Know-nothing investors outperform know-somethings

(MoneyWatch) 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."

Image courtesy of Flickr user eschipul

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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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