Curiosity-free Research

February 10, 2015

by Michael Edesess

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Here is a scenario that I’m confident has happened.

You are a naïve but intelligent investor, with a penchant for researching a subject on your own; a young microbiologist, let us say, recently promoted to associate professor. You have a very small but growing nest egg in a bank savings account. You expect to add to it regularly, but the interest rate is pitiful.

It’s time to think seriously about investing. You want to learn for yourself what investing is all about because you suspect that there’s a lot of bad advice out there. You take to the internet to start exploring.

You come across an article that won the Financial Analyst Journal’s award for best paper of 2013. You tracked it down from something you saw recently in The Economist. It is written by two Yale professors and two researchers at investment management firms – a good mix of academics and practitioners. You decide this article must provide reliable information. It is as good a starting point as any.

After reading the article you conclude that:

  1. There are easily identifiable factors that enable you to assemble superior stock portfolios.
  2. The difference between the best stock portfolio and the worst is huge; $10,000 invested in the best portfolio grows to $8.5 million over 40 years but less than $1 million in an average portfolio and only $17,000 in the worst.
  3. A great deal of academic research into these factors has been performed over more than 30 years.
  4. One of the most potent factors has been discovered only recently.

In short, there is a lot of data, there has been a lot of research and the conclusions it reaches are powerful. You are starting to feel already that solid evidence shows you how to invest. You’re almost ready to go out and invest in the stock portfolio that the article showed was the best.

Wait a minute…

But first you continue your search. You start to discover some surprising information. You learn that most professional investment managers get results that are worse than the stock market’s average. Furthermore, the percentage of those managers that perform better than average consistently is less than you would expect if each were randomly assigned by a coin-toss to do better or worse than average each year.

Didn’t these professional investment managers know about the research, you wonder? They must have gone to inferior schools. But no, you find that isn’t the case.

This is a conundrum. Imagine how baffled our microbiology professor must be. It’s as if years of research found out how to cure polio, but when doctors treat polio, fewer patients recover than if they hadn’t been treated.

Our microbiologist also wonders whether the Yale professors know that practitioners are apparently not paying any attention to their research. Don’t the investment manager coauthors know that their ideas are not being employed? If they do, their article doesn’t say a word about it. Wouldn’t they at least lament that the research is not being put into practice, or speculate about why it isn’t? Or if practitioners are trying to put the research into practice, why isn’t it working?

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