It is, of course, irritating that extra care in thinking is not all good but actually introduces extra error. But most good things have undesired “side effects,” and thinking is no exception. The best defense is that of the best physicists, who systematically criticize themselves to an extreme degree, using a mindset described by Nobel laureate Richard Feynman as follows: “The first principle is that you must not fool yourself and you’re the easiest person to fool.”
But suppose that an abnormally realistic foundation, thinking like Feynman, fears a poor future investment outcome because it is unwilling to assume that its unleveraged equities, after deducting all investment costs, will outperform equity indexes, merely because the foundation has adopted the approach of becoming a “fund of funds” with much investment turnover and layers of consultants that consider themselves above average. What are this fearful foundation’s options as it seeks improved prospects? There are at least three modern choices:
• The foundation can both dispense with its consultants and reduce its investment
turnover as it changes to indexed investment in equities.
• The foundation can follow the example of Berkshire Hathaway, and thus get total
annual croupier costs below 0.1 percent of principal per annum, by investing with
virtually total passivity in a very few much-admired domestic corporations. And there is no reason why some outside advice can’t be used in this process. All the fee payer has to do is suitably control the high talent in investment counseling organizations so that the servant becomes the useful tool of its master, instead of serving itself under the perverse incentives of a sort of mad hatter’s tea party.
• The foundation can supplement unleveraged investment in marketable equities with investment in limited partnerships that do some combination of the following:
Unleveraged investment in high-tech corporations in their infancy, leveraged investments in corporate buy-outs, leveraged relative value trades in equities, and leveraged convergence trades and other exotic trades in all kinds of securities and derivatives.
For the obvious reasons given by purveyors of indexed equities, I think choice #1,
indexing, is a wiser choice for the average foundation than what it is now doing in
unleveraged equity investment. And particularly so as its present total croupier costs exceed 1 percent of principal per annum. Indexing can’t work well forever if almost everybody turns to it. But it will work alright for a long time.