The purpose of this book is to give you the information you need to be your own investment manager. The first edition was written in 2008, as the global financial crisis was unfolding, and published in early 2009. Subsequently, I wrote and published Other People’s Money (Profile and Public Affairs, 2015) which analyses the process of financialisation which culminated in that crisis, and puts forward a programme of reform.
This comprehensively revised and updated version of The Long and the Short of It is a natural companion to Other People’s Money. The critique of the finance sector developed in Other People’s Money raises two questions; what should be done to protect the public interest? What should I do to protect my own interests? The concluding chapters of Other People’s Money attempt to answer the first of these questions. The Long and the Short of It attempts to answer the second. In one respect, my task here is easier. To reform the financial sector, we need to persuade politicians, regulators and the public. To reform your financial affairs, the only person I need to persuade is you.
In this book, I’ll describe the investment options available, and the institutions that will try to sell them to you, I’ll explain the principles of sound investment, and introduce you to the research that supports these principles. Sound investment is based on the returns from productive assets, and in a modern economy these are mostly owned by companies. So I’ll describe how businesses succeed, and fail, in generating value for their shareholders, and how to distinguish fact and fiction in what they tell you.
Profitable investment involves risk, and the returns from investment are uncertain. Amateurs and professionals alike are bad at managing investment risks, although for different reasons. I’ll discuss why, explain the theories that try to explain how we assess risks, and the evidence that provides partial, but only partial justification, for these theories. I’ll go on to develop a practical investment strategy for the intelligent investor, based on three fundamental principles – pay less, diversify more, and resist conventional thinking – and give you the specific information you need to implement that strategy.
I’ll describe the sophisticated innovations of the modern financial system. But these innovations led directly to the global financial crisis of 2008. The world that I will describe is complex and sophisticated, but greedy, cynical and self-interested. The only way to cope is to acquire your own knowledge and form your own judgment. You cannot, unfortunately, trust people who offer financial advice. If you can trust me, it is because the only product I am trying to sell you – this book – is one you have already bought. Even so, I need to insert the caveat that I am not offering advice which is specific to your circumstances, that I am not recommending any particular investment or investment product to you, and that I accept to liability whatever for the consequences of your investment decisions. When they work out badly – and some of them will – it will be your fault and when they work out well – and I hope some of them will also – you will certainly take the credit. I will explain that even a decision that works out badly may have been a good decision. But that is not a proposition that ambulance-chasing lawyers, crusading journalists, or politicians wise after the event find easy to accept. So I am not going to offer advice: only suggest how you should make your own decisions.
Most investment books advise you how to trade: I suggest you to trade as little as possible. Most investment books advise you to get to know the mind of the market: I suggest you think for yourself instead. Most investment books take for granted that your search for new investments is a search for stocks that are likely to go up. While I’m certainly not going to dissuade you from that, I suggest you give equal weight to a different question: is this investment different in character from those I already own?
In this book, I shall describe the principles of intelligent investment that lead to these, and other, unconventional conclusions. But you will probably want to begin with a more conventional stance, and I would encourage you to do so. The conventional investor follows the average of what professional investors do. The power of conventional thinking in the City is so pervasive that this is, in reality, what the vast majority of professional investors do themselves. But you can follow that consensus with the aid of publicly available information and the properties of efficient markets. Instead of paying heavily for conventional thinking, you can use conventional thinking for free.
The conventional investor is in awe of those who have a deep understanding of what the market thinks. He should be: he is typically paying enough for the privilege. The education of the conventional investor begins with forming a sceptical view of financial market expertise. The intelligent investor doesn’t care what ‘the market thinks’, save to the extent that its mistakes and irrationalities create opportunities. For the conventional investor, risk is being out of step: for the intelligent investor, risk is losing money.
But it is uncomfortable to be out of step. And the conventional investor will do as well as the average of professional investors, which isn’t bad, and better than the vast majority of retail investors. The strategy I recommend is that you begin as a conventional investor, and as you gain experience and confidence, you devote an increasing fraction of your portfolio to intelligent investment. The intelligent investor has a mind of his or her own, can take a sceptical view of market wisdom, and make his or her own risk evaluation. Such detachment enables the intelligent investor to earn better returns with less risk of loss.
The term intelligent investor originates with Benjamin Graham, who wrote a book with that title. Graham’s modern disciple is Warren Buffett, the most successful investor in history. He has claimed that
‘Observing correctly that the market was frequently efficient, they (the academics – and many investment professionals and corporate managers) went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day’. (Cunningham, quoting Buffett, 2002)
I’ll paraphrase Buffett’s remark by saying that the market’s hypotheses are 80% efficient, but the profits from investment are mostly to be found in the 20% that is not.
There is more to this comment – a lot more – than meets the eye. Your immediate, and understandable, reaction might be to ask ‘tell me about the 20%’. But I want first to raise the more general philosophical issue. What does it mean to say that a theory is 80% true? We’re used to the idea that theories are either true, or false. There isn’t room for theories that are partly true, or mostly true.
But we have to find room. The world of business and finance is comprehensive only with the aid of theories, like market efficiency, which are illuminating but not true. It would be easy to pursue this issue into the philosophy of science, but this is intended to be a practical book. I shall simply make the pragmatic assertion that you cannot be an intelligent investor if you believe either that markets are always efficient or that they are not mostly efficient – if you believe that the efficient market hypothesis is true, or if you believe it is false. The same is true of two other theories – the capital asset pricing model and the approach to risk analysis I describe as ‘subjective expected utility’ – which are central to modern finance theory and to the risk control models widely used in financial institutions.
The 80%/20% hypothesis – that the world of business and finance is best understood with the aid of models that are partly true, partly false, is at the heart of this book. You need to understand both the 80% and the 20%. It is necessary both to be familiar with the ideas of efficient markets and subjective expected utility, and yet not to take either notion too seriously. Intelligent lay people, who approach finance and investment without preconceptions, may find this easier to accept than professionals who have been forced to take one side or another in a debate.
The target reader of this book has to deal with issues of finance and investment because they have been successful in some other, unrelated, activity. These readers expect the same level of intellectual seriousness that they would expect from a book of popular science or popular history, and that is the level at which this book is written.
Many issues of finance and investment are, necessarily, technical, and their explanation involves jargon. I’ve provided at the end of the book a glossary which offers quick definitions of many terms which may be unfamiliar. The jargon is the language of the financial professional. No apology for jargon should be required if the explanation of its meaning needs to be a good deal longer than the word or phrase itself. There is one conspicuous exception to that principle – the use of the term ‘high net worth’ for rich. I hope there is none of the jargon of the management world, in which new terms are coined to conceal emptiness of thought.
But this book is not an academic monograph. I have kept references down to a minimum. I give references to enable the reader to check the sources of claims made. In a final section on bookmarks and bookshelves, I have indicated some books and websites readers can use to pursue issues further. I have not thought it necessary to provide links to the commercial websites of product providers – these are very easy to locate – but I have included details of some useful websites which provide information or comparisons useful to intelligent investors.