Practical analysis for investment professionals
31 March 2023

The Active Management Delusion: Respect the Wisdom of the Crowd

“My basic point here is that neither the Financial Analysts as a whole nor the investment funds as a whole can expect to ‘beat the market,’ because in a significant sense they (or you) are the market . . . the greater the overall influence of Financial Analysts on investment and speculative decisions the less becomes the mathematical possibility of the overall results being better than the market’s.” — Benjamin Graham

An enduring principle of financial history is that past solutions often plant the seeds of future problems. Among the least-expected examples of this phenomena were the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts mandated extensive financial disclosures by publicly traded companies and outlawed market manipulation and insider trading. Prior to their passage, Wall Street stock operators routinely profited by cheating markets rather than outsmarting them.

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To be clear, these regulations were desperately needed to clean up US securities markets. After they were passed, skillful securities analysis, rather than market manipulation and insider trading, was largely the only way to beat the market. Of course, truly above-the-mean securities analysis was and remains exceedingly rare.

But that hasn’t kept capital from flooding into actively managed mutual funds — even after the first index funds launched in the 1970s. Under pressure to differentiate their products, fund managers introduced a slew of investment strategies covering various asset classes and sub-asset classes. Increased complexity, specialization, and robust marketing budgets convinced the public that professional managers could add value to their investment portfolios beyond what they could otherwise obtain by investing in a diversified portfolio of stocks. Few paid attention when the SEC noted that the average professionally managed portfolio underperformed broad indexes before fees in an exhaustive 1940 study.

For more than 80 years, the fact that few active managers add value has been validated by numerous research papers published by government agencies, including the SEC, and such Nobel laureates as William Sharpe and Eugene Fama, as well as the experience of Warren Buffett, David Swensen, Charles Ellis, and other highly regarded practitioners. Despite a preponderance of evidence, many investors continue to reject the undeniable truth that very few are capable of consistently outperforming an inexpensive index fund. Outside a small and shrinking group of extraordinarily talented investors, active management is a waste of money and time.

The Extraordinary Wisdom of the Crowd

So, why is the active management delusion so persistent? One theory is that it stems from a general lack of understanding as to why active strategies are doomed to failure in most cases. The primary reason — but certainly not the only one — is summed up by the “wisdom of crowds,” a mathematical concept Francis Galton first introduced in 1907. Galton described how hundreds of people at a livestock fair tried to guess the weight of an ox. The average of the 787 submissions was 1,198 pounds, which missed the ox’s actual weight by only 9 pounds, and was more accurate than 90% of the individual guesses. So, 9 out of 10 participants underperformed the market.

Galton’s contest was not an anomaly. The wisdom of crowds demonstrates that creating a better-than-average estimate of an uncertain value becomes more difficult as the number of estimates increases. This applies to weight-guessing contests, GDP growth forecasts, asset class return assumptions, stock price estimates, etc. If participants have access to the same information, the total estimates above the actual amount tend to cancel out those below it, and the average comes remarkably close to the real number.

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The results of a contest at Riverdale High School in Portland, Oregon, illustrated below, demonstrate this principle. Participants tried to guess the number of jellybeans in a jar. Their average guess was 1,180, which wasn’t far from the actual total of 1,283. But out of 71 guesses, only 3 students (fewer than 5%) beat the average. Anders Nielsen came closest with 1,296.

Average Participant Guess by Number of Participants

Chart showing Average Participant Guess by Number of Participants

The Seed of the Active Management Delusion

Speculators prior to 1934 understood the wisdom of crowds intuitively, which is one reason why they relied so heavily on insider trading and market manipulation. Even in the late 1800s, market efficiency was a formidable obstacle to outperformance. The famed stock operator Daniel Drew captured this sentiment when he reportedly commented, “To speckilate [sic] in Wall Street when you are no longer an insider, is like buying cows by candlelight.

The Great Depression-era securities acts improved market integrity in the United States, but they also sowed the seed of the active management delusion. As companies were forced to release troves of financial information that few could interpret, markets became temporarily inefficient. Those like Benjamin Graham who understood how to sift through and apply this new data had a competitive advantage.

But as more investment professionals emulated Graham’s methods and more trained financial analysts brought their skills to bear, the market became more efficient and the potential for outperformance more remote. In fact, Graham accelerated this process by publishing his techniques and strategies and thus weakened his competitive advantage. His book Security Analysis even became a bestseller.

After a time, Graham concluded that beating the market was no longer a viable goal for the vast majority of financial analysts. That did not mean that he had lost faith in their value; he just knew with mathematical certainty that outperformance was too tall an order for most. Despite his indisputable logic, his warning was largely ignored. By the 1960s, too many investment firms and investment professionals had staked their businesses and livelihoods on beating the market.

