There’s a lot of talk going around about cats investing and the implications of those cats’ decisions. Now, before you start thinking I’m talking about cats really investing, I am satirically referring to a study done by the Observer pitting a cat named Orlando against its own portfolio managers to determine if the cat could outperform the pros. In a shocking turn of events (or not?), the cat managed to outperform the professionals, with the Observer quite naturally taking advantage of the situation to throw in some cat related puns that were pawsitively awful.
This article is only one of many that have sprung up comparing the returns of investors and experts to basic statistical results and animal-related oracles. I’m sure we all remember the famous Paul the escapee-octopus who predicted European “football,” aka soccer, matches including making accurate predictions in the 2010 World Cup, as well as the studies showing that American football analysts guess the winner of a game less than half of the time.
The implication of these articles, in the public opinion (although not implied by the articles themselves), is the suggestion that professional services are not necessary because if a cat can invest better than a professional, why can’t the average person?
To begin with, that is not the implication of these publications’ results. For example, in the Observer’s article, they claim that Orlando, the cat, represents the market, not the average investor.
Repeat: the cat is not an amateur. The cat is the stock market. The cat is pure randomness.
The dangers of some of these articles, however, is that it gives the exact opposite impression, that the average person can outperform professional advisors. While we argue that it’s possible that the average person can outperform a professional, there are a vast number of reasons why it’s not only difficult, but inadvisable. It doesn’t make much sense that in a competitive business like the financial industry in which professionals comprehend that the more successful they are for their clients, the more successful they will be professionally, that such professionals are unable to compete with the average person. Unless…
It turns out that people also don’t perform well, as written by Investopedia:
“Studies have shown the track record for individual investors is not encouraging. DALBAR, a leading financial services marketing research firm, released a study that showed from 1990 to 2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. Over that same period, the average equity investor earned a paltry 3.49% annually.”
This was also true of the Observer’s selected novice students in investing, who underperformed the experts as well as Orlando the random cat.
The most important key is that professionals are aware of and less likely to be subject to the psychological traps that plague investors. Poor investment behavior is one of the most dangerous reasons why people lose money in the markets. They are more subject to these traps and thus dangerously able to underperform the markets. There are a number of traps from sunk cost fallacies to confirmation bias which constantly affect the decision making of the average investor and render them more likely to submit to chasing a “hot stock” or the “next Amazon” that will make them rich overnight. The thing about those people who became rich overnight? They are very, very rare.
On the other hand, a lot of people who sat back and let their money grow and be managed are living very well and good lives without astronomical returns. Part of this is because effective money management is more important than chasing stars and panicking. One great quote from famed economist Gene Fama Jr. is, “Your money is like soap. The more you handle it the less you will have.” People have a tendency to overtrade, selling when they have obtained a quick profit while at the same time riding a stock to “the bottom” hoping that it will eventually recover. Frequently trading while not lending a thought to asset allocation is one of the errors that individuals encounter when managing their own money without proper experience.
There are also investment decisions missing from these types of articles. For instance, note how the Observer writes that the investments were made:
“Each team invested a notional £5,000 in five companies from the FTSE All-Share index at the start of the year. After every three months, they could exchange any stocks, replacing them with others from the index.
By the end of September, the professionals had generated £497 of profit compared with £292 managed by Orlando. But an unexpected turnaround in the final quarter has resulted in the cat’s portfolio increasing by an average of 4.2% to end the year at £5,542.60, compared with the professionals’ £5,176.60.”
To begin with, “profit” is the wrong language to use when referring to investments. Is that total return? In dividends? In capital gains? There is no indication in the article how “profit” is calculated. Furthermore, the article ignores investment decisions made during the course of investing. Most investments don’t simply have a three-month timeline and most investors are not forced to hold on to a security for three months. Perhaps they will sell sooner. Though it might seem to contradict with what I mentioned earlier with trading too frequently, remember that investors often have a set return-goal that, if achieved earlier than expected, would let them liquidate the position sooner. For instance, if I purchase ABC stock and expect a 20% return over a year and I find that it makes a 20% return in three months, I may decide to sell it since I achieved the return I wanted from it, rather than wait the year. This is rare, but it can happen.
Another important aspect missing from these types of experiments is that the money managers were not tailoring their decisions to clients’ needs. Different clients will need different assets determining where they are in their life and their risk tolerances, none of which was taken into account in the article (or all the subsequent articles that have been referencing the study made in 2013). The needs of the client always take precedent over the desire to stock pick someone’s way into money.
If it sounds like I’m saying that trying to make your client millions isn’t important, you’re missing the first rule of investing. Returns comes with risk. Financial planning means understanding risk and managing risk and trying to focus on what a client’s needs are. A client entering retirement needs capital preservation, not their investment advisor to take advice from a cat on which stocks to invest in in the hopes that the cat may select a winner.
At the end of the day, there’s a reason and a need for the profession of investment advisors and financial planners, and unless something CATastrophic happens, it will remain that way for a good long while.