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The Abject Failure of Investment Management

Last week the Dow Jones Industrial Average dropped 416 points in a single day (Tuesday, February 27th, 2007). By Friday (March 2nd, 2007) it had dropped another 102 points. This jarring 4% loss – in the course of a single week – was a wake-up call of sorts for investors, many of whom had become complacent and/or less risk averse in the wake of a generally increasing stock market over the past few years.

In response to a question put to him by a local newscaster, the managing director of a local investment management firm – a frequent “talking head” on this station’s evening news program – responded that they (his firm) “never saw it coming.” Of course they “never saw it coming.” Indeed, they couldn’t have – academic and empirical evidence unequivocally supports that markets are highly efficient and that changesin the prices of financial assets happen randomly (and sometimes, suddenly) only in response to new, previously unforeseen and unforeseeable information. Active investment management (the timing of what/when to buy and what/when to sell) thus suffers a fatal flaw, akin to that of “closing the barn door after the horse has escaped.”
While numerous academic studies suggest that active portfolio management maylead to returns in excess of market averages, not a single piece of empirical evidence supports the persistence of excess returns. Worse yet, most studies conclude that few managers earn excess returns over and abovetheir costs to investors. What I find most remarkable about this manager’s candid response to the reporter’s inquiry is his tacit acknowledgement that active management doesn’t work. Which begs the question, “What, then, are your clients paying you for, if not your ability to protect them (at least) from sudden and perhaps significant declines in the value of their investments?”
Over the years, we've toyed with the idea of offering investment management or supervisory services for clients. The going rate for investment management/supervisory services averages between 100 and 200 basis points (1% to 2%) annually on assets under management - which would make it a nice profit center for us (if not you!). But even at 50 basis points, we are not convinced that active management adds value in excess of the cost. We continue to maintain that the best way to ensure a reasonable long-term rate of return on your investments, while guarding against a catastrophic loss of principal, is to allocate your investment dollars among a prudently diversified mix of “no-load” money market, bond, and stock mutual funds and to hold this portfolio for the long-term, making changes only in response to changes in your personal financial situation or objectives and/or changes in your risk tolerance.

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