Occam’s – How Are You Different From the Average Investor?
People are a lot like snowflakes. If you don’t look all that closely, we’re all roughly similar. But the closer you start looking, the more different we are. We all have our own unique situations and experiences, and these drive who we are.
This also describes who we are as investors. We can make big, broad, statements about the market – and by extension investors as a group – but every investor is slightly different. In the past, we have talked about how getting the “average” return is actually rare. It’s the same thing with investors. We can very precisely describe the average investor (it’s the market!), but that person doesn’t really exist, and can’t exist. Everyone is different from the average investor in a multitude of ways. Some of these differences are profound, and some are trivial. But they’re always there, and they drive how your investment portfolio should be built.
But just like with snowflakes, there are similarities amidst the differences. Unique doesn’t mean unique. We can still talk meaningfully about large groups of investors, and we can use those commonalities to figure out how our portfolios should differ from the “average investor’s” portfolio.
So what does the average investor’s portfolio, or the market, look like?
What Does the Market Look Like?
Well, it’s probably a little different than you expect.
When we typically think about “the market,” we generally think about the publicly traded stocks out there. And this is true, as far as it goes. Buying every stock out there does do a pretty good job of covering the stock market. But before we dig too much deeper, it’s worth calling out that the stock market is a global construct. We all intellectually know that the economy and the financial system stretch across the world, but we’re so used to hearing about the S&P 500 Index, or even worse, the Dow, that we’ve internalized the market as being in the United States. The rest of the world is often this other ephemeral thing.
But that’s not what’s actually going on. The US may be the world’s largest economy, but that doesn’t mean that we can afford to ignore the rest of the world. In fact, if you look at the value of the global stock market, it’s roughly 50/50 between the US and the rest of the world. And this has actually been remarkably consistent through time – especially given just how volatile the stock market is.
But even more fundamentally, thinking about the market as the stock market leaves out the vast bulk of the financial market. It leaves out the Bond market. And the bond market is where the real action is. It’s roughly twice the size of the global stock market. The stock market may be flashy, but the bond market is where the average investor has roughly 2/3 of their money invested.
When we think about building portfolios, we start with the market. The market is the most efficient portfolio available. But efficiency isn’t the whole story. We are not the average investor; we have our own particular situation, and are exposed to our own particular set of risks, so we shouldn’t (necessarily) have the average portfolio. Our portfolios need to account for our unique circumstances, so building a portfolio is a continuous process of thinking about how our portfolio should deviate from the market.
So, let’s walk through what some of those changes might be and why you might want to make them. For our purposes, I’m going to make some assumptions. I’m going to assume that you live in the US, do the vast majority of your spending in the US and in US dollars, and that you’re investing for retirement income either as someone saving for retirement or as someone already in retirement. I’m also going to go out on a limb and assume that you are an actual person with a finite lifespan (though I guess that’s implied by the retirement part). From these basic statements, there are all sorts of ways that you are substantially different from the average investor. Now let’s start pulling things apart and looking at what these differences imply for how you should design your investment portfolio.
Let’s get more concrete on some of the specific ways that you, as a completely real person living in the US and thinking about retirement, are going to be different from the market. We’ll touch on four specific areas, but these are just the beginning of the ways that you are different from the market.
The Magic of Diversification
We can start with the most fundamental difference, and work from there…and it’s a doozy. The average investor is a theoretical construct. You, presumably, are not. You have certain things that you want to do (retire), and you are exposed to certain risks because of this. The average investor is also exposed to those risks, but also every other risk as well. Because the financial markets include pretty much everyone from all over the globe (however minutely), all of their risks come to bear on the average investor. In effect, everything cancels out, except for the direct risk of the financial market. Put another way, your idiosyncratic risks are diversified away, and only those risks that everyone faces are left in the market.
To take an extreme example, consider, well, your life. One of the most important unknowns in financial planning is how long you will live. We have ways of estimating how long we’ll live, but they are far from exact. We all have that great uncle who drinks like a fish and smokes like a chimney, and will definitely live until they are 110. But there are a ton of insurance companies who are desperate to sell you lifetime annuities. Why is that? How can they know how to price those annuities without going bankrupt?
Well, it may be difficult to figure out how long an individual person will live, but if you get a big enough group of people together, we can make pretty good estimates of what that group’s mortality curve will look like. We might not be able to say when specific people from that group will pass away, but we can make decent enough guesses as to how many of them will die in a given year. However morbid it is, that big group has effectively diversified the risk from the uncertainty of how long they’ll live.
This is great for the market as a whole, but it does leave individuals with a bit of a problem. We’re still exposed to these idiosyncratic risks – and we need to figure out how to deal with them. It also means that our conception of risk is fundamentally different from the average investors’ conception of risk. Because of the magic of diversification, the average investor only cares about market risk at the global level. But we, as retirement focused investors, care about more than just market risk. We care about being able to fund the retirement that we are planning for. This is (probably) going to be closely related to the performance of the market, but it’s not necessarily the same thing.
One of the specific ways this manifests is with regards to something called sequence of returns risk. The average investor doesn’t particularly care which order market returns come in: abc is the same as cba. But we care about the order that these returns come in. Because we constantly have money going in and out of our investment portfolio (savings while you are working, and spending during retirement), the returns we get right around retirement have an outsized impact on what our retirement is going to look like. If the market is doing well during our early retirement, we’ve got a pretty solid leg up. If we’re retiring into a down market, we might be in for a little bit of a rougher ride than we expected.
