Investor Smackdown: Your Broker vs. Eugene Fama

01/17/2018 06:30 am ET

Photo by Tra Nguyen on Unsplash

I’m going to go way out on a limb here. I assume the investment recommendations you’re getting from your broker are vastly different from what Eugene Fama would advise. More on that later.

In order to decide whose advice to accept, it seems logical to compare the qualifications of your broker with those of Mr. Fama. Presumably, that’s what you do in most other situations. If you needed heart surgery, your due diligence would probably lead you to select a surgeon who specializes in this type of surgery and who has appropriate academic credentials and board certifications. If you did the same kind of due diligence when deciding on investment advice to follow, here’s what you would find.

Your broker’s qualifications

According to Investopedia, “...there are no educational requirements for becoming a broker.” While individual firms may have higher standards and rigorous training programs, it’s important to be aware of this fact. It’s possible that your broker doesn’t even have a high school education and was formerly a used car salesperson.

Brokers are required to pass standard securities tests in order to obtain their license.

They are not required to publish peer-reviewed papers in respected trade journals. Their investment recommendations may or may not have any academic support or basis.

Fama’s qualifications

Eugene F. Fama is the Robert f. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. He is a 2013 Nobel laureate in economic sciences. According to his biography, his is widely recognized as the “father of modern ‘finance.”

He has published over 100 articles in academic journals and is “among the most cited researchers in economics.”

His academic credentials are impressive. He has a bachelor’s degree from Tufts University, and an MBA and Ph.D from the University of Chicago Graduate School of Business.

His extensive research has “transformed the way finance is viewed and conducted.”

Your broker’s recommendations

Many (but not all) brokers earn a fine living by recommending actively managed mutual funds (where the fund manager attempts to beat a designated benchmark, like the S&P 500 index), selecting individual stocks believed to be mispriced and timing the market (predicting when bull and bear markets will begin and end).

The majority of investors still rely on these recommendations, often at the expense of attaining their goal of accumulating sufficient funds to permit them to retire without fear of running out of money.

Fama’s recommendations

The Booth School of Business recently published an article entitled: Embrace passive management already. It summarized Fama’s views on investing in very simple, understandable terms.

He believes there’s “no debate about whether active management is better; it can’t be.”

He says that even if you could prospectively identify active managers who could outperform their benchmarks, after fees, you would be “just as well off buying passive [index]” funds.

He notes that recent past returns (3-5 years) are “basically noise” and tell you nothing about future expected returns.

His view on hedge funds is unequivocal and sobering: “If you want to get poor quickly, you should go into them.”

His advice to institutions may have their high-paid consultants concerned for their jobs: “If I were in the institutional end of the business, hiring people, what I’d say is, ‘Cut the staff down and go passive.’ I’ve been saying that to the university’s endowment for 50 years. They’ve never followed my advice, and it would be a much bigger endowment now if they had.”

Just because Fama’s own University won’t follow his advice, doesn’t mean you should ignore it and rely on your broker instead.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information or content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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