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The smartest Person in the Room

By: Andrew J. Willms

President and CEO, The Milwaukee Company

As regular readers know, I sometimes refer to the stock and bond markets as a whole as “Mr. Market”.  Mr. Market is an allegory that first appeared in a book called “The Intelligent Investor,” written by Benjamin Graham in 1949 and still considered by many (including Warren Buffett) to be one of the most significant pieces of financial literature ever written.

I am also fond of saying that Mr. Market is the smartest person in the room.   By that I mean, the odds are high that, over the long term, an investment in the total market will outperform even the savviest market timer or stock picker.

Study after study has demonstrated this to be true.  For example, Morningstar found that only 23% of all active funds topped the average of their passive rivals over the 10-year period ended June 2019.  Another study by Standard and Poor’s found that 77.97% of large-cap mutual fund managers and 73.21% of institutional account managers underperformed the S&P 500 on a gross-of-fees basis over a ten-year period ending December 31, 2019.

I believe there are three primary reasons for Mr. Market’s success.

  • Fees Matter.  On average, managers of actively managed funds and accounts charge much higher fees than passively managed, total market index funds.  It’s not unusual for the combined fees by an account manager and a financial advisor to exceed 1.50%.  By comparison, Vanguard charges a fee of 0.035% for its total bond market fund (symbol BND) and just 0.03% for its total stock market fund (symbol VTI).
  • Performance Pressure.  The second is the pressure on managers to outperform.  While Mr. Market answers only to himself, if a fund manager or account manager underperforms his benchmark, he or she risks being fired.   To beat Mr. Market, a manager must bet against him.  While these bets can pay off in the short run, the house almost always wins in the long run.
  • Patience Pays.  Perhaps the biggest contributor to Mr. Market’s success is that he stays invested come what may.  (He is the market, after all.)  By comparison, managers typically get in and out of the market depending on what they expect will come next.  A recent article by Ben Carson and a study by Schwab confirm that even successful market timing doesn’t do much to boost the returns as compared to those investors who remain invested over many years.  

Given all that, it may be hard to understand why far more money is invested with managers than is invested in passive funds.  Why is that?

I believe the main reason is that while Mr. Market’s brilliance shines over the long term, he has a bad habit of going on a bender now and then.  What I mean by that is because markets reflect human behavior, they can act irrationally at times, much like Mr. Market after he has had one martini too many.  And even though investors are cognizant of how successful Mr. Market is when he is sober, no one wants him to hand their money to him when he is drunk.  That’s even more true when his bender is weeks or months long.  

And so, people who passively invest in the market often give in to the pressure to sell when Mr. Market is acting badly and stock prices are low, and to jump back in when he sobers up and prices have risen.  The dilemma, then, is how to invest with Mr. Market and still stay the course when he’s behaving badly.  In my view, tactical asset allocation provides the solution.

Think of the data-driven, rules-based strategies that run tactical asset allocation as a breathalyzer that helps identify when Mr. Market is getting tipsy.   It’s at those times that the strategies are designed to adopt a safer, risk-off mode.  In other words, the market and economic indicators that tactical asset allocation use are designed to signal when it’s better to call a cab rather than let Mr. Market drive. 

There is considerable debate over whether tactical asset allocation outperforms passive investing over the long run, but from my point of view, that’s not the point.  It’s easy to talk about the long run in a philosophical sense, but in reality, we all live in the here and now.  Tactical asset allocation risk management can provide investors the confidence needed to stay in the game when Mr. Market takes a turn for the worse.  That may not matter much to day traders, but for investors, it’s tremendously powerful.