The Ordinary Investor

“Each man sees himself in the Grand Canyon,” wrote Carl Sandburg, in Good Morning, America (New York, Harcourt, Brace, 1928).

The image of the individual lifting himself up by his own bootstraps is at the core of the American identity. In investing as in life, the temptation to fashion oneself after this image can be problematic. Technological advances make the expanding array of investment choices seem increasingly attainable. Wall Street’s policymaking influence all but ensures the ordinary investor will continue to face increasingly complex ways to invest his savings.

The confluence of these macro trends – technological change and broadened ordinary investor access to financial products and services – can be a good thing. Prudent do-it-yourself investing can reduce the costs of financial intermediation. However, there is a critical difference between the approach best suited for the professional vis-à-vis the ordinary investor.

Yale Endowment chief investment officer David Swensen articulates this distinction in the University fund’s 2013 annual report. While the “Yale Model” approach came into some criticism for how it performed during the crisis, Swensen’s long-term performance record and public position on topics like mutual fund fees have earned him a reputation as an elite professional investor with a conscience. The advice Swensen has for the ordinary investor is:

“The most important distinction in the investment world … divides those investors with the ability to make high-quality active management decisions from those investors without active management expertise…No middle ground exists. Low-cost passive strategies suit the overwhelming number of individual and institutional^[1] investors without the time, resources, and ability to make high-quality active management decisions.” (p. 15, under the heading, “Institutions versus Individuals”)

Swensen’s message is that unless an investor has the time, resources, skills and expertise to actively manage the investing process (e.g., by researching industries, markets, asset prices, and selecting stocks or hiring stock-pickers, and monitoring, measuring and managing key investment risks), that investor is better off using diversified low-cost index funds to achieve his financial goals.

The challenge is twofold, the first being that technology may be reinforcing the “boot strap” image by misleading the ordinary investor into a false sense of control over the direction of asset prices. The second is that Wall Street plays to the image of the “boot strap” investor as a means of accessing additional investable assets. “Own Your Tomorrow,” implores a recent brokerage firm ad campaign, the implication being that the ordinary investor best take charge of his financial life by actively trading stocks. Recent Wall Street lobbying efforts include (among other fronts in the war on regulation) a push to grant ordinary investors access through their retirement accounts to private equity deals and hedge funds (“alternative assets”).

Unfortunately, the interests of the ordinary investor, and Wall Street’s interests, are in conflict. Famed investor Warren Buffett, among the world’s richest individuals, and Chairman of Berkshire Hathaway, puts it this way in his 2013 annual letter to shareholders (see p. 20 for the following quotes):

“[B]oth individuals and institutions will constantly be urged to be active by those who profit from giving advice^[2] or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.”

Buffett’s advice to the non-professional, or as only Buffett in his inimitable tone can say without alienating readers, the “know-nothing” investor “who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.”

Buffett reveals that his will instructs his wife’s trustee to “Put 10% of the cash in short-term government bonds and 90% in a very low cost S&P 500 Index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

Of course, the ordinary investor’s stock allocation should reflect to his risk tolerance, time horizon, resources, and needs, so Buffett’s trust fund allocation is not fit for all. Buffett’s message remains clear, however. The ordinary investor should invest his savings with an eye toward simplicity, diversify, and keep costs to a practical minimum.

Truth told, elite investors like Swensen and Buffett benefit when ordinary investors succumb to the Street’s siren calls, as trading volume provides professional investors the liquidity needed to execute transactions. Swensen and Buffett stand among the few elite professionals advising the ordinary investor to resist the temptation to transact. They do so in the ordinary investor’s, not their best interests.

Consciously or not, mental images about who he is, and where he is going, drive the ordinary investor’s behavior. Taken together the historical evidence and expert opinion invoke a humble image, one that implores the ordinary investor to recognize his limitations and plan accordingly.