Nassim Taleb – Why you should avoid the investment industry

16th August 2012

Teleb has published a new paper entitled Why It is No Longer a Good Idea to Be in the Investment Industry; as the Wall Street Journal reports:

"He says many of the best money managers earn their success based on "spurious performance" and these folks "rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations and attributions."

"Once they are at the top, though, they get the bulk of the allocations, creating a "winner-take-all effect" that causes distortions in the marketplace, he says."

His argument rests on the idea that investment management has a ‘spurious tail' – those who have attracted assets by luck rather than judgement. The difficulty of competing with this spurious tail, means that, for Taleb, wannabe investment managers may be better off diverting their talents elsewhere.

Taleb's attack comes at a time when parts of the investment management industry were already under fire. Veteran fixed income guru Bill Gross has said that we are witnessing the death of equities: "Stock investors should think again about the age-old "buy-and-hold" investing mantra. He says consistent, annual returns are a thing of the past."

It is difficult to see Taleb's comments as exposing anything particularly new. Of course, it is true that some investment managers do badly and not all investors are rational in the way they analyse performance. As a result, all investment managers have to compete with bad managers that hold a lot of assets. However, one respondent suggests that his conclusion – that therefore new entrants can't and shouldn't compete – is fundamentally ‘anti-capitalist'.

Steve wrote: "Nasim Taleb is right once every 10 years and since we are in year 5 since the last time he was right, he must be wrong. If as an investment manager or hedge fund manager you make money year in and year out you don't need to outperform the market. At some point if you are investing your own money and the pot gets bigger year, why do you need to chase performance or try to beat the market?

"What he is trying to say is actually very pernicious – only the big guys can succeed so please abandon the market. This is the most anti-capitalist statement he could possibly make. He almost sounds like a communist."

A better conclusion would be that investors need to know more about performance assessment. By definition in all industries, half of the staff underperform – ‘promoted to the level of their incompetence' is a cliché that will resonate with all who have been subject to their own equivalent of Dilbert's pointy-haired boss. The difference with the investment industry is that investors know about it. Investment managers can print flattering performance statistics, but any investor can head straight for Morningstar or Financial Express to uncover the real status of a fund manager's performance.

He is right that the industry is competitive. He advises: "Pick a less commoditized business or a niche where there is a small number of direct competitors." The real answer may be to compete and do it better.

Gross's argument is a little different. After all, he is an investment manager himself. He suggests that the historic outperformance of equities over bonds is an "historical freak" that isn't likely to be duplicated anytime soon, due to slowing economic growth around the globe. "The 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy's GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?"

However, neither Gross nor Taleb is arguing against competent active management. Gross is suggesting that equity market returns will not be as high as their long run average. The answer is not necessarily to buy fixed income, but to buy an active manager. Sue says on the Wall Street Journal site: "You cannot simply buy and hold "the market" as in buying index funds. If you do that, of course, in the long run you will not make much of a return if any. That is because, when you buy "the market," you buy the losers as well as the winners and it balances out. You have to identify the companies that will excel and buy them. That's not easy," you say. I agree. If it was easy to pick the winners, we would all be rich. But it can be done."

Equally, Taleb is saying that new entrants should not strive to be good active managers, because they will have to compete with too many incompetent managers. He does not argue that it isn't possible.

Ultimately, buy and hold may be dead (Gross) and there may be weak investment managers (Taleb), but the key is to encourage proper performance assessment to encourage investors to make better choices. The death of investment management has been much exaggerated.

 

More on Mindful Money

The lost generation of investors

'The cult of equity is dying' – so is it time to buy?

Avoiding another financial crisis

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22 thoughts on “Nassim Taleb – Why you should avoid the investment industry”

  1. Anonymous says:

    You are absolutely correct that consumer psychology has changed and that folk are cutting spending as interest rates decline. As 0,25% drops in interest have lost their ability to have any impact I wonder what would happen if we had a 0.25% rise in rates? I suspect that most would in fact sit up and take notice! I wonder why central bankers give so much prominence to the stock market – is it because it is the only bit of good news in town?

    Meanwhile the Euro-airbus continues to defy gravity. It has run out of fuel, the engine is sputtering, the crew in charge can’t decide what to do and yesterday one of it’s wings snapped off. But still it flies on in the face of a storm of bad economic news. Must be full of Eurocrat hot air.

    1. forbin says:

      I actually suspect that a 0.25% “trim” upwards would physically make no difference

      The media would have a field day though – it would be complete hot air ofcourse like the current stock market bubble

      ( the market is flush with japanese,american and euro QE )

      Whatever reality the stock market had to fundamentals has long been broken by QE and per millisecond trading !

      the drop will of course make little difference to anyone in the real world

      Forbin

    2. Anonymous says:

      Hi pavlaki

      Whilst Forbin who I see has already replied is right about the objective response (0.25% up being the same as 0.25% down) I believe that the psychological/expectations impact would be powerful.

