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  • Writer's pictureBrian Schroeder

Investing Lessons from Socrates

Virtually everyone reading this has heard the name Socrates. And most everyone has been exposed to the Socratic Method. Like pealing an onion, every assertion is critically challenged until the heart of the matter is revealed.

Following the Socratic Method, the point is usually reached where the hypothesis ultimately rests upon a guess, hunch or assumption. This was the genesis of Socrates’ most memorable quote, from Plato’s Apology, “I neither know, nor think that I know.”

Investing is about accurately seeing the world today and deploying resources to profit from an accurate vision of tomorrow. Inherently there are assumptions. And these assumptions are clouded by biases, imperfect information and emotions. Add to the problem the Aristotelian Flux (constant change) and it is no wonder that investing is often called a fool’s errand with success being the exception, and not the rule.

Socrates would start with what he does not know when answering investing’s two fundamental questions; Where and How? Where do I invest my assets? How do I invest my assets? The first question addresses asset allocation. The second question concerns management.

Where do I invest my assets?

There is an infinite number of ways to allocate your assets among asset classes. Professionals today have created methodologies that are very “scientific looking” with historical measures of risk, correlations and returns. Add projected return assumptions, scenario analysis, Monte Carlo simulations and the like, and it seems that investors should have no problem meeting their goals every time no matter the markets.

Of course, investors do not always meet their goals. Today’s methods of asset allocation are loaded with assumptions about both the past and the future. Legendary New York Yankees manager Casey Stengel said, “I never make predictions, especially about the future.” He was a smart man, indeed.

Socrates would say the faulty crux of today’s asset allocation methods is the assumption that the future will look like the past. But history is the only guide; unless we start speculating about the future. Logically speaking, strictly relying on the past is speculation, except it is not altered with opinions about the future.

Outside of having a time machine or a perfect crystal ball, we cannot know the future. Socrates might say, “I know I do not know the future.” But can we be more certain about one period over another? Can we use concepts to not only accept our ignorance but embrace it and use it to our advantage?

Like flipping a coin, investors do not know how the stock market will perform the next day. In the long run, however, flipping a coin will be 50/50. In the long run, following history, we can surmise that equities will outperform real estate, which will outperform fixed income, which will outperform cash. (For simplicity, let’s not get into the sub-asset classes nor “alternatives.”) In the short run, the returns for these asset classes may be in any random order.

If we can only hope to come close to knowing relative returns in the long run, why do investors ever make short run or tactical changes? After all, academic research and industry studies routinely show that short-term, tactical allocations and market timing tend to lose value.

If circumstances change then asset allocation may need to change in response. But these circumstances cannot be investment-oriented speculations. Rather, the catalysts would be related to things like cash flows, objectives and funding levels.

Despite the studies and Socrates’ logic, many institutional plan sponsors constantly tinker hoping for advantage. Unfortunately, it seems there is often a negative correlation between change and success.

How do I invest my assets?

Like the randomness of asset class returns, whether an active manager beats its relevant index from year to year is an unknown. Once active manager fees are considered, the task of beating the benchmark becomes more difficult.

If you lump all the active managers together for a particular asset class, they cannot beat the market because collectively they become the market. Except, they charge management fees and pay brokerage, exchange, administrative and custodial fees. On the whole, they must therefore lag their paper index. The SPIVA table below supports the contention.

With a large enough sample size, some active managers will have a hot streak. Some streaks will be long enough and persistent enough to be considered to have “demonstrated skill.” The question for investors is whether they can identify and invest with these managers BEFORE their streak of demonstrated skill. Or do they invest after the party ends?

Academic research and industry studies, like asset allocation, show that investors often display return chasing behavior. They hire managers after their hot streak and fire managers after their cold streak. The active manager then subsequently reverts to the mean by either cooling off or heating up, respectively.

Socrates would say he cannot know in advance which active managers will beat its benchmark over the long run. He would agree that on the whole active managers cannot beat their benchmark net of fees. He would conclude an investor should index where possible, enjoy lower fees and enjoy having shorter and fewer investment committee meetings.

Socrates on Investing in a Nutshell

I do not know how to allocate assets in the short or medium term- Thus Change infrequently.

I do not know how to hire and fire active managers to achieve out-performance- Therefore Index.

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