Investment managers and the paradox of skill

10 June 2016

reading time:  minutes

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.

What do you think?

I'd love your feedback.

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.


About the author 

Sonnie Bailey

I also run a Taylor Swift fan site.

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