Experts Aren’t Helpful, and Other Useful Lessons From “DIY Financial Advisor”

We draw a significant amount of inspiration for the material we cover on this blog from the publications of our financial brethren. Unfortunately, given the non-stop firehouse of information that increasingly characterizes the digital age, it’s nearly impossible to consume anything longer than a blog post. So it’s noteworthy that we were inspired to read – cover to cover – Wes Gray, Jack Vogel and David Foulke’s most recent book, DIY Financial Advisor.

The book is divided into three distinct themes: the fallibility of experts, the FACTS framework, and the actual DIY investment strategies. On the first theme, the book feels downright comforting in its familiarity. Covering increasingly well-traveled grounds, the aptly named “Part 1: Why You Can Beat The Experts” discusses common themes for In-The-Know investors, such as:

• Investors rely far too much on the wrong type of expertise.
• Wall Street’s incentives are a horrifying mess that are rarely in alignment with the client.
• Humans have numerous evolutionarily-ingrained behavioral biases that often undermine long-term success, and even the most deified experts are subject to the same human foibles.
• Narratives are as compelling as they are useless, and can even sometimes spiral out of control to the point of establishing myth as reality.
• And because of all the previous points, simplified models have an astounding track record of outperforming “experts.”

There is no denying these points. Years ago the research community reached a tipping point on these topics; there’s no going back now. Enlightened investors are simply waiting for society to catch up, and DIY is doing its part to speed the process along. As it so eloquently states:

Here’s the bottom line: everyone makes mistakes. And because we recognize our frequent irrational urges, we often seek the judgment of an expert, to avoid becoming our own worst enemy. We assume that experts, with years of experience in their particular fields, are better equipped and incentivized to make unbiased decisions. But is this assumption valid? A surprisingly robust, but neglected branch of academic literature, has studied, for more than 60 years, the assumption that experts make unbiased decisions. The evidence tells a decidedly one-sided story: Systematic decision making, through the use of simple quantitative models with limited inputs, outperforms discretionary decisions made by experts. We’ll leave the last word to Paul Meehl, the eminent scholar in the field of psychology, “There is no controversy in social science that shows such a large body of qualitatively diverse studies coming out so uniformly in the same direction as this one [models outperform experts].”

After laying a solid behavioral foundation, DIY moves onto the second theme: developing a framework for assessing the efficacy of financial strategies. Especially useful for investors currently using a financial adviser, Chapter 5 covers the FACTS method. From the book:

For every investment strategy that needs to be assessed, the FACTS framework (Fees, Access, Complexity, Taxes, and Search) can be employed to clarify important considerations for the prospective investor. Our experience suggests that the vast majority of taxable family offices and high-net-worth individuals should focus on strategies with lower costs, higher accessibility and liquidity, easily understood investment processes, higher tax-efficiency, and limited due diligence requirements. For example, FACTS would suggest, in general, that investors make more use of managed accounts and low-cost passively managed 1940 Act products (ETFs and mutual funds), and fewer private hedge funds and private equity vehicles. Using the FACTS framework can help assess cost/benefit trade-offs across strategy characteristics, which in turn, improves portfolio results net of taxes, fees, and overall brain damage.

And then finally, having established the fallibility of experts and a useful framework for assessing investment strategies, DIY moves into a discussion of actual investment methods. We won’t spend the time here going through the details of the various risk management and investment models because…buy the book. But there are a few points that deserve recognition.

First, diversification is still the cornerstone of any risk management strategy, but it must be implemented intelligently to maximize benefits. This includes making sure diversifying strategies are qualified through the FACTS framework. But there is no escaping it: you should still eat the free lunch. Second, the authors believe in factor investing, but only at the highest levels of reliability. Because of this, their specific strategy recommendations rely heavily on value and momentum as tools for filtering and weighting portfolio holdings. Wes and Jack are just as passionate about applying factor investing for Tactical asset allocation, especially for the purpose of risk management. Specifically, they recommend simple momentum and moving average filters to step aside from asset classes when there is a risk that they may be trending lower. These methods have been shown to preserve returns while substantially reducing the risk of large losses during bear markets.

It’s no secret that we advocate for a similarly active approach to asset allocation. However, we would lodge a minor objection with their assertions about “advanced” allocation strategies. Specifically, Jack and Wes question the utility of mean-variance optimization based largely on studies performed by DeMiguel, Garlappy & Uppal (2009), which show that optimization-based portfolios underperform naive (1/n) portfolios when optimized over rolling 36 month estimation windows. (In an Appendix to the original paper the researchers confirm their original conclusions via a “robustness test” using a lookback window of 60 months). Unfortunately, the DeMiguel et. al. analysis represents a misapplication of factor investing: by using a rolling 3-5 year window to estimate means and covariances, DeMiguel treated the value factor as if it were a momentum factor. We will revisit this issue at length in a future article.

But we digress! Truly, our quibbles with DIY’s assertions on optimization are small relative to our overwhelming alignment with the book’s major themes. At the end of the day, investors are well-advised to pay attention to the changes that will have the largest and most immediate impact on their outcomes, and DIY makes those perfectly clear:

1. Don’t believe the hype on experts,
2. Assess your options using the FACTS,
3. Diversify for risk management, and
4. Harvest persistent factors for risk management and performance.

It’s impossible not to endorse such a practical and well-formulated set of principles. Congratulations to the team at Alpha Architect for publishing a book that will find a permanent place on our financial bookshelf.