Is investing an art or is it a science?
Reprinted courtesy of MarketWatch.com.
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A perennial topic among investors is whether investing is an art or a science. I think it’s mostly science, but there’s also a bit of essential “art” to it.
By art, I don’t mean the practice of picking stocks or managers. Based on all the evidence, that’s foolishness. Follow your own instincts and hunches and amateur research if you want to bet on sports teams. But don’t do that with your savings.
Let me define the terms.
•”Science” in investing means knowing and applying facts based on research and history.
•”Art” in investing means controlling (sometimes even manipulating) things that only you can control: things like fear, pride, regret, laziness and greed.
The psychological part of investing, that which involves your emotions, your expectations, your attitudes and your habits, is a crucial part of the recipe for success.
But that recipe is useless without the ingredients that emerge from objective research into market history. This is the science, and it has to be based on evidence.
By market history, I don’t mean what’s been happening in the past six to 12 months. I mean what happened in the longest period for which accurate, reliable data is available.
Investors are heavily influenced by the financial media and by what salespeople and pitchmen want us to buy.
Yet there is no evidence at all that what Wall Street wants us to buy will be in our best interest. There is no evidence that what our know-it-all neighbors and relatives favor will be in our best interest. In addition, there’s no evidence that what our broker has for sale will be in our best interest.
Nor is there very much evidence that what’s happened recently is more important than what happened further in the past. I don’t make this point quite as categorically as I made the others, because market trends are real, and some of them tend to persist at least for a while.
A bear market is only a bear market because (by definition) a downturn has persisted. A strong trend either upward or downward may very well continue. But any trend can quickly reverse itself at any moment, and there is no evidence that anybody can reliably predict such reversals. There are simply far too many variables that impact the economy and the market.
In 2013, investment author Dan Solin wrote: “Investing is science. … Advisers who understand the science of investing know that returns are the product of risk. Some risks are worth taking, while others are not.
“Advisers who believe they have special insights into the market (which they define as “art”) are engaging in speculation, stock picking, market timing and fund manager selection. They call this ‘art’ because there is no peer-reviewed data indicating it is any more reliable than a monkey throwing a dart at a board and hoping for the best.”
I am a great admirer of Dimensional Fund Advisors, which relies on some of the best brains on the planet to manage many billions of dollars using exhaustive research and cutting-edge strategies to squeeze maximum returns from various stock indexes. That’s the science.
But a form of art is also important in DFA’s success. The company’s funds are available to individuals, but only those who are clients of advisory firms that share DFA’s beliefs. One result is that DFA shareholders are more likely than others to stay the course and benefit from the science.
I believe the science of investing must be based on the notion that no investor can predict the future. If you disagree with that, I can’t help you.
While history can’t tell us the future, the past can tell us the probabilities of various investment outcomes. We can predict with a fair degree of confidence, for example, that over the next 30 to 40 years, stocks are likely to have higher returns and higher risks than bonds.
The same is true for value stocks vs. growth stocks and for small-cap stocks vs. large-cap stocks.
It’s equally probable that investors will see significant periods during which bonds do better than stocks, when growth outperforms value and when large cap outperforms small cap.
The exceptions to the rule don’t disprove the rule. When medical scientists are testing promising new drugs or treatments, they don’t expect everybody to benefit. They are looking for probabilities.
Imagine that your doctor told you a particular course of action had a 50% chance to make you significantly better, a 35% chance of no significant change and a 15% chance of that your condition would be either worse or unimproved with undesirable side effects.
What would you choose?
Assuming those numbers were accurate, that’s the “science” of the proposed treatment. The “art” is in how you and your doctor choose what you should do.
This decision involves your personality, your emotions and your desires. How badly do you want to get better? How willing are you to take the risk of getting worse? How anxious will you be in not knowing? How willing are you to make a decision and then accept the consequences?
These are similar to some of the questions facing thoughtful investors.
I don’t think the art vs. science debate will be over any time soon. But it’s obvious to me that you shouldn’t expect long-term success if you ignore either part of it.
Richard Buck contributed to this column.