Rising Above the Noise
Most investment professionals work very hard to make their work extremely confusing. They have a vested interest in creating investor confusion. They use jargon designed to intimidate you and make it difficult for you to understand.
But investing is actually not that complicated. It can be broken down into two major beliefs:
- You believe in the ability to select superior investments, or you don't.
- You believe in the ability to time markets, or you don't.
Let's explore which investors have which belief systems and where you should be with your own beliefs.
Exhibit 1 classifies people according to how they make investing decisions. Quadrant one is the noise quadrant. It's composed of investors who believe in both market timing and superior investment selection. They think that they (or their favorite financial guru) can consistently uncover mispriced investments that will deliver market-beating returns. In addition, they believe it's possible to identify the mispricing of entire market segments and predict when they will turn up or down. The reality is that the vast majority of these methods fail to even match the market, let alone beat it, particularly after cost.
Unfortunately, most of the public is in this quadrant because the media play into this thinking as they try to sell newspapers, magazines and television shows. For the media, it's all about getting you to return to them time and time again.
Quadrant two is the conventional wisdom quadrant. It includes most of the financial services industry. Most investment professionals have the experience to know they can't predict broad market swings with any degree of accuracy. They know that making incorrect predictions usually means losing clients. However, they believe there are thousands of market analysts and portfolio managers with MBAs and high-tech information systems who can find undervalued securities and add value for their clients. Of course, it's the Canadian dream to believe that if you're bright enough and work hard enough, you will be successful in a competitive environment.
Unfortunately, as un-Canadian as it seems, in an efficient capital market this methodology adds no value, on average. Study after study shows that capital markets work.
Quadrant three is the tactical asset allocation quadrant. Investors in this quadrant somehow believe that, even though individual securities are priced efficiently, they (and only they) can see broad mispricing in entire market sectors. They think they can add value by buying when a market is undervalued, waiting until other investors finally recognize their mistake, and selling when the market is fairly valued once again. We believe that it's inconsistent to think that individual securities are priced fairly, but that the overall market, which is an aggregate of the fairly priced individual securities, is not. No prudent investors are found in this quadrant.
Quadrant four is the information quadrant. This is where most of the academic community resides, along with 40 percent of institutional investors. Investors in this quadrant dispassionately research what works and then follow a rational course of action based on empirical evidence. Academic studies indicate that the average returns of the three other quadrants are negative, not positive. This is due to high turnover, which results in additional trading costs and higher taxes. Quadrant four is where you should be, and where you'll find all prudent investors.
Our goal is to help investors make smart decisions about their money so that they are firmly in place in quadrant four. To accomplish this, we help investors move from the noise quadrant to the prudent investor quadrant. This is where you should be if you want to maximize the probability of achieving all your financial goals.