Beyond Investing’s Conventional Wisdom

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Beyond Investing’s Conventional Wisdom

Investing in stocks, bonds, and other securities has always been about balancing risk and reward.  Prior to the mid-1970s, stock and bond markets mostly involved the assets of institutions and wealthy investors, largely managed by professionals; the exceptions occurred within speculative bubbles, such as the one in the 1920s.  Less affluent individuals mostly relied on savings accounts and defined-benefit pension plans to provide for their retirement needs.  Mutual funds became important in the 60s, but did not yet serve a “mass market.”

Then, in the 1980s, the world of “individual retirement savings” met the world of “institutional finance” for the first time; as a result, both underwent a revolutionary change. Defined-contribution “retirement savings plans,” especially tax-advantaged IRAs and 401Ks, quickly replaced defined-benefit retirement programs as the primary investment vehicles. Much of this money flowed into equity and fixed income mutual funds, and later, ETFs. 

As a result, the 70s and 80’s witnessed the emergence of today’s “Conventional Investment Wisdom.”   It represents the attempt by academia and the investment industry to resolve, or “paper over,” three distinct dilemmas:

  • Active vs. Passive Investment Management
  • Managing risks of low investment returns vs managing risks of volatility, and
  • Adopting a buy-and-hold strategy vs. a market-timing strategy.

Unfortunately, like so many ways of doing things that grew out of a consensus, the Conventional Investment Wisdom has been slow to evolve and still reflects the realities of 40 years ago. 

To understand this situation, let’s consider the first dilemma: Active vs. Passive Investment Management.

Today’s conventional investment “wisdom” was strongly influenced by A Random Walk Down Wall Street which was written in 1973 by Princeton’s Burton F. Malkiel.   Malkiel asserted that active managers can’t consistently outperform the stock market indices.  Therefore, he argued that investors should rely on “passive index funds” which mimic indexes such as the S&P 500.  Since at least the end of the 18th Century, the U.S. and global economies have consistently grown, driven by innovation and population growth.  And since larger companies tend to get a disproportionate share of industry earnings, (due to scale, scope, and network effects) investing in a capitalization-weighted index fund makes sense...

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