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Letting Go of the Fear of Obsolescence

The flawed belief that we can beat the market persists to this day. What’s worse, it has spread to institutional consulting and other sectors. Many firms base their entire value proposition on their manager selection skills and asset allocation strategies. Yet these are subject to the same constraints as Galton’s weight-guessing contest. For example, average estimates of asset class return assumptions — which are freely available — are likely to be more accurate than those provided by individual firms using comparable time horizons. The same holds for manager selection, only the outcomes are quite a bit worse. The average choice of an asset manager may be better than most individual choices, but by definition, even the average is a losing bet. That is, the average manager is expected to underperform an index fund because most asset managers underperform index funds.

To improve client outcomes, investment consultants and advisers must come to terms with this reality. But over the past several decades, most have only intensified their quixotic quest for outperformance. Their collective failure has saddled clients with portfolios that are overly diversified, laden with unnecessary active manager fees, and unnecessarily invested in expensive alternative asset classes that can only add value to a small subset of highly skilled investors. The consequence is subpar performance, higher fees, and costly neglect of more important financial challenges.

Why can’t advisers and consultants accept the truth about outperformance? Because they fear it will lead to their obsolescence. It is a great irony, therefore, that the opposite is true. Once we let go of the outperformance obsession, we can add extraordinary value for our clients. Clients need us to hone their investment objectives, calibrate their risk tolerance, optimize the deployment of their capital, and maintain strategic continuity. By spending less time on unnecessary tweaks of portfolio allocations, the constant hiring and firing of managers, and unnecessary forays into esoteric asset classes, we can better serve our clients by focusing on what really matters.

The first step is to recognize and respect the wisdom of crowds. Only then can advisers and their clients join Benjamin Graham as elite investors.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Mark J. Higgins, CFA, CFP

Mark J. Higgins, CFA, CFP, is an author, financial historian, and frequent contributor to Enterprising Investor. His work draws from his upcoming book, Investing in U.S. Financial History. For those interested in receiving updates on the book and his research, you can subscribe to his free newsletter. Prior to writing Investing in U.S. Financial History, Higgins served as a senior investment consultant for more than 12 years. In this role, he advised the trustees of large pension plans, foundations, endowments, and insurance reserves that had aggregate assets of more than $60 billion. As a consultant, he discovered that understanding financial history proved much more valuable than tracking the latest economic data. He also discovered that there was no single book that recounted the complete financial history of the United States. Investing in U.S. Financial History seeks to fill this void. The book will be published and distributed by the Greenleaf Book Group and will be available for purchase online and in bookstores in February 2024.

11 thoughts on “The Active Management Delusion: Respect the Wisdom of the Crowd”

  1. Steven Mattas says:

    Hello Mr. Higgins,

    I appreciate your brilliant article The Active Management Delusion: Respect the Wisdom of the Crowd. Being “average” is being “best.” It is also the simplest thing to do.

    1. Mark Higgins says:

      Thank you so much for the comment. All of this draws from a book I am publishing in the Winter 2024 on the complete financial history of the United States. Feel free to check out my site and sign up for my newsletter if you are interested.

  2. Hi Mark,
    I would like to add that there is indeed an alternative asset class, which can add value to all mildly advanced retail investors, who understand correlations and Beta values: Simple pure trend following with managed futures.

    The late Harvard finance professor John Lintner first co-created the Capital Asset Pricing Model (CAPM) in parallel to William Sharpe. In 1983, he also published the well known “Lintner Paper,” formally titled “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.” This quote summarizes his tremendously beneficial research result:

    “The combined portfolios of stocks (or stocks and bonds) after including judicious investments in appropriately selected sub-portfolios of investments in managed futures accounts (or funds) show substantially less risk at every possible level of expected return than portfolios of stock (or stocks and bonds) alone.”

    This result is valid until today. Not in hindsight for a few lucky of these futures trading funds. But for decades on average of their active benchmark index SG Trend after costs of the 10 largest investable trend funds, selected at the end of each year for the next one. Therefore, this alternative asset class is one of the very few with true added value to retail investors.

    Thus, it can be recommended to the benefit of them, interested in outperformance at least in risk adjusted terms, to diversify their equity ETF portfolio with a number of these funds. They should be included in the benchmark index or have a high correlation and beta to it.

    As these funds are non-coorelated to equities on long-term average, and negatively correlated to them in financial crashes, they can substantially reduce portfolio drawdowns then without reducing return potential long-term. They require about the same effort as ETFs to select the ones with the right properties, and then buy-and-hold them.

