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BAM Intelligence

Know-Nothing Investors Outperform Know-Somethings — Larry Swedroe

All but the most diehard proponents of the efficient-markets hypothesis accept the fact that with valuable inside information, one can earn abnormal returns. That leaves this question: Does access to information that is publicly available provide investors with a sufficient advantage to outperform appropriate risk-adjusted benchmarks (generate alpha)?

In other words, is the quantity and quality of information correlated with investor returns? Said another way, do investors who have some knowledge about the market and individual stocks have an advantage over those who accept that they don’t possess any special information?

While the perception of most investors is that increased access to information leads to superior results, there is a whole body of research showing that well-informed, professional investors — specifically, actively managed mutual funds and hedge funds — underperform investors who accept the fact that they don’t possess value-relevant information, and thus accept market returns by investing in index funds and other passively managed vehicles. The evidence shows that investors in actively managed funds are net losers because of the high costs (expense ratios, trading costs, and for taxable accounts, taxes).

One explanation for this underperformance is that active investors don’t possess truly inside information. Another is that they are overconfident of their ability to interpret the information more effectively than the collective wisdom of the market. Financial economists would add that the while the “know nothing” investors are protected by the market from making mistakes, the “know something” investors receive no such protection.

To test the hypothesis, Juergen Huber of the University of Innsbruck and researchers from the Yale School of Management ran a series of laboratory experiments on participants given amounts of virtual money and various levels of information about particular stocks. As expected, the best performers were the perfectly informed insiders. They outperformed the market by an average of 10 percent. The worst returns were the moderately well informed. They suffered net losses of 7 percent. How did the least informed perform? They generally matched the market return.

The conclusion we can draw is that, as the saying goes, a little knowledge can be a dangerous thing. The reason is that we tend to overestimate the value of the information, and we are overconfident of our abilities to exploit the information.

Many also forget that it’s not the amount or quality of the information we have. Instead, what’s important is how that information compares to the information held by other investors. In other words, there must be a group of investors you can exploit. Since institutional investors now account for as much as 90 percent of the daily trading, it’s hard to think of a group of likely victims that can be exploited sufficiently to offset the greater costs of active management.

Charles Ellis, author of “Winning the Loser’s Game,” offered this advice: “Everything I know is known by the market and worked in to the market…. The best way to invest is through benign neglect. Get your asset allocation right and leave your investments alone.”

This commentary appeared October 24 on Larry’s blog at CBSNews.com.

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2013, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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