According to a study by hedge fund firm AQR, Warren Buffett's stock portfolio, estimated from Berkshire Hathaway's BRK.B quarterly filings, beat the U.S. stock market by about 2.4% annualized from 1991 to 2011. Among large-cap U.S. equity mutual funds sold south of the border, the highest-returning over that period, Calamos Growth, beat the S&P 500 by about 4.5% annualized. Here in Canada, none of the 16 mutual funds in the U.S. Equity category that were around for that long beat the Canadian-dollar version of the index.
Even if you are very good -- among the best -- you can reasonably expect only a few percentage points of extra return over decades-long spans in a highly competitive market like U.S. large-cap equities.
Why, then, do investors spend so much effort trying to be clever, neglecting the fundamentals? Keeping bonds in tax-sheltered accounts likely adds more value than trying to find the next Apple . The all-consuming quest for alpha is a symptom of overconfidence. More specifically, it is a failure to stay within one's "circle of competence."
I believe this is a big reason many investors fail to achieve their investment goals. Most investors stray outside their circles. I did it myself when I first started investing. I bought shares of Bank of America without even knowing how to intelligently analyze financial statements and the competitive dynamics of the banking industry. I had no business picking individual stocks then, and I have no business picking them now. There are a lot of incredibly smart people picking individual stocks full-time, and they say it's hard. I believe them. I'd feel presumptuous thinking I can do it better with a less-than-full-time effort.
This is not to say you shouldn't own individual stocks or bonds. If you have good reason to believe you have an edge, or if you can afford to lose the money, go for it. But I certainly wouldn't plan my retirement on my ability to outsmart the market. What are your advantages? Most investors don't have many. I can think of two sustainable ones:
1) You're not constantly being measured against a benchmark, which frees you to pursue long-term opportunities.
2) You have a small capital base (relative to professional money managers) which opens up less-liquid, more lucrative opportunities.
These edges will always exist, even though everybody knows about them. Professional investors will always control the majority of assets, and they will always be measured quarter by quarter. The pros often can't be patient enough to ride out bubbles and swoop in to buy during terrifying times like the financial crisis. Good investors almost by definition compound assets quickly, and other investors like to give them their money to manage, so good investors' capital bases tend to outgrow small, illiquid opportunities. There's hope for the brave and clever individual investor. Unfortunately, it looks like most individuals don't exploit their advantages.
After surveying the available literature on individual skill, I don't think there's enough data to know with confidence the percentage of skilled individual investors. Considering how few professional investors beat their benchmarks over the long run, I reckon skilled individual investors are even rarer -- below 5% of the population. Warren Buffett thinks this figure is below 1%.
I believe if you are realistic, you will have a pessimistic view of your own skill, even if you've had years of success. AQR founder Cliff Asness said, "Seriously, anyone, quant or not, with a shred of intellectual honesty recognizes that there is some chance their historical success is just luck." Because overconfidence is so pervasive, I think most investors should ponder how they "know" they can beat the market. I wrestled with this question, and I found it helpful to first assume I knew nothing.
From ignorance
What kind of strategy should an investor with no idea about his own skill pursue? A good case can be made for choosing to make the worst-case scenario as harmless as possible.
With this goal in mind, the first concern for the investor behind the veil of ignorance should be to minimize the chance of being exploited. We've all seen how celebrities and athletes attract swindlers who do a much better job transferring client assets to themselves than managing money. It happens to individual investors, too, though on a petty scale. A few precautions can mitigate this risk: 1) avoid commission-based salespeople; 2) don't buy opaque, complicated, illiquid investments; and 3) deal with people (and firms) with reputations to protect.
Now you can turn to mitigating worst-case market risk, which can be defined as substantially earning below-average returns. An investor can guarantee an above-average return by owning the market-weighted portfolio at a low cost. What does this portfolio look like? A recent study estimates the total world market portfolio as of the end of 2011 was about 55% fixed income, 35% equities and 10% alternatives. Because most alternatives -- hedge funds, private equity and so forth -- repackage equity risk, the portfolio can be approximated by a 50/50 stock-bond allocation. A good know-nothing portfolio, taking into account liquidity, availability and cost, would simply be a 50/50 split between Vanguard Total World Stock Index ETF VT and Vanguard Total Bond Market ETF BND .
Besides guaranteeing above-average returns, the market portfolio has another attractive trait. During bull markets, investors convince themselves they're really in it for the long run, so they overweight equities. When the inevitable bear market arrives, they pull their money out in a panic, permanently harming their intrinsic wealth. The 50/50 portfolio's low volatility reduces the risk of perverse market-timing.
Deviating from the know-nothing, market-weighted portfolio means either 1) you're different from the average investor (due to tax circumstances, investment availability, personal traits and so on); or 2) you think you know more than the market. The former is perfectly fine; the latter is a tough game to play. Every investor should understand this distinction.
To knowledge
The best investors talk about being keenly aware of what they know and don't know. Mediocre or dishonest investors pretend they know. Bad investors don't even know they don't know. I propose that we strive toward becoming more like Warren Buffett and Ray Dalio and less like the pundits in the media.
To that end, I have several pieces of advice:
1) Avoid having individual securities make up a big portion of your retirement fund unless you are very confident in them or locked in with lots of unrealized capital gains (unless you're in a tax-sheltered account, of course).
2) Markets are highly random. Be skeptical of people who discount this fact or admit no fallibility.