      Why

      1. A demonstration that rates can rise as well as fall!
      2. A stop to the trend that will inevitably under current plans take us to negative interest rates.
      3. Start to end the banking/equity bubbles.

      Accordingly I would expect it to come with a load of negative publicity (which in itself might be considered to be demonstrating that it will have impacts). Whisper it quietly but much of the media has been captured.

  2. forbin says:

    Hi Shaun

    And some people wonder why I dont believe in the free hand of the Market…..

    Adam Smith must turning so fast in his grave that if we could tether him up to a generator we’d supply the whole of England with electricity !!

    Forbin

    1. Anonymous says:

      Hi Forbin

      Actually I suspect that Karl Marx is spinning in his grave in Highgate just as fast and conveniently close to London so lower transmission costs and losses!

    2. Drf says:

      Hi Forbin,

      According to one commentator on here that would not do any good, because energy flows from the supplied location back to the power station! So all you need to do is set up the wires and Hey Prestro – you can get the free energy without needing Adam Smith!

  3. James says:

    Ah yes, but the central banking solution has some fantastic benefits for the established political class and their mates in the city:
    1. No-one in the public has a clue what is going on
    2. It doesn’t involve extra tax or cuts
    3. They can talk about “hundreds of billions” being “pumped” into the economy as though this was some sort of reality
    4. They can go on about the stock market strength as a “leading indicator”, ie a financial vote of confidence in their policies
    5. They can all agree at international meetings (as they are all doing it) as to how they have worked out how to deal with the problem
    6. It puts of the evil day, with luck, beyond the next election.
    Er, that’s it.

    1. forbin says:

      well summed up!

      Forbin

  4. Mike from Enfield says:

    On the subject of consumer psychology it is interesting how tens of millions of people seem so much more able to change their ways than government, with its entrenched views and interests. When government (in its wider sense) puts its mind to it, it is highly effective at changing people’s views on almost anything (drink driving, racism, smoking, the latest proposed military adventure…). It just doesn’t seem to work in the opposite direction.

    We now see a battle between on the one hand individuals and companies, who have decided to pay off debts and save, versus governments who are hell bent on forcing us to splash out on credit and to punish savers. Notwithstanding UKIP’s breakthrough (if that is what it is), come election time I expect people to vote for more of the same regardless of which party wins.

    1. Anonymous says:

      Hi Mike

      It has been said for many years that my subject of today central bankers and indeed generals are always prone to fight the last war. Perhaps they forgot to add politician’s and governments to that list

    2. Doubting Dick says:

      Isn’t it better that the Government is not reducing spending while private debt is falling, rather than all sectors reducing spending at the same time. Secondly, (going back to Shaun’s post of a few days ago) perhaps government support for the housing market is helping to maintain the slow deflation of the house price bubble outside of London – I think it’s psychological more than financial support and is helping to avoid a too-rapid fall in prices.

      However, I’m making a lot of assumptions – for example, both my points above are the opposite of stated government policy! There are also many risks. Are individuals and businesses actually reducing borrowing/building savings? How will government mortgage guarantees be unwound? How wil the government deficit be reduced when it finally gets round to real action?

      I too would like to see a small increase in the base rate (but then I have savings). I think it would encourage companies and individuals to accelerate their debt reduction and would lead to a rise in Sterling, reducing (reversing?) imported inflation and encouraging foreign buyers of gilts who would accept below inflation yields in the hope of exchange rate gains. All with littleimpact on the real economy.

  5. JW says:

    Hi Shaun

    Missed commenting on your last report to the Central Committee on the ‘Southern Territories’. Indeed a slow down in the expected imports of their ‘dirt’ will prompt a banking crisis from their property exposure.

    Re the CBs, you describe their paranoid actions to prevent a commercial banking crisis together with their support of Government Expenditure. I think ( I say this with caution because I suspect they don’t really know what they are talking about) the ‘sectoral balance’ brigade would say that the CBs have to do this because something has to balance the increased savings by everyone else ( as you state, the logical reaction by ‘people’ to risk). Its all just ‘accountancy’ you know, one side of the equation has to balance the other etc etc.

    As the UK balance of trade doesn’t improve, the only effect of all this eventually will be an explosion of inflationary pressure, as you have described for the the last 3 years. This will in turn rob the value of the ‘savers’, and we will be back to where we started overall, but with a large switch in wealth to the owners of capital.

    In the meantime the 99.9% lose 30% of wealth through the process.

    1. Anonymous says:

      Only 30% – I’ll take that! More like 70%, I think. Once the government has understood that it can rob people with impunity (which by now they must have), there is no limit. They will want to take it all for their mad schemes.

    2. Anonymous says:

      Hi JW

      I do enjoy the equation debates as they are to my mind like sand castles on a beach. They look so impressive until the tide inevitably comes in…

      Back in the mists of time when I was a young man my first connection with this sort of thing was the equation around the £M3 money supply measure in the UK. Even better for mathematical pedants was the second derivative of this.

