that losses feel bad to a greater extent than equivalent gains feel good
That sounds like usual risk aversion. How is that a bias?
The only sense in which e.g. value and momentum stocks seem genuinely “riskier” is in career risk … but if he chooses Ol’Timer and it underperforms he is a fool and a laughingstock who wasted clients’ money on his pet theory when “everyone knew” NuTime.ly was going to win. At least if he chooses NuTime.ly and it underperforms it was a fluke that none of his peers saw coming, save for a few wingnuts who keep yammering about the arcane theories of Gene Fama and Benjamin Graham.
A financial adviser advising an individual investor that only buys few assets might have this problem, but a fund could diversificate on thousands of different assets, therefore reducing this “reputational” risk. Which brings us to the following point:
Though traditional index funds are a reasonable option, in recent years several “enhanced index” mutual fund and ETFs have been released that provide inexpensive, broad exposure to the hundreds or thousands of securities in a given asset classes while enhancing exposure to one or more of the major factor premiums discussed above such as value, profitability, or momentum. Research Affiliates, for example, licences a “fundamental index” that has been shown to provide efficient exposure to value and small-cap stocks across many markets.56 These “RAFI” indexes have been licensed to the asset management firms Charles Schwab and PowerShares to be made available through mutual funds and ETFs to the general investing public, and have generally outperformed their traditional index fund counterparts since inception.
Why in recent years? Why aren’t these funds more common? And since you are talking about “rebalancing” in the next paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?
I think there is a kind of “meta” risk you are not considering here: index funds are proven investment strategies, based on empirical evidence and economic theory. The investment strategies you propose here are more uncertain. You link many studies in favor, but I don’t have the expertise to evaluate their relevance, and I suppose this holds true for pretty much anybody who isn’t a professional investor. From the “outside view”, the strategies you propose are inherently more risky than index fund investment.
One of the greatest misconceptions about finance is that investing is just a zero-sum game, that one trader’s gain is another’s loss. Nothing could be further from the truth. Economists have shown that one of the greatest predictors of a nation’s well being is its financial development.
Correlation doesn’t imply causation. It is plausible that correlation actually goes in the way opposite than what you are proposing: in wealthier nations people have more disposable money to play zero-sum games with.
That sounds like usual risk aversion. How is that a bias?
Loss aversion is different than risk aversion, though they are related concepts, the shape of an agent’s utility function under loss aversion can lead to inconsistent preferences.
Why in recent years? Why aren’t these funds more common? And since you are talking about “rebalancing” in the next >paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?
I can only speculate as to what the average of all the millions of decisions that go into releasing an investment product and whether it gains popularity looks like. As to why in recent years, I think it mostly is a function of the rise of index strategies, the emergence of the ETF as a vehicle that is well-equipped to execute strategies like this, and the general fall in popularity of expensive, black-box, active management strategies.
Internally, these products rebalance according to some rules-based methodology. IMO the “active vs. passive” debate is a false dichotomy, the better scales to judge an investment by are “cheap” vs. “expensive” and “transparent/rules based” vs. “black box/dependent on skill.” Some of the enhanced index funds are in fact cheaper than some of the “true” index funds on the market.
Externally, there is currently no such thing as target date retirement fund which tries to strategically target these factor premiums in a rules-based fashion, they are generally limited to single-asset classes and so will require some measure of asset allocation/portfolio management decision making.
I think there is a kind of “meta” risk you are not considering here: index funds are proven investment strategies, based >on empirical evidence and economic theory. The investment strategies you propose here are more uncertain.
You link many studies in favor, but I don’t have the expertise to evaluate their relevance, and I suppose this holds true >for pretty much anybody who isn’t a professional investor.
From the “outside view”, the strategies you propose are inherently more risky than index fund investment.
I basically agree. And you may say the possible greater expected return from these strategies is compensation for this meta-risk. As I am quick to point out, these strategies do underperform from time to time, sometimes badly. It is during these periods that investors proclaim that “things are different now” and change course, often to their detriment. This epistemic factor can make the strategies more risky in practice.
