23 February 2010

Retail Investing

A "retail investor" is anyone who is not a professional investor or money manager.  If you have money that you can afford to leave invested for a time in assets that are more risky than a bank savings account, then you can expect for that money to earn more for you than it would at an FDIC insured bank's risk-free interest rate.

A generation ago market investing and portfolio construction was considered a skilled art best left to professionals.
  1. There was an erroneous (and now thoroughly debunked) belief that professional "active" mutual fund managers could deliver better performance than one could get by "passively" tracking the market overall.  Active fund managers still charge annual fees ranging from 1-3% (and even more!).  On average, investors in their funds end up under-performing the associated market by exactly the amount of those fees.
  2. The theory behind optimal portfolio construction was not well developed, so most individual investors paid an investment advisor to allocate their money to try to match their risk tolerance and personal financial goals.
Market investing today is easier, more transparent, or more efficient than ever.
  1. A number of large investment companies, led by Vanguard,* offer low- or zero-cost "passive" funds that allow investors to assemble a diverse portfolio that matches the returns of market indices.
  2. The fundamentals of portfolio construction are also mainstream.  Plenty of companies and websites offer questionnaires and calculators to help individuals find a mix of asset classes that are appropriate for their particular risk tolerance.
Using retail investment tools any individual can, with minimal expense, put together a diverse portfolio of financial securities that performs as well as portfolios compiled by professionals.  

Lamentably, the investment advisory industry has been slow adapt to these changes.  I find many individual investors still paying financial advisors or asset management companies anywhere from .5% to 1.5% per year of investable money to compile an efficient and diversified portfolio.  I disapprove of such businesses for several reasons:
  1. Advisory expenses do not significantly increase with the amount of assets under management, so they should not charge a fee that is a function of assets under management.
  2. Money managers cannot reliably increase risk-adjusted returns through active allocation, so they should not charge a fee that is a function of assets under management. (You will, of course, continue to see managers who advertise their record of “beating the market.” The problem is that nobody can predict ahead of time which managers will outperform their benchmark. Just because someone did it for ten years doesn’t mean they’ll do it for an eleventh. There is ample evidence that, on average, active managers underperform their benchmarks — by an amount roughly equal to the average they charge in fees. Cut out the middleman and keep the fees for yourself!)

* Why I prefer mutual funds from VanguardVanguard is a true mutual company, meaning that it is owned by its customers.  This means that it faces no conflicts of interest with the investors in its funds.  For example, Vanguard funds have been known to turn away large institutional investors with characteristics that could negatively impact the profit of its existing retail investors.  The eminent professional investor David Swensen, who managed Yale's endowment for a number of years, aptly elaborated:
[T]here’s an irreconcilable conflict in the mutual fund industry between the profit motive and fiduciary responsibility. There are two major organizations, Vanguard and TIAA-CREF, which operate on a not-for-profit basis. That conflict between profit and fiduciary duty disappears. Vanguard and TIAA-CREF are dedicated to serving their investors. They are shining beacons in this otherwise ugly morass.

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