Opportunity Costs Matter

Includes: BAM, BND, BRK.A, BRK.B, L, VT
by: Anthony Grossi

Yes, you can beat the market, but is it worth your time? Investors who consider the value of their labor and opportunity costs when calculating returns on investment may find that beating the market doesn't pay as much as they had hoped.

There is a widely read case study by the hedge fund AQR entitled, "Buffett's Alpha" that simply states that combining a low beta portfolio with leverage could replicate Warren Buffett's outperformance. The case study also revealed that over the 20 year period from 1991 to 2011 Mr. Buffett outperformed the S&P index by 2.4% annualized.

This begs an obvious question: if the greatest investor of all time can only produce a few extra percentage points of total return over a decades long time horizon using leverage, why bother?

Let's not fool ourselves here. Those small percentage advantages add up to huge sums of money over time, especially if you are managing millions or billions of dollars of mostly other people's money. But most of us aren't managing large portfolios, we're managing our own money for retirement. What's the true cost of active versus passive management for a middle class or working class investor?

Take a moment to consider the following hypothetical. Assuming that we start with a $5,000 IRA contribution at the age of 25 and invest an additional $5,000 per year until retirement at the overly optimistic age of 55, how much additional earnings would Warren Buffett earn over the index? At the end of the 30 year period, the index investor earning 6% annually would have a portfolio valued at $449,071.04 while the active investor earning 8.5% would have the significantly larger sum of $753,357.55.

That additional $300,000 is a lot of money to the average worker, but what did that outperformance cost? Assuming that ([A)) you are the equal of Warren Buffett and that (B) you only worked 10 hours a week, 50 weeks a year, for 30 years managing your portfolio, then one can conclude that your investing acumen is valued at $20 an hour ($300,000 divided by 15,000 hours). Which is a very fine wage, certainly on a par with many college educated professionals.

So let's examine our assumptions. The second assumption is actually plausible. It is very likely that you will spend a lot of time up front learning about investing principles and securities analysis and then require less hours to maintain that knowledge base and review holdings as the years drag on. Obviously Mr. Buffett has spent more than 10 hours per week working on this stuff, but hey, we can replicate those returns working less than part-time.

The first assumption, of course, is the worrisome one. Consider our hypothetical IRA, if your performance slips just one percent to 7.5% your outperformance diminishes by half, bringing your hourly wage as an investor down to $10 per hour. At an annualized return of 7% a year versus our assumption of a passive 6% a year, your value added as a money manager diminishes to just $6.66 per hour. We've gone from college educated professional to working for less than minimum wage, and we're still assuming that we can defy the odds and beat the market.

There are a lot of highly intelligent, motivated people actively managing funds and picking individual stocks as a full-time profession. According to the most recent SPIVA scorecard, fund managers as a group do not outperform passive market indices in any asset class. It is equally unlikely that individual investors will outperform working less than full-time. It is far more likely that you are closer to the average than you are to being Warren Buffett. How do you "know" that you will outperform the market? What demonstrative method do you have to justify your confidence?

Therefore, accept the premise that Warren Buffett is an outlier. The time consuming quest of seeking alpha is a sign of hubris. It is a mathematical certainty that the average investor will achieve average results, and that most of us are average. Furthermore, the value of added returns earned by individual active investors are likely to be modest amounts for people with normal middle-class sized savings accounts relative to the time invested. Given the probability of sustained outperformance, it is a poor risk to reward scenario for the overwhelming majority of people.

This doesn't mean there is no value in active management or owning individual stocks or funds. Berkshire Hathaway (NYSE:BRK.B) is an obvious place to start. Specifically, small companies and companies that are not part of the popular indices are places where one may realistically outsmart the market. I happen to think that the market is currently pricing investment holding corporations like Brookfield Asset Management (NYSE:BAM) and conglomerate businesses like Loew's (L) at attractive discounts.

But would I bet my retirement account on it? Index funds should be the core of everyone's long term portfolio strategy, and active stock selections should only be added after that core position is funded. It is the opportunity cost, all those other things you could be doing with your time other than researching and studying markets that makes index investing the clear choice for investors.

My advice for retirement planning: your $5,000 per year IRA contribution should go towards a global balanced index portfolio, like the DFA global 60/40 or popular Vanguard ETFs like (NYSEARCA:VT) and (NYSEARCA:BND). The lower cost the better. Anything you are able to contribute to savings above that $5,000 threshold is when you should start considering individual stocks and active management strategies. This way you can truly have the best of both worlds while handicapping your odds of beating the market.

Also, this strategy has the added feature of distributing most of your active investment decisions towards your later years, meaning you will have far more experience and competence in investing when you make those decisions. Unlike the conventional wisdom propagated by the financial services industry, I do not believe that young investors should take on more risk or greater equity expose. Actually, when you are young and have time and the law of compounding on your side is when you should be conservative. When you are older, the time value of money may dictate that you need to reach out on the risk curve.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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