William J. Bernstein
The Probability of Success
(Or, Confessions of a Personal-Finance Writer)
Having spent nearly a decade writing about investment management for the little guy, I have come to the conclusion that I no longer believe in the basic premise of my public personaóa surreal cross between Harry Markowitz and Johnny Appleseed, as a friend put it.
A decade ago, I really did believe that the average investor could do it himself. After all, the flesh was willing, the vehicles were available, and the math wasnít that hard.
I was wrong. Having emailed and spoken to thousands of investors over the years, Iíve come to the sad conclusion that only a tiny minority, at most one percent, are capable of pulling it off. Heck, if Helen Young Hayes, Robert Sanborn, Julian Robertson, and the nationís largest pension funds canít get it right, what chance does John Q. Investor have?
Why the sad state of affairs? Itís pretty simple. To invest competently, you need four faculties:
An interest in investing. Itís no different from cooking, gardening, or parenting. If you donít enjoy it, youíll do a lousy job. Most people enjoy finance about as much as Carmela Soprano enjoys her husbandís concept of marital fidelity.
The horsepower to do the math. As Scott Burns explained to me years ago, fractions are a stretch for 90% of the population. The Discounted Dividend Model, or at least the Gordon Equation? Geometric versus arithmetic return? Standard deviation? Correlation, for Godís sake? Fuggedaboudit!
The knowledge baseóFama, French, Malkiel, Thaler, Bogle, Shilleróall seven decades of evidence-based finance back to Cowles. Plus, the "database" itselfóa working knowledge of financial history, from the South Sea Bubble to Yahoo!
The emotional discipline to execute faithfully, come hell, high water, or Bob Prechter. Mr. Bogle makes it sound almost easy: "Stay the course." Alas, it is not.
I expect no more than 10% of the population passes muster on each of the above points. The devastating part is, to succeed you need to string all four together. Thus, in a state of nature, just 0.01% of investors have what it takes. An optimist might guess a 30% success rate on each count, in which case one percent of the population can make all four.
Perhaps I overstate the case. After all, these four abilities are not entirely independent: if youíre smart enough, itís more likely youíll be interested in finance and be driven to delve into the appropriate finance literature. But even if true, more than a little luck is involved. Head down to the personal-finance section of your local Barnes and Noble, and youíre more likely to run into Suze Orman than Jack Bogle. Youíll need a telescope to find the really important stuff. Worse, Iím here to tell you that the last conditionóthe ability to deploy what Charley Ellis calls "the emotional game"óis completely independent of the other three. I wish I had a nickel for every smart, savvy, and motivated financial type Iíve met who simply could not execute.
There are exceptions. Come to a Vanguard Diehards meeting and youíll think there is hope. Then travel a few feet down the hall where the gurus of the month are holding forth and youíre quickly brought back to reality.
Call Me Vladimir Illych
In my opinion, about the only way to disseminate financial competency among more than a few percent of the population would involve totalitarian methodsóestablishing an Efficient Markets Propaganda Ministry. Investment reeducation camps would be set up for the likes of Jim Glassman, Abby Cohen, and the Beardstown Ladies, featuring several hours per day of remedial math and statistics.
Short of that, the Forces of Darkness will remain ascendant. It cannot be any other way. In a society with an increasingly abbreviated attention span and burgeoning innumeracy, the logic of asset-class-based passive investing has about as much appeal as the vegetarian buffet at a cattlemanís convention. There is no place for CNBC and 95% of the nationís financial journalists in the World According to Bogle.
Of course, Iím not recommending the establishment of efficient-market martial law, administered with an iron fist from Valley Forge, Chicago, and Santa Monica. Rather, Iím pointing out that in a liberal democracy, the overwhelming majority of the population will always invest incompetently. Our society pays many costs for our precious civil liberties; this is surely one of the smaller ones.
The good news is that this increases the rewards to those who make the effort. After all, in a world where everyone knows how to calculate realistic expected returns, eschews high expenses, and trades little (and then only concavely), the marginal reward for doing so is low.
The main purpose of this exposition is not to consider how we can increase aggregate investor competence. This is a process so glacially slow that the grim reaper easily outruns it. Take a look around after every bubble and youíll find that the only investors left reasonably intact have gray hair.
Rather, I want to focus debate on just who should be running the nationís investment pools. An overriding concern for public safety mandates that those commanding the nationís airliners, nuclear power plants, and military hardware obtain and maintain a precisely defined degree of competence. We should demand no less of those managing the countryís retirement portfolios. The events of the past few years underline the bankruptcy of the notion that every worker can be his or her own portfolio manager. The default option for retirement accounts should be a professionally managed low-cost balanced approach, preferably passive. Only those who can demonstrate competence in evidence-based finance should be licensed to drive their retirement vehicles on the public highways of our capital markets.
Copyright © 2003, William J. Bernstein. All rights reserved.
The right to download, store and/or output any material on this Web site is granted for viewing use only. Material may not be reproduced in any form without the express written permission of William J. Bernstein. Reproduction or editing by any means, mechanical or electronic, in whole or in part, without the express written permission of William J. Bernstein is strictly prohibited. Please read the disclaimer.