Can you imagine a world where people who followed a few simple guidelines about diet and exercise but never visited doctors had health outcomes as good as those who do see doctors? Can you imagine a world in which wonderful music might come from people who played instruments but had little musical knowledge, training or experience?
In both cases, it would be a world in which specialized knowledge and practice did not improve outcomes. Such a world would be strange. We are so accustomed to believing that specialized knowledge and practice improve performance that it’s extremely difficult to understand a world in which that may not be true.
Now imagine an investor who buys a large, representative sample of common stocks and bonds, then simply holds them for years, never reading company financial statements and seldom consulting investment professionals. Can you believe that her investments will do better than a neighbor who invests similarly but under the guidance of professionals? Although this too may seem a strange outcome, it happens most of the time.
In medicine and music, performance isn’t random. It yields to specialized knowledge and disciplined practice. But with stocks, prices are mostly random in the short-run (days to a few years). That means that short-term price behavior can’t be predicted. No one really knows which stocks will rise or fall more than others or whether the entire market is poised to hold steady, soar or collapse. Therefore, it makes little sense to pay large fees to someone who promises to keep you and your portfolio abreast of market trends.
Over long periods of time, however, stock prices tend to rise and bond interest accumulates. The difference between short- and long-run price behavior gives rise to the classic buy-and-hold recommendation. Further, the unpredictability of individual stock behavior gives rise to the idea of buying a large, representative sample of securities that will mimic the entire market.
Wealth management firms like Merrill Edge, whose study we wrote about last week, along with many others will argue that their expertise produces real benefits for clients who entrust their money to those firms and advisers. That expertise is demonstrated daily on television’s financial channels, which offer endless chatter about arcane topics. Wealth management people understand and participate in that chatter.
Professional wealth management firms have a natural edge in gathering clients because it’s so difficult to accept randomness in financial markets when it is rare in other markets. We are led to believe that a lone person without all that specialized knowledge can not compete.
Yet author after author of academic studies and investment books produce data pointing to the superiority of buying and holding a large, diversified portfolio of investments. If investors pick large representative samples of stocks and bonds, perhaps through index funds, their investments will usually perform better than if they had professional management. After all, professional managers must be paid. Investors who can muster the confidence to go-it-alone save those fees and thereby achieve better long-run returns.
A Positive Course
Last week’s writing prompted me to see the mass affluent (people having between $50,000 and $250,000 of investments) as more vulnerable than before. With five years of slow economic growth, people in the United States have experienced declining incomes, declining net worths (and home values), sagging employment prospects and reduced or jeopardized pensions. We may also have a “lost generation” of young people who aren’t able to get started and may be passed by if growth resumes. The middle class seems more on its own at a time when its income and wealth have declined.
In a series of earlier blog posts, I offered a positive approach for investors to achieve good returns at low costs and thereby beat most of the professionally managed retirement accounts of peers:
- First, for retirees who use their investments for retirement income, I recommended a 4% withdrawal rate from a simple balanced portfolio.
- Then readers saw that the approach worked using only one stock index fund and one bond index fund, and that it worked better with a more broadly diversified stock fund. Investing with two mutual funds is about as simple as it gets.
- Next, readers learned to broaden their asset classes to include real estate and international stocks. These broadened the portfolio to four funds.
- I described some benefits of rebalancing a portfolio periodically—keeping specified proportions of the different investments.
- Readers worked through an example, year-by-year, of a model retiree who used the approach for the last eleven years, a period thought to be one of the most challenging since World War II.
- We compared passive investing with active investing, estimated the costs of active investing, and discussed some of the ethical problems and special arrangements attending active investing.
Perhaps one essential point that needs amplification is this: how can amateur investors gain the confidence to take charge? That’s a good topic for future discussion.
So where does all this leave mass affluent investors? It’s good that many families are taking greater interest and charge of their financial lives, and it’s good that Merrill Edge is aiming to serve those clients. But for retirees with confidence, the low-cost, passive investing approach is as close to a sure bet as they can get.