Investment managers and the paradox of skill

I think some of the smartest people on the planet are investment managers. As a group, they're smart, well-educated, well-resourced, dedicated professionals.

This is surely a recipe for success, right? 

Not really.

You see, most investment managers act in something resembling a zero sum environment.

They're competing against other smart, well-educated, well-resourced, dedicated professionals, making it hard for any one investment manager (or team of investment managers) to excel. 

Let's take a simple example. An investment manager whose job is to invest in large publicly listed shares.

Based on all of the information they have to hand, they make decisions about whether shares are undervalued or overvalued. This drives their decisions to buy and sell shares.

Buy low, sell high. Simple, right? Especially if the person making decisions is a smart, well-educated, well-resourced, dedicated professional.

But remember: every time they buy or sell a share, there is another person at the other end of the trade.

That person is probably just as smart, well-educated, well-resourced, dedicated, and professional. That person has just made a different assessment of the value of those shares, based on all of the information available to them.

In reality, the market for these shares doesn't involve just two people like this. It involves many, many people.

No one knows exactly what a share is "worth". You need a crystal ball to know that, because the future is inherently uncertain. But the collective buying and selling decisions that these professionals make shape the price of any given share, which represents a "wisdom of the crowds"-type assessment of its value.

This means that, because everyone in the market is so smart, well-educated, well-resourced, dedicated, and professional, it's very difficult to outperform the market. 

There are some corollaries to this:

  • Even if you're dedicated completely and professionally to the task, you're going to be hard pressed to beat the collective wisdom of the market. We see the paradoxical outcome that as the number and collective skill of investment managers increases, their outcomes become more mediocre. This is known as the paradox of skill.
  • If you're investing, you're playing against big boys. No matter how smart you are, unless you're prepared to dedicate completely (and professionally) to the task, trying to invest by picking individual financial investments is a fool's errand. (I'm looking at casual investors, day traders, and financial advisers who fancy themselves as investment managers here. You can't be half pregnant.) 
  • What we are seeing with active investment management is essentially a zero sum game. And in fact, it's worse than zero sum. Because we also need to factor in taxes and fees. (These investment managers need to be paid; often they are paid very handsomely.) 

I admire investment managers. I think they provide an important service. But there are so many of them, the value added by any one investment manager is limited. There may come a point where active investment is worthwhile for an individual investor. But we are far from that point.

Sonnie Bailey

Sonnie is the founder and principal of Fairhaven Wealth.

Before founding Fairhaven Wealth, Sonnie worked in the legal and financial services industries for over a decade.

Sonnie first became involved with financial advice as a specialist financial services lawyer. For many years, he was an “adviser of advisers”, reviewing thousands of advice files prepared by hundreds of financial advisers, and providing feedback in relation to the quality and appropriateness of advice; industry best practice; risk management; and regulatory compliance. He has published work in industry publications and spoken at various financial advice conferences.

Sonnie has also worked with banks, investment management firms, insurers, and derivatives providers.

Sonnie has worked as a private client lawyer, focusing on succession, estate planning and trusts. He ran his own legal firm in Australia before relocating to New Zealand. He has also acted in independent trustee and company director positions.

Sonnie is passionate about helping people achieve their goals and manage the risks to which they are exposed.

He has written extensively on his blog, New Zealand Wealth and Risk, which can be found at www.wealthandrisk.nz.

Sonnie is married to his wonderful wife Chrissy, and has two young children, Ben and Anna.