc. But even when that happens, the price of the stock may drop dramatically. There isn't really too big a difference between the "protection against big drops" that large and medium companies may "guarantee". Companies with a lots of debt have more volatile prices but the overall size of the company doesn't affect the volatility much.

Also, M2 believes tons of superstitions about the changes of prices connected with the dividends. So I say, when the dividend is paid (it's decided who will get paid) on a decisive day, the price of the stock drops by the same amount (at most, one may discuss whether it's the pre-tax or post-tax dividends that is subtracted from the stock price, or something in between – and how close to either). And aside from the dividend-related drop, there's also the usual daily noise that can go both ways. M2 was convinced that some companies don't see this drop even if the dividend is 7%. It's great to have this stock before the decisive day etc. I've shown all the actual data that make it clear that the drop was always there – one must know the actual correct date, of course – but M2 still doesn't get it. He believes that there are all these supersimple ways how to make the money easily, lots of these superstitions, and I am sure that lots of people in the markets believe in similar superstitions and misunderstand the proportionality laws and other things as much as M2 does.

And I think that I have forgotten some of the M2's ideas that I often find incredible. But the broader issue is that M2 – and others – just never learn a lesson. When they're shown that the pizza cut to 8 slices is as hard to be eaten as the same pizza cut to 4 slices, they still believe that they're very different. When they're shown the graphs that look different than they expected or claimed, they still continue to believe the wrong general claims. Their beliefs aren't ever abandoned when they are falsified by the evidence. The belief persists even when they lose lots of money in a way that falsifies one of their beliefs.

Despite the life-long entrepreneur's credentials, M2 is very far from a person who could be hired as a pension fund manager or something like that. But Buffett's comments make it rather clear that the nicely dressed people – often with degrees – who do these things believe lots of irrational things, too. These superstitions penetrate not just the people's money management but virtually all aspects of the everyday life. Superstitions about "this regular food is good/bad for you" are equally widespread and equally indefensible by scientific or rational arguments.

But most people simply aren't rational and, as Feynman said, this is not the epoch of science yet. And that comment apparently applies to most people who are "financially important" enough and "supposedly sophisticated" (Buffett's words) to meet Warren Buffett and talk about the logic of the financial markets, too.

By the way, Buffett made many other wise points. Berkshire isn't hiring according to "diversity" criteria; blaming obesity on soda is "spurious" (e.g. Coke drinker Buffett is doing well); his company etc. will be OK both with Hillary and Trump; Valeant Pharma model is flawed. Also, shareholders rejected a motion proposed by climate alarmists and didn't publish a "sky is falling and Berkshire is also at risk" declaration.