Benjamin Graham makes distinction between two type of investors in his investment classic ‘The Intelligent Investor’;
- the “enterprising” investor who is willing to devote time and energy to continually research, select and monitor a dynamic mix of stocks, bonds or mutual funds, and
- the “defensive” investor who places chief emphasis on avoidance of serious mistakes or losses and aims at creating a portfolio that runs on autopilot and requires no further effort.
Enterprising investing is extremely interesting and rewarding but also takes great amount of time, effort, wisdom and deeper understanding of investing. Defensive investing on the other hand is effective, takes little time and effort but generates little excitement.
It is very important for an investor to understand what kind of investor he really is. If he has a full time job, he may not be able to do enterprising investing; and therefore better off sticking to the sound principles of defensive investing. Most retail investors with superficial understanding of investing, try to do what should only be done by enterprising or professional investors (like direct stock investing, stock trading etc.) and end up doing worse than what can easily be achieved by defensive investing.
It is also important for an investor to have rational return expectations from his investments. While enterprising investors can aim at generating market beating return, non enterprising investors must first learn to get and retain market return.
Getting market return is simple. All one has to do is either invest in index funds or multicap category funds of established fund houses. Most retail investors can do fine in equity investing if they do this but usually they don’t; because they want to invest in the best or highest return generating fund. Investors also expect advisers to find such funds for them when in reality neither investors nor advisers can do that. (Most retail investors find this difficult to digest. In fact one client left me because I told him that I have no ability to pick the highest return generating fund of the future. He said why should he pay me fee if I cannot even find the best fund for him.)
In most cases, retail investors want higher return because they are willing to take higher risk. Investors must understand that the return they should aim at depends more on the amount of intelligent effort they are willing to put themselves, not on the degree of risk they are willing to take.
It is also foolish to think that investment adviser can help investors generate enterprising investor return. Remember, advisers cannot find out the highest return generating fund of the future. They can only save investors from making terrible fund choices. While advisers can increase allocation of midcap and smallcap funds in the portfolio but that is not the most sensible thing to do on part of advisers since it makes portfolio fragile.
There could be advisers in the market who can help investors invest directly in stocks and generate superior returns but it is difficult to find them. Market is full of imposters and half baked advisers making tall claims. Unless one is a good investor himself, he can not distinguish between a good adviser and a bad one. There is high probability of landing with a confident but ignorant adviser having delusions about his own skills in search for a superior one. Such adviser can make investor take foolish risks and put him in a deep hole.
Therefore, no matter how much risk a non enterprising investor is willing to take, he is better off sticking to defensive approach of investing.
Things become a lot simpler when investor understands that he is not an enterprising investor and decides to follow defensive investing instead of chasing return. There are three steps involved in it.
- Understanding underlying principles of defensive investing.
- Developing a process based on these principles.
- Sticking to the process instead of deluding oneself that one can know what markets will do.
Most investors fail at investing because they do not understand basics of sound investing and do not have emotional discipline to follow them.