Without thinking about it, we make a lot of decisions about the world around us based on models that are only approximations of reality. For example, if you check the weather forecast before you leave home, you are relying on many imperfect assumptions in a meteorological forecasting model. This and other models can be helpful to an extent, but anyone who has been caught by an unexpected rain shower will know that models have their limits.
Professional investors use models to gain insights that help them make their investment decisions. But markets, like the weather, cannot be fully explained by a model that only approximates reality.
Much research is done in an attempt to improve financial models, and debate is often had over which model is “better”. But these debates are unlikely to be fruitful; you cannot judge the usefulness of a model unless you also consider the user of the model and its application.
Using another example, a simple model of the earth describes its shape as a perfect sphere. This model is useful to teachers explaining the solar system or manufacturers of globes. But an explorer who is using this model to circumnavigate the world might be surprised when first encountering a mountain range that is not a part of the simple sphere.
Investors should pay similar attention to the application of models. For investors in public markets, the efficient market hypothesis is a model stating that asset prices reflect all available information. This model helps inform investors that they can rely on prices and that it is not worth trying to outguess prices that are collectively set in real time by millions of investors around the world. This insight is confirmed by numerous studies on the performance of traditional active investment managers.* This is not to say that having this insight protects investors from making mistakes; close attention must still be paid to any practical application of it.
Along these lines, when evaluating different investment approaches, private investors should try to understand the manager’s ability to effectively test and implement the ideas they garner from models. Managers who can explain in a straightforward fashion how they interpret and apply research generally require a lower level of trust than those who are more opaque.
By selecting an investment manager who has experience putting financial research into practice in a transparent and effective way, investors can increase their chances of having a positive investment experience.
*For example, see Fama and French (2010), “Luck vs. Skill in the Cross Section of Mutual Fund Returns.”