I have laid out what I consider to be the best evidence to support my philosophy, much of it is Nobel-prize winning research (not that having Nobel laureates on your side is always profitable...) But how comfortable you feel evaluating that evidence or trusting me to present it in a fair manner is a question I can’t answer for you. If you are doubtful, and I do not find that an unreasonable proposition, you would do well to use index funds and be done with it. More intrepid investors may have a different attitude.
The message I take away is that most “normal” people, that is, financial non-experts with an average risk aversion, would probably benefit from investing in index funds. Unusual people outside this demographic may benefit from knowing that there are some investment strategies which are claimed to yield higher risk-neutral expected returns.
Correlation doesn’t imply causation. It is plausible that correlation actually goes in the way opposite than what you are >proposing: in wealthier nations people have more disposable money to play zero-sum games with.
Which is why I said predictors, not correlates. There is plenty of research to support my claim; the source I cite points to some of it. Obviously teasing out the arrow of causality is difficult in large scale, trans-generational, international macroeconomic settings, but economists have done their best and the evidence supports the Solow growth model that Metus has brought up.
That sounds like usual risk aversion. How is that a bias?
A financial adviser advising an individual investor that only buys few assets might have this problem, but a fund could diversificate on thousands of different assets, therefore reducing this “reputational” risk. Which brings us to the following point:
Why in recent years? Why aren’t these funds more common? And since you are talking about “rebalancing” in the next paragraph, are these funds really automatic, like index funds, or do they still require active portfolio managment?
I think there is a kind of “meta” risk you are not considering here: index funds are proven investment strategies, based on empirical evidence and economic theory. The investment strategies you propose here are more uncertain.
You link many studies in favor, but I don’t have the expertise to evaluate their relevance, and I suppose this holds true for pretty much anybody who isn’t a professional investor.
From the “outside view”, the strategies you propose are inherently more risky than index fund investment.
Correlation doesn’t imply causation. It is plausible that correlation actually goes in the way opposite than what you are proposing: in wealthier nations people have more disposable money to play zero-sum games with.
Loss aversion is different than risk aversion, though they are related concepts, the shape of an agent’s utility function under loss aversion can lead to inconsistent preferences.
I can only speculate as to what the average of all the millions of decisions that go into releasing an investment product and whether it gains popularity looks like. As to why in recent years, I think it mostly is a function of the rise of index strategies, the emergence of the ETF as a vehicle that is well-equipped to execute strategies like this, and the general fall in popularity of expensive, black-box, active management strategies.
Internally, these products rebalance according to some rules-based methodology. IMO the “active vs. passive” debate is a false dichotomy, the better scales to judge an investment by are “cheap” vs. “expensive” and “transparent/rules based” vs. “black box/dependent on skill.” Some of the enhanced index funds are in fact cheaper than some of the “true” index funds on the market.
Externally, there is currently no such thing as target date retirement fund which tries to strategically target these factor premiums in a rules-based fashion, they are generally limited to single-asset classes and so will require some measure of asset allocation/portfolio management decision making.
I basically agree. And you may say the possible greater expected return from these strategies is compensation for this meta-risk. As I am quick to point out, these strategies do underperform from time to time, sometimes badly. It is during these periods that investors proclaim that “things are different now” and change course, often to their detriment. This epistemic factor can make the strategies more risky in practice.
I have laid out what I consider to be the best evidence to support my philosophy, much of it is Nobel-prize winning research (not that having Nobel laureates on your side is always profitable...) But how comfortable you feel evaluating that evidence or trusting me to present it in a fair manner is a question I can’t answer for you. If you are doubtful, and I do not find that an unreasonable proposition, you would do well to use index funds and be done with it. More intrepid investors may have a different attitude.
Thanks for your extensive reply.
The message I take away is that most “normal” people, that is, financial non-experts with an average risk aversion, would probably benefit from investing in index funds.
Unusual people outside this demographic may benefit from knowing that there are some investment strategies which are claimed to yield higher risk-neutral expected returns.
Which is why I said predictors, not correlates. There is plenty of research to support my claim; the source I cite points to some of it. Obviously teasing out the arrow of causality is difficult in large scale, trans-generational, international macroeconomic settings, but economists have done their best and the evidence supports the Solow growth model that Metus has brought up.