Department of Defense photo

Remember Donald Rumsfeld, Defense Secretary from 2001 to 2006? In response to a reporter’s question about weapons of mass destruction, he offered us valuable epistemological insight into known knowns, known unknowns, and unknown unknowns. Here’s a link if you have 35 seconds to enjoy a little history.

Mr. Rumsfeld never mention unknown knowns, with which investors often wrestle.

What are these unknown knowns? These are things we know but refuse to acknowledge. We know that passive investing with index funds is a superior practice for most investors, but huge numbers of us refuse to admit and act on that knowledge.

Two recent articles are relevant:

First, the March issue of the AAII (American Association of Individual Investors) Journal carries an article entitled, “Lessons Learned from Many Years of Investing,” by H. Bradlee Perry. For 62 years Mr. Perry has managed other people’s portfolios and, more recently, served as an investment consultant.

The lessons he writes about are valuable:

• Act on what you know
• Do the math (use financial data—he has two complex charts in his article)
• Learn from history (study economic and investment history)
• Don’t try to be smart, just use plain common sense
• Pay close attention to stock valuations (in the context of stock picking)

He concludes that investing is fascinating and enjoyable if you follow his advice. You should find enjoyment and financial rewards, as he has.

What Mr. Perry fails to mention (know) is that his lessons should lead him, and his clients, to index investing. We know from math and history that index or passive investing produces superior yields. That result is common in the objective literature, and I’ve written about it in this blog (click on “Investment, Finance” category in the right-hand column of this blog’s home page to call up the posts).

Once you study the literature, it’s just plain common sense; and it does away with the need to pay close attention to individual stock valuations. Having spent 62 years in the investment business, Mr. Perry must know about passive investing, yet he doesn’t mention it.

Traditional passive investing with market-capitalization weighted index funds isn’t the only successful strategy. Lots of people have made money in other ways. And there are caveats to the passive investment approach, if a reader wants to dig, read and learn about investing. But plain vanilla index investing is still the Honda Accord or Toyota Camry of investing: a great reliable ride at reasonable costs. Actually, index investing offers a great ride at very low costs.

As I read his article, with no mention of index investing, I’m forced to infer that we have a good example of an unknown known.

Second, yesterday in an online, Wall Street Journal article, Jonathan Clements argues that index funds not only produce higher total returns than most actively managed mutual funds, “[t]hey also make more money for investors (based on dollar-weighted returns).” (parentheses added) Those two ideas aren’t the same.

My son brought the article to my attention.

Mr. Clements sets up the distinction this way: “Suppose a fund finished the year where it began, for a 0% total return, but during the year its share price rose sharply and then fell. If investors poured money into the fund after the sharp price gain, the average shareholder would have lost money, despite the fund’s 0% total return.”

Morningstar, an investment research firm, studied this distinction and concluded that index investors make more money than active fund investors—index investors are less likely move in and out of the market with short-term strategies, which often lose money.

Why do index investors behave more sensibly? Mr. Clements asks.

He dismisses the idea that index investors are smarter, and settles instead on the conclusion that they have more conviction.

I think conviction—a firmly held belief—is the wrong idea. Both types of investors may hold their investing beliefs firmly.

A better conclusion is this: index investors have more applied intelligence. That might be defined as the ability to see an idea, assess its power, and adapt one’s behavior accordingly.

In other words, index investors aren’t trapped in unknown knowns.