3) Keep expenses of all kinds razor-thin. In a world where Warren Buffett's stock portfolio beats the market by 2.4%, you should think twice about paying more than 1% in fees.
4) A good active manager or process can produce bad outcomes, and a bad manager or process can produce good outcomes--for years on end. You can't really tell whether someone's good or bad simply by his short-term performance. Judge process over outcome. If you can't judge the process, then you should probably avoid the strategy.
Why, then, do investors spend so much effort trying to be clever, neglecting the fundamentals? Keeping bonds in tax-sheltered accounts likely adds more value than trying to find the next Apple . The all-consuming quest for alpha is a symptom of overconfidence. More specifically, it is a failure to stay within one's "circle of competence."
I believe this is a big reason many investors fail to achieve their investment goals. Most investors stray outside their circles. I did it myself when I first started investing. I bought shares of Bank of America without even knowing how to intelligently analyze financial statements and the competitive dynamics of the banking industry. I had no business picking individual stocks then, and I have no business picking them now. There are a lot of incredibly smart people picking individual stocks full-time, and they say it's hard. I believe them. I'd feel presumptuous thinking I can do it better with a less-than-full-time effort.
This is not to say you shouldn't own individual stocks or bonds. If you have good reason to believe you have an edge, or if you can afford to lose the money, go for it. But I certainly wouldn't plan my retirement on my ability to outsmart the market. What are your advantages? Most investors don't have many. I can think of two sustainable ones:
1) You're not constantly being measured against a benchmark, which frees you to pursue long-term opportunities.
2) You have a small capital base (relative to professional money managers) which opens up less-liquid, more lucrative opportunities.
These edges will always exist, even though everybody knows about them. Professional investors will always control the majority of assets, and they will always be measured quarter by quarter. The pros often can't be patient enough to ride out bubbles and swoop in to buy during terrifying times like the financial crisis. Good investors almost by definition compound assets quickly, and other investors like to give them their money to manage, so good investors' capital bases tend to outgrow small, illiquid opportunities. There's hope for the brave and clever individual investor. Unfortunately, it looks like most individuals don't exploit their advantages.
After surveying the available literature on individual skill, I don't think there's enough data to know with confidence the percentage of skilled individual investors. Considering how few professional investors beat their benchmarks over the long run, I reckon skilled individual investors are even rarer -- below 5% of the population. Warren Buffett thinks this figure is below 1%.
I believe if you are realistic, you will have a pessimistic view of your own skill, even if you've had years of success. AQR founder Cliff Asness said, "Seriously, anyone, quant or not, with a shred of intellectual honesty recognizes that there is some chance their historical success is just luck." Because overconfidence is so pervasive, I think most investors should ponder how they "know" they can beat the market. I wrestled with this question, and I found it helpful to first assume I knew nothing.
From ignorance
What kind of strategy should an investor with no idea about his own skill pursue? A good case can be made for choosing to make the worst-case scenario as harmless as possible.
With this goal in mind, the first concern for the investor behind the veil of ignorance should be to minimize the chance of being exploited. We've all seen how celebrities and athletes attract swindlers who do a much better job transferring client assets to themselves than managing money. It happens to individual investors, too, though on a petty scale. A few precautions can mitigate this risk: 1) avoid commission-based salespeople; 2) don't buy opaque, complicated, illiquid investments; and 3) deal with people (and firms) with reputations to protect.
Now you can turn to mitigating worst-case market risk, which can be defined as substantially earning below-average returns. An investor can guarantee an above-average return by owning the market-weighted portfolio at a low cost. What does this portfolio look like? A recent study estimates the total world market portfolio as of the end of 2011 was about 55% fixed income, 35% equities and 10% alternatives. Because most alternatives -- hedge funds, private equity and so forth -- repackage equity risk, the portfolio can be approximated by a 50/50 stock-bond allocation. A good know-nothing portfolio, taking into account liquidity, availability and cost, would simply be a 50/50 split between Vanguard Total World Stock Index ETF VT and Vanguard Total Bond Market ETF BND .
Besides guaranteeing above-average returns, the market portfolio has another attractive trait. During bull markets, investors convince themselves they're really in it for the long run, so they overweight equities. When the inevitable bear market arrives, they pull their money out in a panic, permanently harming their intrinsic wealth. The 50/50 portfolio's low volatility reduces the risk of perverse market-timing.
Deviating from the know-nothing, market-weighted portfolio means either 1) you're different from the average investor (due to tax circumstances, investment availability, personal traits and so on); or 2) you think you know more than the market. The former is perfectly fine; the latter is a tough game to play. Every investor should understand this distinction.
To knowledge
The best investors talk about being keenly aware of what they know and don't know. Mediocre or dishonest investors pretend they know. Bad investors don't even know they don't know. I propose that we strive toward becoming more like Warren Buffett and Ray Dalio and less like the pundits in the media.
To that end, I have several pieces of advice:
1) Avoid having individual securities make up a big portion of your retirement fund unless you are very confident in them or locked in with lots of unrealized capital gains (unless you're in a tax-sheltered account, of course).
2) Markets are highly random. Be skeptical of people who discount this fact or admit no fallibility.
3) Keep expenses of all kinds razor-thin. In a world where Warren Buffett's stock portfolio beats the market by 2.4%, you should think twice about paying more than 1% in fees.
4) A good active manager or process can produce bad outcomes, and a bad manager or process can produce good outcomes--for years on end. You can't really tell whether someone's good or bad simply by his short-term performance. Judge process over outcome. If you can't judge the process, then you should probably avoid the strategy.
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