      Unfortunately reality was rather rude and simply would not play ball. This did not deter some who seemed to insist that reality was wrong. As ever as time went by a long word (disintermediation) was used to cover up the situation.

      One way or another all of the efforts since have gone down the same road.

  6. MS says:

    Hi Shaun,

    Preventive medicine is better than any therapy, as they say, and no medicine at all is better than poison. Unfortunately, we’ll never know just how much pain could have been avoided if more competent decisions had been made, especially with regards to Greece & co.

    Even politicians must have realized by now that it’s not working. What I can’t tell is whether this approach is just the best fit for their own agenda, or whether they’ve fallen victim to deer-caught-in-headlights syndrome. They might even be like the gambling addict convinced he’s about to win it all back.

    I was looking forward to Grillo’s party possibly gaining power in Italy, if for nothing else but to watch the ensuing fireworks. As I understand it from contacts in Italy, the very bizarre government which has been ‘formed’ in Italy is rather unstable and Grillo’s party has good odds of winning were a re-election to take place.

    I’ve also heard from a contact in Cyprus that the once mercedes-filled roads (Cypriots were big fans of German luxury cars, it seems) have become quite empty and it’s much, much easier to get around, apparently. Most shops in the busiest streets of the capital, Nicosia, have closed, too. It’s amazing how quickly things can go horribly wrong. The austerity vote in Cyprus barely passed by one or two votes a couple days ago, as I understand it; it would have been interesting to see what would have happened had the contrary occurred.

    Another interesting anecdote I’ve been made aware of is from a friend of mine who runs a business in Italy. It would seem as though there’s some shadowy mass-buying of struggling Italian SME assets by (primarily) German companies for as low as 5-10% of the ‘normal’ price going on. e.g. he’s heard of 200k+ euro construction vehicles being sold off for as low as 5k euros. It took him a while to work out exactly what was going on as it seems this is being done rather covertly.

    I wonder just how much longer all this can go on before something finally gives and things start to break loose. The eurocrats must have more than a few worries by now. Or at least one would hope so, but maybe all that hot air has filled their cranium to the point of it causing thir mind to malfunction.

    Interestingly, I’ve also heard from a contact in Denmark that things are starting to not look so bright there, either. Have you by any chance looked into how things are going over there?

  7. Paul C says:

    Hi Shaun,
    How I wish that the real economy was actually a 3rd place priority. I think the real economy is more likely an ugly and troublesome cousin that holds an honest mirror, best hidden behind a plethora of distorting statistics and valueless Q.E. influenced GDP accounting.

    1. Anonymous says:

      Hi Paul

      I did contact the UK Office for National Statistics about the UK’s recent GDP numbers to ask what they would have been if we had replaced the “improvement” of the CPI with the RPI. Here is the reply.

      “Hi Shaun
      Due to the complexity of the calculations involved that’s not something we can estimate.

      Regards

      Rob”

      I simply do not believe that and suspect that the answer is simply inconvenient.

      1. Paul C says:

        Shaun, thanks for your response. The reason I respect your blog is the honesty and dogged persistence you show in revealing the facts. There are few people with the knowledge and integrity that you show, in upholding the shared interest. The trouble with state employees is that they are not independent and as individuals take a salary to tow the Govt. line. I think there room for big data and independent analyses in this field. Flow the real-time data, let web statisticians reveal their calculation models (as per rogoff) and people can watch the indices of their choice. It would save the cost of the ONS!

  8. Noo 2 Economics says:

    I think the CB’s mistakenly believe that if you pump up the equity markets via QE then “magic” will happen and the increased asset prices will translate into expanding businesses and economies with increasing employment.

    They are interfering with the equity price finding market mechanism but then leaving the real economy to fend for itself because they think the equity market will automatically look after the real economy once the equity market starts rising.

    They don’t seem to have heard of jobless recoveries and won’t interfere with the real economy thinking the free market knows best.

    If the free market knows best with the real economy then why shouldn’t it know best for equities etc?

    Unfortunately Governments/CB’s have a poor reputation for winner picking in the real economy (remember Solyndra in the US?) so they are steering clear. As they have no proven record of failure in equities this represents a new field of activity for them where they can evade criticism for some years to come until the next market crash.

    1. Noo 2 Economics says:

      That’s gone off at a tangent on what I really wanted to say which was that propping up the banks via QE/FLS/lower interest rates etc will encourage them to speculate more in equities too – the CB’s know that which, according to CB mentality will help the real economy, Oh and a rising stock market makes for good news copy for their political masters. So much for Independence!

      1. Anonymous says:

        Hi Noo2

        Yes and the rest of us are left to wonder why central banks seem to think that they should be behaving like hedge funds…

        1. MS says:

          We might just be missing the point and central banks were never meant to deal with the real economy, but only with financial markets. This is the global financial crisis after all, not the global economic crisis…

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