In a Fortune.com article, ‘Warren Buffett Warns of ‘Casino-Like’ Investor Behaviour’, the authors highlight Buffett’s concerns about the rise of impulsive, risk-driven trading in today’s commission-free environment, warning that this “casino-like” behaviour could lead to hidden costs for investors.
The rise of commission-free trading and low-cost ETFs has dramatically transformed the landscape of investing. While these innovations have enabled retail investors to enter the market more easily, they have also introduced new, less visible costs. These costs, tied to increased risk, may be just as harmful as the fees that once dominated the investment world.
The article discusses John Bogle, founder of Vanguard, who championed the “Cost Matters Hypothesis” (CMH). The CMH emphasised active portfolio returns must equal the market’s overall return minus fees. This approach drove many investors toward low-cost, diversified index funds. However, with trading and investment fees nearly eliminated today, Bogle’s hypothesis has less sway over investor behaviour, leaving many to take on higher risks without considering the full consequences.
Understanding the hidden risk in ‘free’ trading
As commission-free trading has grown, so has the tendency for retail investors to engage in frequent, often high-risk trades. According to the Fortune article, the stock market tempts many individuals to treat it like a fast-paced casino, disregarding long-term strategies. The authors of the article posted a paper in December 2023, ‘Sharpe’s Arithmetic and the Risk Matters Hypothesis,’ which explores William Sharpe’s 1991 paper ‘The Arithmetic of Active Management’ and present a corollary, the “Risk matters hypothesis” (RMH). The RMH suggests that the average risk level across all active portfolios surpasses the risk of the overall market portfolio.
This increased risk means that investors holding concentrated stock positions are likely to experience lower returns relative to the risks they take. Diversified index funds, by contrast, tend to offer a more favourable balance between risk and reward, yet many traders overlook this crucial distinction. The article states, ‘The return-to-risk ratio is very important because taking risk is the price we pay for the promise of higher returns.’
Warren Buffett’s warning on market speculation
Warren Buffett has observed the shift in investor behaviour with concern. “Markets now exhibit far more casino-like behaviour than they did when I was young,” he noted, cautioning that this mentality has invaded people’s homes, tempting them to make impulsive decisions. The surge in stock options trading, especially high-risk zero-day-to-expiration options, and the rise of trading platforms that promote day-trading as entertainment, provide evidence of the “casino-fication” of the market. The article suggests that the ‘glorification’ of day trading and online trading platforms is almost indistinguishable from online gambling sites.
Leveraged and options-based ETFs have also gained traction, drawing vast amounts of capital from retail investors. However, these products often require professional traders to take opposing positions, increasing overall market risk. It is crucial to note that not all participants can beat the market, and those who stray from diversification often take on the highest risk for minimal rewards.
In the current investment environment, the real cost for active investors isn’t fees. It’s risk. Portfolios with additional risk exposure tend to perform worse on a risk-adjusted basis. The Fortune article says, in fact, a portfolio with just 4% extra risk could be as costly, in terms of risk-reward ratio, as paying a 1% fee.
Thus, in a world where fees have nearly vanished, the price of active investing has shifted towards the risk that comes with straying from market norms.
The double downside for retail investors
For retail investors, taking on more risk has a compounded downside. The professional trading firms that take the opposite side of their bets are also taking on more risk. To justify this risk, these firms must earn higher returns: returns that, unfortunately, often come from the pockets of retail investors. This creates a double bind: active traders take on more risk, but instead of gaining extra returns, they often end up with less, as other market players capitalise on their moves.
The allure of “free” trades may be strong, but the reality is that investors face significant risks when they deviate from broad market diversification. For most, the best strategy may still be to focus on low-cost, diversified index funds, which offer a balanced and reliable approach to long-term investing.
For further insights, read the original Fortune article by Victor Haghani, James White and Vladimir Ragulin here.
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