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By Samuel Lee

According to a study by hedge fund firm AQR, Warren Buffett’s stock portfolio, estimated from Berkshire Hathaway's (NYSE:BRK.B) quarterly 13F filings, beat the market by about 2.4% annualized from 1991 to 2011. The highest-returning large-cap U.S. equity mutual fund over the period, Calamos Growth (CVGRX), beat the S&P 500 by about 4.5% annualized. Even if you are very good—among the best—you can reasonably expect only a few percentage points of extra return over decades-long spans in a highly competitive market like U.S. large-cap equities.

Why, then, do investors spend so much effort trying to be clever, neglecting the fundamentals? Keeping bonds in tax-sheltered accounts likely adds more value than trying to find the next Apple (NASDAQ:AAPL). The all-consuming quest for alpha is a symptom of overconfidence. More specifically, it is a failure to stay within one’s "circle of competence."

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I believe this is a big reason many investors fail to achieve their investment goals. Most investors stray outside their circles. I did it myself when I first started investing. I bought shares of Bank of America (NYSE:BAC) without even knowing how to intelligently analyze financial statements and the competitive dynamics of the banking industry. I had no business picking individual stocks then, and I have no business picking them now. I confess I own shares of Berkshire Hathaway (BRK.B), but it’s practically a closed-end fund—and I’m in it only with “fun money,” not my retirement funds. There are a lot of incredibly smart people picking individual stocks full-time, and they say it’s hard. I believe them. I’d feel presumptuous thinking I can do it better with a less-than-full-time effort.

Finding Your Circle of Competence
“Above all, I guess you’d say we have a strong sense of our own limitations.” —Warren Buffett

This is not to say you shouldn’t own individual stocks or bonds. If you have good reason to believe you have an edge or if it’s fun money, go for it. But I certainly wouldn’t plan my retirement on my ability to outsmart the market. What are your advantages? Most investors don’t have many. I can think of two sustainable ones:

1) Not being constantly measured against a benchmark, freeing the investor to pursue long-term opportunities.

2) A small capital base, opening up less-liquid, more lucrative opportunities.

These edges will always exist, even though everybody knows about them. Professional investors will always control the majority of assets, and they will always be measured quarter by quarter. The pros can’t act as “patient” capital, which can ride out bubbles and swoop in to buy during terrifying times like the financial crisis. Good investors almost by definition compound assets quickly, and other investors like to give them their money to manage, so good investors’ capital bases tend to outgrow small, illiquid opportunities. There’s hope for the brave and clever individual investor. Unfortunately, studies suggest most individuals do not exploit their advantages.

Researchers Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean looked for skill in all day-trading Taiwanese investors from 1992 to 2006. In an average year, 1,000 traders out of 360,000 could predictably outperform after fees, meaning they showed convincing evidence of skill. Barber et al. write, “To our knowledge, we provide the only study of individual investor performance that documents that savvy investors are able to cover a reasonable estimate of trading costs.”

Of course, most individual investors are not day traders, so we can’t conclude only 0.3% of individual investors are skilled. In addition, Taiwan charges a steep 0.3% tax on all sales, driving up day traders’ costs; the number of skilled investors before fees is likely much higher. Then again, the Taiwanese stock market may be less efficient than that of the U.S., making it easier for individuals to outperform.

After surveying the available literature on individual skill, I don’t think there’s enough data to know with confidence the percentage of skilled individual investors. Considering how few professional investors beat their benchmarks over the long run, I reckon skilled individual investors are even rarer—below 5% of the population. Warren Buffett thinks this figure is below 1%.

I believe if you are realistic, you will have a pessimistic view of your own skill, even if you’ve had years of success. AQR founder Cliff Asness said, "Seriously, anyone, quant or not, with a shred of intellectual honesty recognizes that there is some chance their historical success is just luck." Because overconfidence is so pervasive, I think most investors should ponder how they "know" they can beat the market. I wrestled with this question, and I found it helpful to first assume I knew nothing.

From Ignorance
Philosopher John Rawls is famous for the following thought experiment: A group must agree upon the kind of society they want to live in. The caveat is they are behind a “veil of ignorance,” meaning they don’t know the abilities, preferences, and other endowments they’ll possess in the society. How would they go about it? Rawls argued risk-aversion and self-interest would lead them to choose to make the worst-off person as best-off as possible. Similarly, what kind of strategy should an investor with no idea about his own skill pursue? A good case can be made for choosing to make the worst-case scenario as harmless as possible.

With this goal in mind, the first concern for the investor behind the veil of ignorance should be to minimize the chance of being exploited. We've all seen how celebrities and athletes attract swindlers who do a much better job transferring client assets to themselves than managing money. It happens to individual investors, too, though on a petty scale. A few precautions can mitigate this risk: 1) avoid commission-based salespeople; 2) don’t buy opaque, complicated, illiquid investments; and 3) deal with people (and firms) with reputations to protect.

Now the investor can turn to mitigating worst-case market risk. One way to define it is substantially earning below-average returns. An investor can guarantee an above-average return by owning the market-weighted portfolio at a low cost. What does this portfolio look like? A recent study estimates the total world market portfolio as of the end of 2011 was about 55% fixed income, 35% equities, and 10% alternatives. Because most alternatives—hedge funds, private equity, and so forth—repackage equity risk, the portfolio can be approximated by a 50/50 stock-bond allocation. A good know-nothing portfolio, taking into account liquidity, availability, and cost, would simply be a 50/50 split between Vanguard Total World Stock Index ETF (NYSEARCA:VT) and Vanguard Total Bond Market ETF (NYSEARCA:BND).

Besides guaranteeing above-average returns, the market portfolio has another attractive trait. During bull markets, investors convince themselves they’re really in it for the long run, so they overweight equities. When the inevitable bear market arrives, they pull their money out in a panic, permanently harming their intrinsic wealth. The 50/50 portfolio’s low volatility reduces the risk of perverse market-timing.

Deviating from the know-nothing, market-weighted portfolio means either 1) you’re different from the average investor (due to tax circumstances, investment availability, personal traits, and so on); or 2) you think you know more than the market. The former is perfectly fine; the latter is a tough game to play. Every investor should understand this distinction.

To Knowledge
The best investors talk about being keenly aware of what they know and don’t know. Mediocre or dishonest investors pretend they know. Bad investors don’t even know they don’t know. I propose that we strive toward becoming more like Warren Buffett and Ray Dalio and less like the pundits on CNBC.

To that end, I have several pieces of advice:

1) Avoid having individual securities make up a big portion of your retirement fund unless you are very confident in them or locked in with lots of unrealized capital gains (unless you're in a tax-sheltered account, of course).

2) Markets are highly random. Be skeptical of people who discount this fact or admit no fallibility.

3) Keep expenses of all kinds razor-thin. In a world where Warren Buffett’s stock portfolio beats the market by 2.4%, you should think twice about paying more than 1% in fees.

4) A good active manager or process can produce bad outcomes, and a bad manager or process can produce good outcomes--for years on end. You can’t really tell whether someone’s good or bad simply by his short-term performance.
Judge process over outcome. If you can't judge the process, then you should probably avoid the strategy.

Summed up: Assume your circle of competence is small, and invest in a way such that even if it turns out you’ve strayed out of your circle of competence, it won’t hurt you.

A version of this article originally appeared in the December 2012 issue of Morningstar ETFInvestor.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Finding Your Circle Of Competence