  3. Charles M Reilly says:

    Yes, history shows investment managers do not consistently outperform benchmarks but investment managers need to be accountable for the returns their portfolios generate and the associated return risk. Aswath Damodaran, NYU Finance Professor, defines risk as the difference between beginning of period return expectations and end of period return results. This definition of investment risk should be central to holding the investment manager accountable for their portfolio management. Yes, investment managers should not focus on outperforming the market but instead focus on presenting their return expectations and each quarter reconciling beginning of period return expectations with end of period return results. In this way, investment managers will communicate to their portfolio investors the return risks the investors are exposed to by the investment managers.
    The challenge with the need to ‘calibrate their risk tolerance’, ‘optimize the deployment of their capital’, and ‘maintain strategic continuity’ lies in making such tasks of the investment manager understandable and quantifiable to the investor in a clear way such that the investment managers can be held accountable for the investment risk taken in the portfolio.
    Investment managers and plan sponsors prefer to focus on benchmark relative returns rather than the actual absolute portfolio return while the portfolio investors shoulder the actual return variability of the portfolio which the portfolio managers really need to be accountable for.
    This linked post offers a solution ;
    refer to January 6 2023 dated SEC Comment file ‘Gap Attribution’

  4. Paul OBrien says:

    This is an important point about investing. How can we fix it?

    One way would be for advisors to be clear what they are doing to add value: picking markets or sectors or picking managers. And then keep score to demonstrate added value over time, say three to five years.

    If picking managers is the tool to add value, then compare manager choices to the universe of managers. How did your pick do to versus the peer group? How did managers you hired do versus the ones you fired?

    1. Mark Higgins says:

      This is absolutely correct and it is one of the greatest ironies of the non-discretionary investment consulting profession. Many of the largest firms started as performance reporting service providers, yet nobody reports the results of their recommendations. Unless an independent entity assesses their performance and reveals that they add value, what are clients paying for?

  5. Benjamin Doty says:

    Part I of A Random Walk Down Wall Street does a great job of recounting financial history for its length.

  6. robby says:

    Point taken. But if everyone wised up and started using low cost index funds then where would the wisdom of the crowds intersect with the markets? There would be no one guessing about prices. There wouldn’t even be a market. The people who think they can beat the market, the ones who are right and the ones who are wrong, they and the prices they offer and accept are what provide the wisdom of the crowds pricing for the market.

    1. Mark Higgins says:

      I have heard this argument before. While there is a kernel of truth, it is pretty small one. Craig Lazarra at S&P recently did some interesting analysis that reveals that we are not even close to reaching the point in which passive investing becomes so large as to become problematic. The reason is that most of the trading is done by active fund managers, so it takes very little presence of active managers to create efficient markets.

      In theory (emphasis on theory), this may be a problem in the distant future, but this renders the argument to use active funds now to be something along the following lines: “use active managers now even though the odds are that it will fail because maybe someday it won’t.” That is not a compelling argument on which to make an investment decision — especially if it involves somebody else’s money.

  7. WILLIAM says:

    I like your summary and the data you provide in support, but I note you have left out the ‘other hand.’ Index funds rise and fall in tandem with the related index, e.g. S&P 500, which itself rises and falls in tandem with the 500 stocks in its ‘basket,’ but neither the Index Fund nor the S&P 500 Index actually own any stocks, a form of property. All the Index Fund owns are promises of other financial participants. The 500 Index owns nothing, for the data it uses is owned by the Exchanges on which the stocks are sold. This means that the Index Fund performance is subject to promises being honored fully and faithfully, and the 500 being honestly computed on the basis of information honestly collected from the Stock Market, where stocks, not promises, are actually bought and sold. As you point out, it is the pre-market decisions to buy or sell when the market is open will drive the price up and down during market hours. It these decisions made by humans and machines that determine how the market performs. Many of these decisions are made by Mutual Fund Managers whose funds actually own property, stocks, and not promises, like Index Funds. Their decisions are what count, the passive ‘decisions’ of the Index Fund are irrelevant. Since these Mutual Funds are so large, they own much more than half of the stocks named in the 500 fund, and the votes they cast as owners of most of the stock in the 500 determines who runs the companies whose stocks are held in their Funds. This ‘invisible’ group actually own, have the power, and exercise that power to benefit them, as individuals and the employees of their Fund Companies, it seems reasonable to presume. Index Funds (also known as Tracker Funds) are the Tail of the Mutual Fund Managers’ Dog. Active Managers try to anticipate and place their bets on individual company stock moving up or down in price. Index Fund Managers are not interested in company stocks, and, in any event, provide no advice only a service. How many shares of Apple did the Index Funds buy when first offered? None. When did they ever buy Apple? None. They have never owned Apple. How many bought Apple on the advice of Active Managers? Everyone. Neither the Mutual Fund, nor the Index Managers advise purchase the any stock in particular, just BUY BUY BUY Risking all of your wealth on whims of people who don’t care about you at all, i.e. the people who compute the 500 Index, and the people who run the Index Fund, and play no part in the direction of stock prices, instead of a living, breathing, person you know and who knows you and depends on satisfying you so he can eat seems reackless at the very least. The fact that you fail to point this out, I presume is unintended, and not the result of being unduly influenced by Index Fund “Managers” (who in fact manage nothing).

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