"There Ain't No Such Thing As A Free Lunch"
We have shown that without risk there is no reward. Only the slimiest predators in the investing world say otherwise. They are preying on people who never heard the phrase "too good to be true".
The more insidious pitch comes from smart, silver-tongued salespeople and brokers who convince you that their fund or watchful eye can spot the best deals. Their pitch is usually just a slight tweak. They give the most optimistic possible pitch that registers just below your bullshit detector.
This lucrative sales ability is much further ahead than their investing acumen is I assure you.
Reality Check By Induction
The reality is there are conceptually very few sources of edge in markets. They rely on rare information asymmetries or even rarer analytical abilities. The chance you are being offered access to that is zero.
A sensible pitch would offer you a fair payoff for a given level of risk. The logical basis for this trilemma is captured by what Newfound Research coined The Frustrating Law of Active Management which states:
For a strategy to outperform in the long run, it must underperform in the short run
- If achieving outperformance with a certain strategy is perceived as being “easy,” enough investors will pursue that strategy such that its edge is driven towards zero.
- Rather, for a strategy to outperform in the long run, it has to be hard enough to stick with in the short run that it causes investors to “fold,” passing the alpha to those with the fortitude to “hold.”
You can also flip the table around.
Even if a strategy was purely dominant in all circumstances, its manager would have the clout to choose its investors. They would either select investors who could offer them something of high value in exchange or they could select investors who were willing to pay fees so large that the manager retains all the surplus of their dominant strategy.
Be Wary Of People Selling Noise As Signal
We are right to be wary of quack remedies. Since many conditions, including the common cold mean revert, our minds are quick to assign causality to what is actually randomness. "My cold went away I guess the mega dose of Vitamin C worked!". The charlatans of the investing world are just quacks with expense accounts.
For any disciplined investment approach to underperform over the long run, it must experience periods of outperformance in the short run.
In other words bad strategies must by necessity appear to be good strategies. This is obviously true for multiple reasons.
- If the strategy never had a winning moment it wouldn't survive. Nobody has ever invested in a perfectly losing track record.
- A strategy that always loses is a gold mine. Just do the opposite. It's symmetrical to a perfect strategy which we know does not exist.
- And while we are doing mental inversions, let's consider the truth that in order to earn a reward we must take risk. It is not true that if we take risk we are entitled to a reward. Enough trips to the Bellagio will teach you that.
Ruling Out Is Easier Than Ruling In
The implication of The Frustrating Law of Active Management is to be skeptical of optimistic claims about an investing strategy.
These are my trusty initial filters when presented an opportunity.
The Grouch Marx Rule The old Groucho Marx line says it all: “I don't want to belong to any club that would accept me." Why are you getting a look at this opportunity? Didn't that realtor have a closer friend or repeat client to show that off-market deal to. Be wary of adverse selection
The Moontower Trilemma A strategy may: 1. Have an outsize edge 2. Be easy to stick with 3. Be scalable Pick 2 If you think you see an exception go back to The Groucho Marx Rule
- For a strategy to earn a premium its risk must manifest occasionally. Otherwise, it will be bid up until there is no juice left.
- The inversion means sometimes bad strategies look like good strategies. It can be hard to tell the difference.
- The default response due to Grouch Marx is to rule out. The Moontower Trilemma can then temper your remaining expectations.
There is no free lunch. If returns show up early, the risk is bound to show up.
- The noise in investing typically swamps the signal. A nice setup for story-telling salesfolk. This can even obscure good strategies. A nice reminder comes from Nick Maggiulli who explains the paper Even God Couldn't Beat Dollar Cost Averaging (Link)
- Newfound Research's No Pain, No Premium (Link)
- Newfound Research’s Frustrating Law Of Active Management (Link)