the overwhelming number of individual and institutional investors without the time, resources, and ability to make high-quality decisions. The framework of the Yale model applies to only a small number of investors with the resources and temperament to pursue the grail of risk-adjusted excess returns.13
One of the biggest problems for individual investors just starting out is that they try to pursue the grail of earning higher returns with lower risks without the proper understanding of how hard it truly is to obtain. They assume that they need to use the most sophisticated investment strategies to succeed in the markets. On the flipside of that coin, those that are at the top of their game and have used the most complex approaches always seem to offer simple solutions to individual investors. In essence, they are saying, “Do as I say, not as I do.” In a way, it takes an understanding of complexity to see the beauty in simplicity. This is a painful lesson for individuals to learn on their own, which is why it's preferable to let someone else pay the tuition for you. Learn from them and try not to make the same mistakes or understand why they advise you to think and act a certain way when investing.
The middle ground that Swensen describes is a place that many investors often find themselves stuck in. They want to try to beat the market by using sophisticated strategies, but they don't have the resources or knowhow to do it. In this case, trying to be above-average leads to below-average performance. Trying too hard becomes a weight around your neck. There's no shame in admitting that truly extraordinary market performance, such as Swensen's, is difficult to achieve. What hurts most investors is trying to be extraordinary in the markets, without the correct understanding that it's a game suited for a small number of investors.
The middle ground isn't reserved just for individual investors either. It's also littered with institutional investors that don't have the same resources or expertise as Yale. Table 1.1 shows the performance numbers over varying time horizons for Yale's Endowment Fund along with the numbers for one of their peers, Harvard, and the record for all endowment funds set against a simple 60/40 stock/bond benchmark. These numbers show how extraordinary Swensen's long-term results have been over a multidecade time horizon – phenomenal, in fact. Harvard, one of Yale's biggest rivals, has also shown the ability to deliver above average long-term returns, as well. Now look at the results of all endowment funds in this institutional investment universe. When compared to a 60/40 portfolio made up of two simple index funds the results look nearly identical. They basically matched a balanced fund's performance over every period, not something most novice investors would expect.14
Table 1.1 Endowment Fund Annual Performance Comparison
Source: Vanguard.
Not only is it difficult for the average individual investor to come close to matching David Swensen's return figures, but even his peers in the institutional investment community have a hard time coming anywhere near his performance. In fact, most have a hard time beating one of the simplest portfolios you can create for nearly nothing in fees today. Swensen himself is an advocate for passive funds; as he says, “Certainly, the game of active management entices players to enter, offering the often false hope of excess returns. Perhaps those few smart enough to recognize that passive strategies provide a superior alternative believe themselves to be smart enough to beat the market. In any event, deviations from benchmark returns represent an important source of portfolio risk.”15 This comes from a guy who has beat the market handily over the past two and a half decades. Sometimes it takes the perspective from someone that utilizes a complex approach to portfolio management to recognize the beauty of simplicity for everyone else without the same resources at their disposal.
Yale is definitely the Michael Jordan of the institutional investing world. (I guess that makes Harvard the Kobe Bryant?) It's a pipe dream to think individual investors can match their success. But look at the results of the rest of these multimillion- and billion-dollar portfolios: A simple 60/40 mix of stock and bond index funds that merely matches the returns of the market is right there over every single time frame. It's not out of the realm of possibilities for the average investor to hang with professional investment offices, assuming they have the required patience, discipline, and long-term perspective.
To match or even beat the performance of institutional investors, the individual has to think differently. You can't try to beat Wall Street at its own game. In this case, a very simple portfolio pulled in nearly the same performance with much less work involved and a far simpler strategy. Obviously, not all institutional investors can outperform the market. There will always be winners and losers.
Yet just think about all the work that goes into the returns for the institutional investors. Each large fund has a fulltime staff that can range in size from a few trained professionals to more than a couple thousand at the largest pension funds. There are also third-party consultants and back-office employees. The fulltime staffs that run these funds are constantly researching and analyzing the markets for investment opportunities. Although information access is becoming more widespread, annual budgets allow institutional investors to pay top dollar for the best research and market-data providers.
On the flipside, individual investors are on their own more often than not. If you don't work in the industry, you probably have a fulltime job or family to worry about. You can't track the markets or perform research on a daily basis. Even though your investments are extremely important to your future well-being, you have to live your life and likely don't have the time or interest to follow the markets as closely as the pros. As individuals, we are much more emotionally invested in our portfolios because it's our money. It's not other people's money that we're managing. No one's ever going to care more about your money that you. Your investment portfolio really contains your goals and desires.
We're All Human
One of the biggest mistakes investors make is letting their emotions get in the way of making intelligent investment decisions. Research shows individuals sell winning stocks and hold on to losing stocks. They chase past performance and make decisions with the herd, buying more stocks after a huge run-up in price and selling after a market crash.16 These errors cost investors a lot of money when compounded over very long time horizons.
Even with all of the advantages outlined in the previous section, professional investors are not immune from making these same exact mistakes. Researchers looked at a dataset of more than 80,000 annual observations of institutional accounts from 1984 through 2007. These funds collectively managed trillions of dollars in assets. The study looked at the buy and sell decisions among stocks, bonds, and externally hired investment managers. The researchers found that the investments that were sold far outperformed the investments that were purchased. Instead of systematically buying low and selling high, these professional pools of money bought high and sold low. We often hear of individual investors buying and selling mutual funds at the wrong times (we'll get to that later), but this study shows that professional investors practice this same type of money-destroying behavior. In fact, the authors of the study figured that these poor decisions caused this group of investors to lose more than $170 billion.17
Another study looked at large pension plans. These funds had an average size of $10 billion each, but they also made the mistake of chasing past performance. Nearly 600 funds were studied from 1990 to 2011. The authors of the study found that these sophisticated funds allowed their stock allocation to drift higher when the markets were rising in the bull market of the late 1990s, making them overweight to their target asset allocation percentages. So when the market crashed they held more stocks than their policies and risk controls suggested. And following the financial crisis in 2008, these funds were far underweight in their target equity allocations and kept them low. These pension funds didn't factor in reversion to the mean.
David Swensen, “The Yale Endowment: 2013,” http://investments.yale.edu/images/documents/Yale_Endowment_13.pdf.
Brad Barber and Terrance Odean,
Scott D. Stewart, John J. Neumann, Christopher R. Knittel, & Jeffrey Heisler, “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors,”
