In general, we expect that a beginner or novice in a field is likely to be out-performed by a seasoned veteran. We would be surprised if a beginner could build a better house than a skilled carpenter, or if an amateur boxer could knock out a pro.

Yet, something like this may be true in the investment field. In his book “The Gone Fishing Portfolio” author Alexander Green argues that the average individual investor, even if not trained in investments, should manage his or her own portfolio instead of turning it over to a professional investment manager. The basis for this counter-intuitive advice is twofold: first, since investment management is an extremely competitive industry and the financial markets are highly efficient, the average professional investor is likely to produce net investment returns (i.e., returns after deducting management fees) that fall short of market averages. Second, the financial services industry has produced a great product, the so-called “index fund,” that can come very close to replicating market returns at very low cost. Thus, Green asserts, the typical investor can obtain a greater return (net of fees) by passively investing directly in index funds.

The steps that Green lays out are as follows: first, select a set of asset classes including US and international equities, real estate and various types of bond funds, along with an investment vehicle that represents each class; second, determine appropriate weights for each class (Green’s recommendation is generic); and third, adopt an adjustment or rebalancing strategy. Green’s partly tongue-in-cheek adjustment strategy is to review the portfolio once a year, and conduct trades to move the current allocation back to the target allocation, if necessary. This should take less than one hour, and then you can “go fishing.” If you can follow Green’s simple program, then you should be able to achieve reasonable portfolio returns.

Table 1. Green’s Program (the Investment Vehicles are broadly diversified low-cost Exchange Traded Funds)

 

Asset Class	Investment Vehicle	Allocation
US Value Stocks	VTI	15%
US Small Stocks	VB	15%
European Stocks	VEO	10%
Pacific Rim Stocks	VPL	10%
Emerging Market Stocks	VWO	10%
High Grade Bonds	BND	10%
Inflation-Indexed Bonds	TIP	10%
High Yield Bonds	HYG	10%
Real Estate	VNQ	5%
Gold	GDX	5%

 

Not many individual investors follow the Green approach (less than 20% of retail investor funds are passively invested in index funds), even though it would almost surely improve realized performance. Studies show that actual performance of retail investors falls dramatically short of market returns. For example, Jack Bogle, the founder of Vanguard, shows that retail equity investors have lagged market returns by hundreds of basis points (one hundred basis points is one percent). Over time, this adds up. Bogle’s decomposition of the sources of this massive performance shortfall includes a) high fees and commissions, b) excessive trading, and c) miserable timing (buying at the top and selling at the bottom). It is not certain why individual investors do so poorly on their own, but one possibility is a variety of psychological biases that impair clear thinking. Another factor is that some gullible investors fall prey to hustlers and are sold high-cost inappropriate strategies.

The key step to improving portfolio returns is clear: stop making these mistakes.

Surely professional advisors are aware of the mistakes people make and the reasons for them. A great benefit of hiring a professional may be to keep you from hurting yourself. Another potential source of value added for the professional manager is to tailor a portfolio to your specific risk tolerance and situation. For example, someone employed in a cyclical industry like construction might be well-advised to avoid concentrating his investment portfolio in cyclical stocks. The reason is to avoid a major drop in portfolio value at the same time that his earned income or “human capital” is being impaired. Finally, you may be able to find a manager that provides market beating returns.

To summarize, there is a simple strategy that the novice investor can deploy to realize market-like returns, if he/she has the confidence and interest to implement the strategy. Alternatively, there are a variety of potential benefits accruing to hiring a pro. Which is best for you? I think the answer is: it depends. In subsequent posts we will explore the issues more carefully.