The Paradox of Dumb Money

“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
– Warren Buffett, 1993 Berkshire Hathaway Shareholder Letter

Warren doesn’t believe that active management doesn’t work or that beating the market cannot be done. In fact, he believes the opposite – that it can be done. Unfortunately, just not by most people and certainly not by the average person.

By definition, most people cannot be above average – although for a long time most investors did believe that they were, in fact, above average. It appears that they have learned. The “dumb money” has figured out the truth about the game. It is changing it’s behavior and becoming cognizant of what it can and can’t do.

Vanguard has now taken in $2 trillion dollars with a very simple implicit promise – that its funds and vehicles will never “beat the market.” This message is resonating. The movement began as a surrender of sorts: “Forget it, I can’t be bothered with this anymore.” It has morphed into something more confident, more wizened. The stigma of resigning one’s self to hands-off, average returns is almost non-existent now; it would have been unthinkable to investors just fifteen years ago.

This easy-does-it approach’s ascendancy – while virtually every category of actively managed fund exsanguinates month after month –  tells you a lot about the average investor. The average investor is learning.

The average investor, sitting in its dumb money S&P 500 index fund, may be sitting on a 17% return so far this year. By contrast, he quintessential “above average” investor – the hedge fund manager – has an average return of 5.4%. At least this is superior to last year’s average hedge fund return of just 3.5% while the dumb money index earned closer to 16%.

Who’s the dumb money now?

Becoming aware of its own limitations and choosing to direct its energies elsewhere – away from “outperforming” – the average investor is showing itself to be smarter than ever before.

By the way, the ultimate irony of this rush into index products and plain vanilla beta is that excellent opportunities will be created for active managers by the competitive vacuum. Inefficiencies will once again become bountiful in the absence of people looking for them – stockpickers will find themselves alone on the beach, metal detector in hand, once again.

I love this business.