Saturday, September 09, 2006

Even Harvard Students Don't Seem to Know Any Better

Research by three academics at Wharton, Yale and Harvard suggests that superior investment judgment is not a function of superior access to information, nor is it a function of superior academic intelligence.

The article: “Today’s Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” from Knowledge@Wharton, is about experimental research done on Harvard undergraduates and MBA students.

The students were, for all practical purposes, given equal information about four different index funds, all of which contained the same securities. The only difference between the funds was the management fee structure. Yet, they overwhelmingly failed to make the optimal investment decision: to focus their investment into the index fund with the lowest management fees.

The students were misled by irrelevant information showing “annualised returns” (a moot point since going forward, all the funds had the same securities in the same proportions and would thus perform identically, apart from management fees), and also diversified their investment into several funds, even though there was absolutely no diversification benefit to be gained from investing in more than one fund.

This research thus suggests a few important things:

1. Superior investment judgment is not a function of superior academic ability. We can safely assume that the Harvard undergraduates and MBA students represent the cream of America, if not of the world. Yet they overwhelmingly demonstrated inferior business judgment. Hence, If you are evaluating someone as a potential manager of your money, it is irrelevant to look at his or her academic credentials. Superior investment judgment is a function of something else. And that something else is not academic intelligence.

2. One does not need superior information to make superior investment judgments. The notion that one needs to have better information than the next person in order to make a better informed judgment, is a myth. As a result of this research, it seems investing is akin to the game of chess - where the participants in the game both have complete access to all relevant information - the one who wins is the one who has the superior ability to synthesize and evaluate the available information, not the one who has better access to information. Hence, it is wise for investors to avoid any such schemes which claim to have “superior inside information.”

3. Another important implication of this research, and perhaps the most profound of all, is that having complete information does not necessarily lead one to make the optimal investment decision! In other words, markets are not efficient. The efficient markets hypothesis holds that markets adjust rapidly and rationally to take into account available public information, and that market valuations are thus optimal or rational. Yet the research results indicate otherwise: 80% of Harvard students were unable to come to the optimal investment decision, despite them having all relevant information required!

If the vast majority of the intelligent population is unable to make optimal investment judgments given unhindered access to information, how can markets possibly be efficient? The notion that markets are efficient i.e. that securities are always priced rationally, must necessarily be thrown out of the window. This has profound implications for supporters of such theories as the CAPM or MPT (i.e. the vast majority of fund managers) - and provides support, once again, for Graham & Dodd’s theory of intrinsic value i.e. the best way to invest is to purchase securities trading at a substantial discount to their intrinsic value (i.e. when markets are behaving irrationally), and sell them when they are trading above intrinsic value.

In short, this research provides proof that investing is, ultimately, a game of skill, and that those who have superior ability will ultimately outperform those without.

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