A wise man once said: “The man who is his own lawyer has a fool for a client.” So is it advisable, or even possible, to be your own investment manager?
DIY law or medicine is unwise. A doctor or lawyer may not always get it right, but their opinions are based on extensive knowledge derived from a rigorous training programme with demanding entry requirements. And the doctor or lawyer will have real concern for your interests, not just his or her own.
Traditionally, financial advisers were neither expert nor disinterested. Regulation has attempted to raise standards of competence and to address commission bias, and has imposed on advisers a requirement to “know your client”. But a bias to activity is intrinsic to the processes of financial advice; few people will pay much to be told to do nothing, even though that is often wise counsel. You do not have to worry about “knowing your customer” if you are your own customer. You need not fear bias in the advice you give yourself.
And the retail investor can benefit from the skills and activities of the thousands of able people who have been attracted to wholesale financial markets by the extraordinary salaries available there. You can be a beneficiary of the efficiency of financial markets — and by the end of this article, you will be ready to begin.
Buying and selling
The efficient market hypothesis is the bedrock of financial economics. The professional expertise of everyone in financial markets is focused on the value of stocks and shares, bonds, currencies and properties, and advising on when to buy and sell. The market is a voting machine in which the opinions of all participants about the prospects of companies, the value of currencies, and the future of interest rates are registered, the result is publicly announced and market prices reflect a consensus of informed opinions. The corollary of the efficient market hypothesis is that the result of the painstaking research of everyone in the City is available to you — for free.
If the efficient market hypothesis were true, then all investment strategies would have the same risk-adjusted return and the DIY investor would do well simply to build a portfolio of index funds in line with the average asset allocation of major institutions. This “conventional investor’s strategy” enables the DIY investor to achieve at modest cost a return in line with that achieved by sophisticated professionals.
The least risky method of improving investment returns is to pay less to the financial services industry.
The least risky method of improving investment returns is to pay less to the financial services industry. With low prospective yields, the compound effect of charges over a saver’s lifetime can be dramatic. If the underlying rate of return on your savings is 5 per cent, £1,000 invested could grow to over £7,000 in 40 years. Even an annual charge of 0.5 per cent would reduce this to £5,800. With a more common total cost of 2 per cent, your savings would accumulate to only £3,250 — more than half the potential return would have been dissipated in fees and charges.
But while the efficient market hypothesis is an illuminating insight into the operation of markets, it is not true. Warren Buffett, the most successful investor in history, put it this way: “Observing that markets were often efficient, they (academics and Wall Street) concluded that they were always efficient. The difference between the two hypotheses is night and day.” Mr Buffett has made a spectacular fortune from that difference. By following an intelligent rather than a conventional investment strategy, you may hope to accumulate more modest amounts.
Strategies for imperfectly efficient markets
Markets are approximately, but only approximately, efficient. Most security prices display “short-term positive serial correlation” — upward price movements are slightly more likely to be followed by further upward price movements. Downward price movements are also more likely to lead to further downward price movements. This feature of short-term price change is called momentum.
There is also evidence of long-term negative serial correlation. If you look at prices over much longer periods — three or five years — upward movements are more than averagely likely to be followed by downward movements, while periods of underperformance of this length are more than averagely likely to be followed by periods of outperformance. This feature of long-term price movements is called mean reversion.
Momentum rules in the short run, mean reversion in the long run. A day is short run, five years is long run. If there were a means of telling just when the short run becomes the long run, there would be a sure-fire route to making money. Sadly, this isn’t possible.
The two phenomena of momentum map into two basic investment techniques. One seeks to understand the vagaries of market sentiment and anticipate how prices will move: exploit momentum, buy into market rises, sell ahead of market falls. The other analyses the sources of fundamental value — the future cash flows which underpin any valuation. You can then use the volatile mind of the market as an opportunity to buy assets that are underpriced relative to their fundamental value.
The intelligent but amateur investor cannot expect to match the professionals in understanding market psychology. The David and Goliath notion that with a home computer, a proprietary software package and a book of trading rules, you are likely to succeed where the best resourced institutions in the world have largely failed is laughable. Most people who claim to trade successfully in this way are themselves on a lucky run in a rising market or engaged in self-delusion (or both).
But the intelligent investor does have advantages when it comes to fundamental value. For the majority of professional fund managers, bound by the routine of quarterly performance measurement, the value of an asset is worth what someone is willing to pay for it.
[Volatile markets are] your friend, not your enemy.
To an intelligent — and therefore patient — investor, an asset is worth the higher of its fundamental value and its market price. If the market price is above fundamental value, an intelligent investor can sell for the market price and look for something else. If the market price is below fundamental value, an intelligent investor can continue to hold and enjoy the benefit of the projected stream of cash returns. As Ben Graham and Warren Buffett have told investors for decades, the fickle, volatile Mr Market (who is sometimes willing to sell things for less than they are worth, and buy for more than they are worth) is your friend, not your enemy.
Gauging investment risk
The models that financial professionals use to measure risk focus either on asset price volatility or “tracking error” — performance relative to a benchmark. But unless your purpose in saving is to make a purchase in the immediate future, these measures are of no relevance to the intelligent investor.
Risk is failing to achieve your realistic investment goals. Risk means one thing if you are saving to put down a deposit to buy a house in the next few years, and something different if you are saving for retirement 20 years from now. If you hope to buy a property in the Algarve, your definition of risk will change, ditto if you are retired and anxious to ensure that you can meet the costs of long term care.
