Fool's Eye View

[ July 11, 2000 ]

It's Great To Be Dumb

By Maynard Paton (TMFMayn)

Carburton Street, London -- Imagine this. You're just starting out on the investment trail. You've got some savings that are currently receiving a paltry rate of interest. You've never owned any shares before. But you've heard about the superior long-term investment returns that can be had from equities. You've also read articles that report something along the lines of "had you put £1,000 into Miracle.com in 1996, you'd now be worth £1m". And you now fancy a slice of the investment action.

So what's the best way forward, in terms of moving from the building society to the stock market?

In situation like this, it always pays to listen to those people who've "been there, done that". But that doesn't include following those who dream up the Sunday newspaper share tips or ramp their underperforming penny shares on various bulletin boards. Oh no.

A billionnaire's observations

When it comes to good, sound investment advice from a reliable source, there is perhaps no better person to listen to than Warren Buffett. After 40-odd years of investing, the US investor has accumulated around $30b solely through stock market investment. He should know a thing or two about getting started.

Buffett, the Chairman of Berkshire Hathaway (NYSE: BRK.A), was asked at his company's recent AGM about the advice he would give to investors before they jumped into the stock market for the first time.

Buffett answered the query by referring back to his mentor Ben Graham and that basic question addressed in Graham's book, The Intelligent Investor. In the book, Graham divided stock market investors firmly into two camps -- the passive investor and the aggressive investor. The first decision any prospective investor has to make is to choose which camp, initially, to join. The preparation for the two is completely different.

Decisions, decisions

The passive investor simply wants the exposure to the long-term returns from equities, but doesn't yet have the time, knowledge or inclination to pick out the shares for an individual purchase. Here, the low-cost index tracker is the investor's first and last stop, as Buffett explained:

"Once you decide on this strategy, there is no reason to read the Wall Street Journal or listen to CNBC. The passive investor simply says: 'I'll ride along on the economy and keep the frictional costs to a minimum'. That is the best way to invest if you don't bring anything to the (investing) game. If you are not willing to spend hours and hours at the weekend looking at annual reports, learn accounting, do all that sort of thing, the best way to play the game is to be passive. You are a fool to do anything else."

"Most people fit the passive investor category. They have a job. They have other interests. If they make this decision, it is very simple. They just decide how much a month or year they are going to be able to put in. And they don't try and fool around with it over time, because they don't know enough to fool around in an appropriate manner."

Outperformance

The aggressive investor brings some effort to the investing table. Here, the investor will use their "ability" to try and pick individual companies that will outperform the stock market in the future. However, as perhaps most readers will be aware, consistently beating the stock market over time requires considerable talent and skill. Over the long-term, 90% of all fund managers will underperform the stock market. And if they, with all their professional resources and information to hand, can't beat the market, then what chance does the normal man in the street have? The performance of our longest-running "active" portfolio, the Qualiport, shows the perils that could lie in store for the would-be aggressive investor.

Buffett warns of the daunting tasks ahead for those who are considering embarking on stock market outperformance:

"You should understand accounting very, very well, and that is not easy. You have to learn the nuances of it. You have to learn what the numbers mean and what they don't mean. Then you have to learn a lot about a few industries. You should read lots of trade publications, that sort of thing. You have to create a circle of competence in which you can operate."

"All that means you have to understand what you are buying. It means understanding the business in the same way as if you went out and bought a McDonalds (NYSE: MCD) franchise, a filling station or a dry cleaning establishment. You have to understand the business, or you are not going to do well over time."

"That requires effort. Nobody is going to tell you how to be an above average investor by following them day after day. It just isn't that easy. You have to do it yourself. I've never read anything by somebody else telling you how to do something. Financial advice isn't worth anything."

Arrogance

In my book, the greatest decision any novice investor can make is the low-cost index tracker. It's the investment no-brainer. There's no need to swot up on accountancy, no need to continually "watch the market", no need to consider the merits of particular industries and no need to get bogged down in tedious company comparisons. All in all, the performance-to-effort ratio for the passive investor is much greater than for most aggressive investors.

In fact, with passive investors likely to outperform those who spend time and money pouring over investment research, it begs the question "Why do people bother trying to outperform?" Simply, it's just human nature.

I can do no better than point readers to Whitney Tilson, a guest writer for the US Fool, for a full explanation of this phenomenon. In these features, Whitney describes the arrogance of the typical stock picker and the perils of investor overconfidence.

Whitney comments: "I understand why people don't invest in index funds -- it's natural to want to do better than average. But the refusal to accept average performance causes most people to suffer below-average results, after all costs are considered. I encourage you to invest in individual stocks, but only if you're willing to take the time and effort to do so properly."

And so Buffett gets the final word: "By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

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Where Next?

Have a question on Index Trackers? Then click here for answers to some frequently asked questions, or visit the index tracker discussion board.

Or read Whitney Tilson describing the arrogance of stock picking and the danger of investor overconfidence.

Finally, click here to discover how Warren Buffett has run rings around the stock market.