Warren Buffett warns of ‘casino-like’ investor behavior. Here’s the hidden cost of ‘free’ investing
The landscape of investing has undergone a seismic shift, with the advent of commission-free trading and low-cost ETFs. While this has empowered retail investors, it has also introduced new challenges. Fees have been significantly reduced, but investors now face less visible but equally harmful costs associated with increased risk.
Vanguard founder John Bogle's "cost matters hypothesis" (CMH) was based on the mathematical truth that the sum of all active portfolios equals the market portfolio. From this it follows that the average return on all active portfolios must equal the market return, minus the fees charged by active investment managers. This may have been the single most powerful argument driving the relentless growth of indexing over the past 30 years. However, now that trading and investment fees have gotten close to zero, the CMH has lost its power to direct investors toward low cost, diversified index investing.
Risk matters
From discussions with family, friends, and online investor forums, we’ve noticed it’s become much harder to convince people to avoid frenetic trading of their personal accounts now that trading appears to be “free.” As we scratched our heads over this problem, we realized that the logic underlying Bogle’s CMH applies with equal force in the dimension of risk.
We recently published a paper that puts forward the "risk matters hypothesis" (RMH), a corollary to Bogle’s CMH. The RMH asserts that the average risk across all active portfolios is greater than the risk of the market portfolio. It cautions investors with concentrated stock portfolios that—in aggregate—they must suffer a lower return-to-risk ratio (a.k.a. Sharpe ratio) than they’d get from a broadly diversified index fund. It was an idea we couldn’t find in any personal finance books or textbooks—which surprised us given its significance and simplicity.
The return-to-risk ratio is very important because taking risk is the price we pay for the promise of higher returns. Investors should seek the portfolio with the highest return-to-risk ratio possible, to get as much expected return as they can for a given amount of risk.
Buffett’s warning
In today's "free" investing world, many in the finance industry seem bent on distracting investors from this goal. Investors who have not (yet) embraced broad market indexing are being encouraged to trade more actively and take more risk. As Warren Buffett observed, “markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.”