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What Advisors Think, Know and Can Prove

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Being human, we all want investing to be easy. We want formulas to plug in, systems to follow and outcomes to be assured. Instead, successful investing requires hard work, mental acuity and the willingness to adapt when things (inevitably) don’t go as planned.

When I was a kid in the 1960s, plenty of people were telling me to question everything, but the implicit (and erroneous) suggestion was that I reject everything. Instead, I suggest honoring the past without being bound by it. Consistent with Robert Hagstrom’s idea that investing is the last liberal art, we should always explore and learn, combine thoughts from multiple sources and disciplines, and try to think nimbly because the need for new approaches is ongoing; and we should test and retest our ideas.

Our psychological make-up and behavioral and cognitive impairments conspire against us. Even when we recognize these problems generally, we typically miss them in ourselves. If we are going to succeed, we’re going to have to ask questions and keep asking questions. As my late father used to tell me (and as I have noted here before), it’s what you learn after you think you know everything that really counts.

Asking such questions in a systematic way is what science is all about. “The Oxford English Dictionary” defines the scientific method as “a method or procedure that has characterized natural science since the 17th century, consisting in systematic observation, measurement and experiment, and the formulation, testing, and modification of hypotheses.” What this means is that we observe and investigate the world and build our knowledge base predicated upon what we learn and discover, but we check our work at every point and keep checking our work. It is inherently experimental. In order to be scientific, then, our inquiries and conclusions need to be based upon empirical, measurable evidence.

Galileo’s life and work became a scientific watershed in this regard. Most fundamentally, Galileo’s greatness was a function of his unwillingness to take anyone’s word for it. He checked others’ work, made it his work, and then checked his own work. As such, he is the key to experimental science, an expression that is now redundant, thanks in no small measure to him. When Galileo read Aristotle and his assertion that heavier objects fall faster than lighter objects, he checked it out himself (which, astonishingly, neither Aristotle nor anyone else to that point had apparently bothered to try).

Thus the scientific method can and should be applied to traditional science as well as to all types of inquiry and study—including investing. The great scientist Richard Feynman even applied such experimentation to hitting on women. To his surprise, he learned that he (at least) was more successful by being aloof than by being polite or buying a woman he found attractive a drink.

This approach to figuring out what has gone on, is going on and will go on as a matter of objective fact—the essence of the scientific method—is demonstrated in the 1993 television film “And the Band Played On.” In a crucial scene early on, researchers at the Centers for Disease Control meet in 1981 to discuss the statistics of a deadly virus—that we later learn to be HIV—sweeping through the gay community. To that point, nobody had been able to come up with a decent explanation for what they had been observing. So the boss walks into the meeting and asks, “All right, what do we think? What do we know? What can we prove?”

That concept ends up being a running theme in the movie and gets to the heart of the scientific endeavor. What do we think? What do we know? What can we prove?

These categories can be bit loose, of course, with distinctions based upon the nature and quality of the evidence. Moreover, “proof” in science doesn’t have the certainty that it can in math. We could be wrong, at least in theory, even when we’re really, really sure and can demonstrate something factually. Still, there are a relatively few things in the investment world I am confident I can prove with a high degree of certainty. Among these are the existence and persistence of the size premium, that costs matter a lot and that we are slaves to our cognitive and behavioral biases.

In this context, then, “know” is less sure or (more likely) really sure but where we don’t have all the data we’d like to support it. As in the movie, “I can’t prove that the sun isn’t going to turn into a bran muffin next Tuesday, but after 20 years of doing this I know what I know.” This category includes the existence and persistence of the value premium, momentum and low beta outperformance persistence, the efficient market hypothesis being nonsense (even though it is exceedingly difficult to beat the market), the folly of trying to forecast where markets are going and the reality that good advice matters a lot.

Stuff in the “think” category includes things I believe to be true but am not entirely sure of. These include the idea that mixing passive and active strategies makes great sense, that “old always” (mean reversion) beats “new normal” and that the universe of advisors is poorly trained, poorly incentivized, and ill-equipped in the aggregate.

Finally, the key to science is perhaps the idea that every concept, no matter how well established, is subject to revision or even rejection based upon new or better evidence. That’s how good science works. We’re all wrong and wrong a lot even if and as our cognitive shortcomings prevent us from seeing current examples very often. If we’re going to be any good consistently, we need (counterintuitively) to commit to the idea that we’re going to be wrong a lot and to intentionally look for ways to be shown where and how.

Authority Problem

Unfortunately, life experience conspires to make it more difficult to adjust or amend our positions over time. The older we get, the more authority we acquire, the more success we achieve, the more prominent we become, the more admired we are, the harder it is for us to see our mistakes and act accordingly. And since greater conviction leads to greater perceived confidence, certainty and thus credibility and success, it’s easy to continue to fool ourselves, especially when things are going well.

There’s a famous expression to the effect that it’s hard to reason someone out of a position that wasn’t reasoned into, and there’s truth in it. It’s hard enough to influence or help alter a person’s beliefs—about investing, religion, politics or even the Yankees’ relative evilness—much less someone’s life commitments. But if we’re to have a chance to make better, more reality-based decisions (about investing and everything else), we’re going to have to try and to begin with ourselves.

Given what we know (even if we can’t quite prove it), we should probably start with a simple commitment, but not a commitment to any cause. Instead, let’s make a commitment to truth and to continually checking our work. I’m in, despite my many flaws and errors. I want my commitment to truth—wherever it leads—to be one of my defining features. So let’s do some science. Our clients’ financial lives depend upon it.


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