I’m often asked to provide investment advice. My advice is hardly revolutionary. It has been repeated by many others (e.g. John C. Bogle) yet is consistently ignored: passive index investing is the way to go. My goal in this article is to change this behavior for at least some people. I plan to do this by (1) laying out my own version of the advice, (2) providing the rationale for this advice, (3) pointing out behavioral reasons why people do not follow the advice, and (4) providing some tangible ways you can prevent yourself from falling into the trap of not following this advice. In my view the last piece is critical because it is a fundamental reasons why asset allocations are so poor.
Before I go any further, my disclaimer: I am not a licensed financial adviser and I am providing this write-up for informational purposes only as an expression of my opinions and views. Any investment actions you take as a result of reading this article are solely your responsibility. If it works out, feel free to thank me later. In case it does not work out, I take no responsibility. If you do not agree to that, then do not read any further.
For most individual investors, I recommend a diversified asset allocation consisting of low-cost index funds. Factors to consider when making this allocation are your investment horizon, risk tolerance, and desire for simplicity. Let me briefly define the 5 key terms I have used:
It is extremely difficult to beat the markets consistently and most managers cannot do it. Given the difficulty, “good” managers charge high fees. This means they must perform even better to outperform the market net of fees. As a result, I believe there are only a handful of people in the world that are capable of consistently beating the markets – and very few of them are likely to be reading this post. You may not believe me, but if you think you can beat the markets (or know someone who can), you are not only playing against the odds you are also likely on the wrong end of bias about your own abilities (more about this below).
So you are left with a choice. You can either play the market and pay 0.25% in fees or you can try to beat the market (the expected value vs the market here is zero since for every winner there is a loser) and pay 1.00% in fees. This means that not only do you need to be a winner in your picks, you also need to consistently win big so you can overcome the extra fees.
This is where people tell me all sorts of things that they think matter (they don’t really matter, trust me):
So why does none of this matter?
There are behavioral impediments that obfuscate the difficulty of consistently beat markets in the long run. First and foremost is the overconfidence effect, which indicates that we are more confident in our ability to accomplish something than is warranted. Second, we attribute excessive weight to past performance because we fail to consider the likelihood of the manager’s performance being random. In other words, if I told you that I flipped a coin heads 5 times in a row, that might be impressive if I only threw the coin 5 or 6 times total. It would not be impressive, however, if I told you I flipped it 500 times. Not knowing “how many coins were tossed,” is a manifestation of survivorship bias. Survivorship bias is the idea that we do not know how many money managers attempted to match your managers track record and failed. Third, we tend to focus on what is sexy and cool, which in the investing world often means equities. For this reason, the equity markets are among the largest, most liquid, and efficient markets in the world – meaning they’re harder to beat. Other markets are far simpler to beat (the currency markets, as an example, includes many players who are not profit-maximizing). That’s not to say that beating the currency markets is easy, it isn’t. I digress…
If you do not think you can beat markets, the low-cost index fund strategy is a great way to go. If you do think you can beat markets, you are probably wrong, but you can give it a try (consider your negative expected value the price you pay for the fun of spending your time looking at stock screens, reading 10-Ks or reading credentials of potential financial advisers.)
If you’re an active investment decision-maker, be sure to check out ways to mitigate destructive cognitive biases for investors.
Overcoming these cognitive biases is difficult, but I have found these tangible actions and thought exercises have helped me come to grips with the fact that I will not beat the markets (I do what I described above for 90% of my asset allocation. The other 10% is for fun.)
I do not mean to offend anyone by telling them they cannot beat the markets. While it is likely true, I could be wrong in any individual case. The main argument is that with a well-structured plan of saving from a young age, merely following the market passively is easy (very little work) and will provide a very reasonable nest egg for retirement. Trying to beat the markets is time-consuming and likely to fail, so I’m very content with the table stakes.