No Shortcuts to Investment Success (Part 1)

In other words, I think the market is pretty efficient and that the cheapest broad market-cap-weighted index funds are a great starting point. Investors who stick to these funds will prob­ably do better than most who hire active managers over the long term, as they are cheaper and more tax-efficient, harness the market's collective wisdom, and never miss out on the market's big winners (which tend to more than make up for its many losers).

While I have a healthy respect for the difficulty of beating the market, I think it can be done. The market is not perfect because people are not perfect. We are all susceptible to fear and greed, which can cause us to do dumb things with our investments, like selling out of a position after a crash when it is priced to offer high returns going forward or losing our valuation discipline when things feel less scary in the midst of a long bull market.

Investors are not perfectly rational. We often exhibit systematic biases that can create mispricing, such as extrapolating past results too far into the future, underreacting to new information, focusing too much on the short term, and rolling the dice on risky stocks in hopes of winning big.

Institutional frictions can also create mispricing. For example, many investment-grade-bond fund managers aren't allowed to hold bonds rated below BBB. This can trigger forced selling that can push prices below fair value when investment-grade bonds are downgraded to junk status.

Even when there is no mispricing, it is often possible to earn market-beating returns by taking on greater risk. That's what many investment-grade-bond fund managers have done in the past few years, taking greater credit risk than the Bloomberg Barclays U.S. Aggregate Bond Index to boost returns.

Qualitative judgment and rules-based models could both parlay these effects into market-beating performance, but I put my faith in the latter. Models are more consistent and less prone to cognitive biases. Qualitative judgment relies on intuition: knowing when certain rules apply and when they do not. But as Daniel Kahneman points out in his book Thinking, Fast and Slow, it is tough to develop reliable intuition in an environment that is tough to predict (like the stock market) because the quality of feedback is low. That makes it hard to learn whether the insights you glean are valid.

Of course, many models are flawed, too. There are only a handful of truly distinctive stock characteristics (or factors) that have historically been predictive of market-beating performance and that I think will continue to pay off. These include value, momentum, quality, small size, and low volatility.

In part 2, we will continue to explore the journey to investment success.