Wednesday, January 19, 2022

Fewer, Better Decisions?

Market data for 2021 show once again stock index mutual funds outperformed mutual funds managed by humans ( source ).   Fully 85% of actively managed funds fared worse than automated funds which seek to simply mimic the aggregate behavior of the market.   

Which got me thinking...why?   Mutual fund managers are very smart people, deeply experienced in company analysis.  They have clear incentives to outsmart the market.   Yet, each year, a very few do.   And those few will likely NOT be amongst the few who outperform the market next year.   Why?  

Is it perhaps the complexity and volume of decision making required by an active fund manager?   

Consider the decisions a mutual fund manager must make to succeed in a single transaction:

  1. Which stock should I buy? 

  2. At what price should I buy it?

  3. How many shares should I buy? 

And, with purchased shares in hand, two further decisions await:

  1. At what price do I sell? 

  2. Do I sell all or a portion of my holdings? 

The manager must make five decisions correctly to notch a profit from a single stock purchase.   Given that most mutual funds have at least fifty, and oftentimes hundreds, individual stock positions, the number of decisions multiply like rabbits.   As the portfolio turns over, there is more cash to invest and the cycle repeats.   It’s virtually impossible to get all of the choices right. 

Contrast these decisions with those facing an index fund.   The index fund organizers simply spread the available cash across all the stocks in the underlying index in a predetermined proportion.   The only buying and selling happens as customers send cash into or out of the fund.   All of which can be automated.   

Decision making takes time and mental effort.   Even if skilled and speedy, the decision maker can only make one decision at a time.  

Can I learn from this?   

Are there arenas where one can substitute a predetermined choice, like the index fund manager does, for a more involved set of choices, like an actively managed mutual fund manager does? 

  • Can I predetermine always to eat a salad for lunch rather than choosing each day what to have? 

  • Can I predetermine to hit the gym four mornings each week rather than deciding if I’m up for it today? 

  • Can I predetermine what my restocking level will be for a supply rather than deciding afresh each time? 

  • Can I predetermine to only pursue a new product innovation if I have three independent market-size estimates rather than deciding anew on each proposal at the moment? 

We often recoil at the thought of making predetermined choices.  Lunch will forever be boring!!!   We recoil at the thought that a human can’t pick stocks better than an algorithm.   You gotta know the company!!   But are those reactions valid??

It got me thinking. 



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