9 Bits of Conventional Wisdom You Should Ignore

Conventional wisdom can be defined as ideas so accepted they go unquestioned. Unfortunately, conventional wisdom is often wrong. Two great examples are that millions of people once believed that the Earth is flat, and millions also believed that the Earth is the center of the universe. Just because millions of people believe a foolish thing, doesn't make it any less foolish.

Today, we look at some ideas that could be said to be conventional wisdom on investment strategy, and offer an alternative view, one we will call the New Finance.

Before we begin, it's important to note that we're not saying that people who believe these bits of conventional wisdom are necessarily fools. Anyone who goes along with the conventional wisdom simply may not have been exposed to the truth. However, once you know the truth, you can no longer claim ignorance as a defense.

Also, feel free to leave your own bits of conventional wisdom in the comments below.

Photo courtesy of hans s on Flickr.

• Next: Don't Just Stand There! Do Something!

However, a passive investment strategy is often confused with a do nothing strategy. As we have discussed, the prudent strategy is buy, hold, rebalance and tax-loss harvest as appropriate.

Photo courtesy of paddynapper on Flickr.

• Next: If Your Plan Doesn't Seem to be Working, Change Direction. Try Something Else

One of the essential lessons smart investors learn is to not confuse strategy and outcome. In a world where there are no clear crystal balls, a strategy is either right or wrong before we know the outcome. If you doubt that, consider the case of term life insurance. If you don't die during the life of the policy, does that mean the decision to buy was a bad one?

There are only a few good reasons to alter your plan:

• If one of the underlying assumptions of your plan has changed (something occurred to alter your ability, willingness or need to take risk)
• If new evidence is presented from peer reviewed academic journals changes how you view investing. For example, just as Copernicus revolutionized the way we think about our universe with the 1530 publication of On the Revolutions of the Heavenly Spheres, in 1992, professors Eugene Fama and Ken French revolutionized the way we think about investing with the publication in the Journal of Finance of their paper "The Cross-section of Expected Stock Returns."
• New investment vehicles are introduced that allow you to more efficiently implement your strategy. The introduction of index funds, tax managed funds, core funds, ETFs and other passive strategies have all helped improve our options.

• Next: Stay Informed

The unfortunate truth is that for most investors, paying attention causes them to make all kinds of investment mistakes as their emotions take over. Investors persistently get it wrong because they pay attention. They tend to buy (high) after periods of good performance and tend to sell (low) after periods of bad performance. They also fail to understand that what they're paying attention to is only information that everyone else already knows, and thus is already incorporated into prices.

It's ironic that Richard Bernstein, former chief quantitative strategist for Merrill Lynch once warned investors: "Today's investors find it inconceivable that life might be better without so much information. Investors find it hard to believe that ignoring the vast majority of investment noise might actually improve investment performance. The idea sounds too risky because it is so contrary to their accepted and reinforced actions."

Photo courtesy of Adrian Pursur on Flickr.

• Next: You Get What You Pay For

Something becomes conventional wisdom because it's often true in many arenas.

However, that doesn't necessarily mean it has to be true of investing. In the case of investing, higher costs most often result in lower returns. In other words, with low-cost passive vehicles, you get what you don't pay for: market returns in the asset classes in which you invest with low costs and -- if done right -- with a high degree of tax efficiency.

Photo courtesy of MJ/TR on Flickr.

• Next: Focus on Managing Returns

Active management focuses on trying to manage the part of the investment experience we have no control over: the returns we earn from our investments. Unfortunately, there's only one person who knows where the market is going, and none of us gets to speak to that person and get an answer -- at least in this lifetime (and it won't matter in the next one). Thus, prudent investors focus on the things they actually can control:

• The amount of risk they take
• Diversifying those risks across asset classes/risk factors, minimizing idiosyncratic risks
• The structure of investment vehicles they use to implement their plan
• Keeping costs low and tax efficiency high

• Next: Past Performance of Active Managers Is Prologue

As presented in The Quest for Alpha, the overwhelming body of evidence -- be it on individual investors, mutual funds, pension plans, hedge funds or behavioral finance -- demonstrates that there's little to no persistence of performance beyond the randomly expected. Even 15 years or more of outperformance has been shown to be unreliable for indicating future performance.

Photo courtesy of nicubunu.photo on Flickr.

• Next: Active Management Works in Inefficient Markets Such as Emerging Markets

Passive investing doesn't rely on the efficient market hypothesis to be the winning strategy. It only needs what John Bogle called the Cost Matters Hypothesis, as eloquently explained in William Sharpe's insightful paper "The Arithmetic of Active Management." What investors often fail to understand is that informationally less efficient markets (such as emerging markets and markets for micro-cap stocks) have greater implementation costs. Those extra costs increase the hurdle to generate alpha.

Photo courtesy of alastairduncan on Flickr.

• Next: Active Management Protects You From Bear Markets

The 2009 Spring/Summer issue of Vanguard Investment Perspectives provides us with evidence on the performance of actively managed equity funds during bear markets. Vanguard's study covered the period 1970-2008 and examined the returns of active funds during the seven periods when the Dow Jones Wilshire 5000 Index fell at least 10 percent and the six periods when the MSCI EAFE Index fell by at least that amount. Despite acknowledging survivorship bias (poorly performing funds disappear and are not accounted for), Vanguard found:

• It didn't matter whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term cycles. The costs of security selection and market timing proved a difficult hurdle to overcome.
• "Success" can be explained at least in part by style exposures. For example, during the bear market of September 2000-March 2003, the Russell 1000 Value Index fell just 21 percent, while the U.S. total market lost more than 42 percent. Once active funds were compared to their style benchmarks there was no consistent pattern of outperformance. Past success in overcoming this hurdle didn't ensure future success. The degree of attrition among winners from one period to the next indicates that successfully navigating one or even two bear markets might be more strongly linked to simple luck than to skill.

Photo courtesy of AZRainman and www.azrainman.com on Flickr.
More on MoneyWatch:
How to Build a Diversified Portfolio Passive Management Wins in Emerging Markets T. Rowe Price: Does It Add Value? Rebalancing Myths That Need to Be Debunked Why Interest in GNMAs Doesn't Make Sense
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