Even leaving aside the risk tolerance question (which we’ll touch on in a second), it may be advisable to take into account where you are relative to retirement when you are deciding what your portfolio should look like. By reducing your risk (and potential return) right around retirement, you are minimizing the chance that bad market returns will significantly hurt your retirement (say hi to everyone who retired in 2007). This also limits the potential upside as well – just like bad returns are “extra” bad around retirement, good returns are “extra” good – but for most people, having to reduce their planned standard of living hurts more than how good an increase in their standard of living feels.
This brings us to another one of the big differences between you and the average investor: your time horizon. The average investor is a philosophical construct that will be around for time immemorial, but they also care deeply about what is going to happen in the next day, week, month, quarter, or year. The market can have a very short-term perspective, which retirement investors don’t (necessarily) share, because we have a fixed(ish) time horizon that spans decades . This allows you some flexibility that the average investor doesn’t give themselves.
And we can take advantage of this by tilting our portfolios towards things that will pay off in the long run, but which could lose money in the short term. The market really worries about that short-term loss, but, while it’s never fun to lose money, most retirement investors are able to weather some down years.
And we see this pretty obviously in how retirement focused investors position their portfolios compared to the average investor. The average investor’s portfolio is roughly two thirds bonds and one third stocks. This would be a very conservative retirement portfolio. The “standard” retirement portfolio of 60% stock and 40% bond is basically the inverse of the market weights.
The story is a little bit more complicated than simply time horizon – not least because some of those bonds in the market portfolio are actually backing reliable income sources and reserve assets that you might be holding – but the point still stands. You most likely have a much longer-term perspective than the market , and this gives you the flexibility to focus on the longer-term possibilities of your portfolio.
As someone who is retiring, you are likely pretty concerned about inflation risk. And with good reason. Over time things get more expensive, meaning the money that you have saved is worth less than it was in the past. Inflation can take a big bite out of your spending power if you aren’t paying attention. And, because of the mix of goods they purchase (most notably spending on health care), retirees tend to be uniquely exposed to inflation risk.
There are a couple of ways to tilt your portfolio away from the market to mitigate your inflation risk. The first, and most common (even if you don’t know you’re doing it), is to overweight stocks. Stocks are great, if noisy, inflation hedges. And they likely already represent the majority of your portfolio.
Another common way to deal with inflation risk is short-term bond funds . Because the bonds in the fund are constantly rolling over, they are always bringing new bonds into the fund. These new bonds are bringing in all sorts of new information – including information about inflation.
But the most direct way of handling inflation risk is with TIPS (Treasury Inflation Protected Securities). These are, well, bonds from the Treasury that are explicitly inflation protected. If inflation goes up, they pay out more.
Another area where you are different from the average investor is that you live in the US, and primarily buy and sell things with US Dollars. This means that you are more exposed to the US economy than the average investor is. This doesn’t mean that you should not be exposed to the global market, but it does mean that you probably want to tilt your portfolio towards the US.
But here’s the thing. Most people’s portfolios are wildly tilted towards their home country. One of the most striking examples of this comes from a paper looking at home bias in Australia. The paper is a little bit old, but gets at how strongly many people prefer to keep their money “at home.” In 2005, Australia represented a little bit less than 2% of the global stock market. Now, I’ve already primed you that there’s a crazy amount of home bias going on here, but how much do of their portfolios do you think Australian investors kept in Australian stocks? 20% A third? 50%?
In 2005 Australian investors invested more than 80% of their money in Australian companies. To put it mildly, this was nuts.
But it’s not just crazy Australians here. Everyone prefers to invest at home with different levels of home bias, and different definitions of “home”. For instance, Europeans tend to overweight Europe as a whole within their portfolio, but within the category of Europe, they don’t tend to hugely overweight their home country.
In the US, thankfully we’re not as bad as the Australians, but that’s probably more a function of the fact that we can’t overweight US stocks as much as Australians overweight Australian stocks.
But again, you probably do want to tilt your portfolio towards the US to some degree. You want exposure to the global market, but you also want to tie your investment portfolio to the economy that you are most exposed to. But it’s important not to tilt so far you slide off the size.
There’s No Perfect Answer
The average investor doesn’t exist. It can make sense to customize your portfolio and tilt away from the market portfolio based on your particular situation, but it is important to remember that for all the ways that you are different from the average investor, the market portfolio is a good portfolio. And the portfolio that you actually put into practice is infinitely better than the one you keep tinkering with in your spreadsheet until it’s perfect. The truth is there is no perfect portfolio. There’s too much noise in the system, and everything simply changes too rapidly to pinpoint what your portfolio “should” look like. We can make big statements, but we can’t know what the “right” portfolio was until after the fact.
You want to find something that feels right, and that will help you stay disciplined. We know that over the course of your retirement the market will have some ugly periods. And you need to feel comfortable with your investment portfolio, and more broadly your retirement income plan, to stick with it.
You’re not looking perfection. You’re looking for a portfolio that works.
McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.
The information throughout this presentation, whether stock quotes, charts, articles, or any other statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission there of to the user. MAMC only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. It does not provide tax, legal, or accounting advice. The information contained in this presentation does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before making any decisions.