Such an approach makes clear that the meaning of risk is necessarily personal. And risk is a characteristic of an investment portfolio, not a characteristic of an individual investment. The lowest risk portfolio is likely to be one that consists of a diversified collection of individually risky investments. Over a 20-year time horizon, the premium that risky assets currently appear to offer relative to so-called low risk assets — cash and bonds — is sufficiently large that real assets — such as shares and property — are virtually certain to provide a higher return.
Do not confuse security with certainty. The man who knows he will be hanged tomorrow has certainty, but not security. His fate is not much more comfortable than that of the saver who today plans to use bonds as a vehicle for retirement saving — the certainty such a saver will achieve is the certainty of a low standard of living in old age.
And even at retirement, you should view your portfolio as a whole and disregard short term fluctuations. Bluntly, if you are only going to live for five years, it doesn’t much matter what you invest in. If you enjoy 25 years of retirement, then what matters is to give yourself the best possible chance of good investment returns.
Effective diversification, not the avoidance of specific risk, is the key to safe and successful investment.
So disregard the “know your customer” questionnaires which purport to assess your “risk appetite”. Are you cautious? Yes, you are. Are you upset if the value of your portfolio goes down? Yes, you are. Are you willing to invest in a risky proposition? Yes, you are, so long as the returns from it are not correlated, over the long run, with the other similarly risky investments you have. Effective diversification, not the avoidance of specific risk, is the key to safe and successful investment.
The conventional investor has improved returns by minimising charges. The intelligent investor plans additionally to benefit from market inefficiencies by making judgments. He or she will diversify more than the conventional portfolio allows; that portfolio is heavily biased towards the stocks of large global companies all of which sell to similar markets. A market index contains many stocks but that is not the same as diversification, which emphasises lack of correlation between the likely outcome of different investment choices. And the intelligent investor has the opportunity to stand back from the waves of optimism and pessimism which drive markets — and to avoid bonds, whose current yields should be of no interest to any long term investor.
Most investors will, and should, begin with funds. Trackers or exchange traded funds (ETFs) with low charges enable you to invest not just in the US and UK indices, but in Brazil, Taiwan and other small and emerging markets. In the larger markets, you can choose to focus on smaller or larger companies, or on a particular sector, like utilities or real estate. Plan to build up a diversified portfolio of such funds, emphasising sectors that are unfashionable.
Then consider an allocation to actively managed funds. Pick two or three idiosyncratic funds with widely different styles and approaches. This gives a better balance of risk and return. But keep a close eye on charges. Buying a closed-end fund with low charges and a discount to asset value gives you a chance of earning the return generated by the underlying productive investments.
You can buy Reits or property companies domiciled in US or European markets, as well as the UK. With such a range of possibilities, it is easy with two or three purchases to construct a portfolio of property assets diversified across many different kinds of property and across geographical locations.
As your experience of intelligent investment grows, you may wish to consider individual stocks. Intelligent stock pickers are concerned with fundamental value, not share price momentum; with the characteristics of the company, not the stock price history. Conventional investors are unduly averse to individual stock risk; such risk can and should be diversified. You do not mind that a stock is risky, as long as it does not add greatly to the risk of your portfolio as a whole.
Your aim is to buy good companies on a contrarian basis, probably when their sector is out of fashion.
That implies, of course, that you can understand what the risks are. Look for a clear, comprehensible business model. The only sources of fundamental value are tangible assets and competitive advantage. If you cannot identify tangible assets from the accounts that support the valuation, or don’t understand the source of the competitive advantage of the business, then you cannot judge either its fundamental value or the risks associated with it. Your aim is to buy good companies on a contrarian basis, probably when their sector is out of fashion.
Three simple rules — pay less, diversify more, and be contrarian — will serve almost everyone well. Modern financial markets are complex, but much of the complexity is for the benefit of providers rather than consumers of financial services. If you don’t understand it, don’t do it. That simple maxim would have saved both amateurs and professionals billions of pounds in recent years.
The new, updated edition of John Kay’s book “The Long and the Short of It: a guide to finance and investment for normally intelligent people who aren’t in the industry” is out now, published by Profile Books.
This article was first published in the Financial Times on December 2nd, 2016.
The conventional investor’s strategy — or how to build a portfolio with £10,000
The conventional investor can freeride on the asset allocation decisions of large institutions. Large investors publish details of their investment allocation.
A useful benchmark for the British investor is provided by local authority pension funds. In 2012, the average scheme held between 60 and 65 per cent of its portfolio in shares. Slightly less than half these holdings were in UK companies and the balance in foreign equities. The typical fund held 15 to 20 per cent in bonds, 5 to 10 per cent in property and around 10 per cent in cash and other assets.
A conventional investor can simply and cheaply replicate these decisions via a few index tracking unit trusts or exchange traded funds with a sum as small as £10,000. Put £3,000 in a UK index tracker and £3,500 in a fund which invests in developed world equities (excluding the UK). Vanguard offers such funds with an ongoing charges ratio of 0.15 per cent.
This leaves £2,000 earmarked for bonds. You may be able to hold bonds in your internet stockbroker’s account but some basic dealing services do not offer this option Absurdly, you may actually find it cheaper to buy a global bond fund with diversification across a range of currencies and maturities.
Finally there is £1,000 for property. You are not going to buy property of your own for £1,000, so your choice is between funds. Most closed-end property funds (Reits) today stand at substantial discounts to the reported value of the underlying property.
And that is it. You have £500 left in cash to experiment with more adventurous choices. With four clicks of a mouse you have created a diversified portfolio similar to that adopted by well-advised large investment funds with long-term aspirations to total return, at low initial and ongoing cost. You can safely forget about this portfolio for years, in the confidence that your performance will be most likely be similar to, but significantly better than, the balanced portfolio a sophisticated adviser might construct on your behalf, by virtue of its lower costs.