The Impact of Intellectual Capital on Investment Returns

Authored by: Scomac

What value does our skill and intellect as investors bring to the table? This is a question that all investors, professional and amateur alike, ask themselves from time-to-time. Most often, we will quantify it in terms of how our portfolios did against a chosen index or other benchmark. If we outperformed that standard, then our skill was responsible for “X” amount of incremental return. The problem with this is that we aren’t measuring ourselves over a long enough time frame to have a definitive idea of what our investing intellect is worth. Over short periods of time, we could just as easily be measuring luck or noise as skill. By the time we know for sure, it maybe too late to do anything about it if we have discovered that all our efforts have gone for not.

With this in mind, it behoves all investors to take a long hard look at this question. I would submit that quantifying intellectual capital and its impact on investment returns is somewhat simpler than would appear at first blush. First of all, we must accept a basic truth: The return of a market is the sum total of all returns of all participants in the market during the timeframe in question (William Sharpe PhD). From this we can conclude that the return of the average market participant will be the return of the market less their costs. Now anyone who spends more than a passing moment thinking about their investments and especially those who DIY will consider themselves above average investors. While this isn’t necessarily wrong from a knowledge perspective, how this fact translates into investment returns is far from certain. When you consider the breadth of individuals and depth of talent dedicated to investing in this country, not to mention globally, it becomes pretty obvious that we are just “average” investors and shouldn’t expect to be anything more from a returns perspective. Still, all is not lost. A good basic grounding in investing theory and a solid grasp of markets is all that is required to get a “better than average” return by managing costs. Using The Stingy Investor’s Upside/Downside Market View+, there is a drag on market returns of about 1.5%/annum (SCUB/TSX60/S&P500/MSCI EAFE equal weighted). This will give us a very good approximation of average costs. Compare this to a market portfolio that is constructed of index funds or ETFs and the cost savings will amount to 1%+ per year. If we choose to accept the market return at lowest cost (i.e. the beta), then the return to our intellectual capital for basic investment knowledge is clearly 1%-2%/year. This may not sound like much, but it is significant as the cost savings are compounded at the base rate of return for the market. As an example, a $10000 portfolio that earns an average return of 5% annually for 30 years will be worth $43219. If we can gain access to the average return at a cost savings of 1%/annum, the value of the above portfolio will have increased to $57435. That is an increase of ~33% that is due to basic investing intellectual capital!

We’ve established that the market return, or beta, can be had easily and cheaply. This is the return that can be attributed to basic intellectual capital in investing. However, most aren’t interested in this measure; they are far more interested in quantifying the excess return (if any) or alpha that their intellectual capital can bring to the table. Fortunately, this isn’t all that difficult to measure either, at least in general terms. Because the market return is the sum total of returns of all participants, for every participant with an excess return, there is a corresponding participant with a deficit return. IOW, active management, or stock picking, or whatever you want to use is a zero sum game. Unfortunately, it would seem that the bulk of the intellectual capital is expended in pursuit of excess return to no avail. Benjamin Graham said it best: “It takes a tremendous amount of effort, intelligence, diligence and wisdom to coax excess return out of the investment process on a consistent basis. Those that wish to apply a modest amount of additional effort, intelligence, diligence and wisdom to the process might just find out that they end up doing worse than if they take what the market would have given them cheaply and easily.”

So what of the small cap and value premiums you ask? Volumes have been written about the pursuit of these excess returns. There’s plenty of academic data to support their existence. O’Shaughnessy’s analysis of the Compustat data base indicated that small stocks on average outperformed the average stock by ~1.5%/annum and value stocks outperformed the average stock by ~2.5%/annum. Much of that work has been based upon owning large numbers of cheap and/or small stocks, in essence, buying the cheapest/smallest portion of the market. Still, 1.5%-2.5%/annum is nothing to be sneezed at. Over time, it will amount to a considerably greater sum than what can be availed to basic investment intellect. Surely that makes the pursuit of these premiums worthwhile, no? The problem with this, as I see it, is that exploiting these premiums requires the application of considerable skill, intellect and patience. To successfully earn these premiums over the long term would probably place an investor among the top 10% of all active investors and the top 1% of the general investing public. Are you this person? The probability is low, especially when you factor in that we’re not quite as good as we believe we are. Lottery tickets anyone? Recently, these roadblocks have been removed with the advent of a whole host of ETFs that are dedicated to exploiting the small cap and/or value premiums. Now that large numbers of investors can gain relatively easy access to the value (by various definitions) and/or small cap segments of the market place, how much longer will those premiums exist? Logic would dictate that these premiums will decline due to the simple fact that they are readily available to many more individuals. Is it going to be worth your effort?

In summary, we can conclude that basic investment knowledge properly applied can return somewhere from 1%-2%/annum over and above that which the average investor will experience. The effort to generate excess returns to the market will return 0% cumulatively to the intellectual capital employed. I think that this is especially relevant at this time because many investors will tend to confuse their good efforts at stock selection with the general returns delivered in a bull market. Just recently, I was socializing with a group of DIY investors. I asked them if they knew what the 5 yr. compounded return of the S&P/TSX Comp. was? I got a range of values from 8% to 16%. All were shocked to learn that the index had return 20% CAGR over the past 5 years. You could see that look of shock in their faces. While all were very pleased with their investment returns, I could tell that none of them had made that kind of money…and it was there for the taking without effort.

It wasn’t my intention to pen an ode to the merits of indexing and efficient markets. By now it should be relatively obvious that market efficiency, or lack there of, is completely irrelevant in terms of the returns an investor should expect. This is meant to be a pragmatic discussion of the distribution of returns and the probability of generating a significant excess return no matter how much effort is expended. The simple truth is that for most of us, we would be much further ahead to accept that fact that average will be good enough. This can be difficult to do in a competitive society. If we accept that average is good enough and willingly pursue that goal at the lowest cost, it’s likely that we will end up at least as well off in the long term. This will be especially true if you channel all the effort and intellectual capital towards profit or pleasure in some other pursuit that offers a much higher probability of success.

SCOMAC