Personal Finance: The Jonathan Davis Column - The simple way to profit
For decades Cambridge dons bought shares, then left them alone. Two years ago, they meddled
Saturday 22 August 1998
The most remarkable feature of the college's approach to planning its investments is its extreme simplicity. As long ago as 1953, years before the cult of the equity had taken hold in this country, the college took the then extremely bold decision to switch all its investment capital out of bonds and invest it in the stock market. This despite the fact that the college relied - and continues to rely - on income from its investments to sustain its (I am quite sure) comfortable way of life.
Not content with such a radical shift of tack, the college also became one of the first institutions in this county to adopt what we know as a passive investment strategy. It assembled a broadly diversified portfolio of equities and imposed on itself the simple rule that it would only review the portfolio on one given day a year. For the rest of the year, it would simply sit back and leave the market to take its course. It would make no attempt to pick stocks during the year, and even on its one annual review it would try to avoid making any big changes just for the sake of it.
At the heart of this approach was the college's realisation - well ahead of its time - that there is little point in trying to outperform the market averages without some reason for believing that you can actually achieve such outperformance. The college's time horizon as an investor is long term - at least 100 years, it reckons - and the view of its investment committee is that it has no real basis for thinking it can work out which stocks are going to do best over that time frame. In its own words: "Nobody really has any idea what the future will bring over the next century or two, so an active policy of portfolio management is likely to give worse results than a passive one, because every change of investment incurs dealing costs."
By sticking to its simple policy of minimal changes in its portfolio, the college not only saves on the transaction costs of buying and selling new shares, but also avoids the financial burden of paying management and advisory fees to fund managers or financial advisers - an investment that often fails to yield commensurate rewards. In essence, therefore, the college has for more than 40 years been pursuing a policy of low-cost, passive investment management - the same strategy that, in my view and that of a growing number of others, should logically form the basis of many ordinary investors' strategy.
Needless to say, the college has been remarkably well rewarded for its prescience in avoiding trying to be too clever in its stock market dealings. As the charts show, both its capital and income have fluctuated with the market as a whole, but over the long haul its results have continued both to grow in real terms and to outperform those of the All Share index over the same period. The track record is an excellent advertisement for the merits of simplicity in investment. The college is entitled to put two fingers up to those who, as its chronicler says, prefer to call its approach "simple-minded" rather than "simple".
So why, then, did I describe this as a cautionary tale? Well, sad to report, for the last two years the dons at the college have by their own admission made the mistake of abandoning their own best self-denying ordinance and fiddling with their tried and tested policy. Convinced that the market was becoming dangerously overvalued at their annual review last summer, they decided to modify their policy. First they made the historic decision to switch 25 per cent of their portfolio out of shares and into Treasury bonds, on the grounds that share prices had become "unjustifiably high". Then they compounded the error by using traded options on the main indices to guard against the risk of a significant fall in the market's overall level.
Now it ill behoves me to take issue with these actions, since I have been urging caution about share price valuations and praising the merits of bonds for some time. (The index options are another matter.) Yet I have to record the doleful news that the college's fateful decision has not so far been a conspicuous success. In one sense the college has enjoyed a satisfactory year since its change of tack last year. Its investments have yielded a total return of 14 per cent, comfortably above inflation at 3 per cent - and more than adequate.
The only trouble is that, had the college simply left well alone, and ignored the siren charms of its options, the portfolio's capital value, instead of rising 9.4 per cent, would have risen by 16.6 per cent. (When the market continued to rise, the options lost a significant portion of their value.) If it had stuck to its 100 per cent weighting in equities, rather than moving into bonds, the chances are that it would have matched the 25 per cent gain that anyone investing in a tracker fund could have achieved during the year.
"We are frankly unhappy," concludes a chastened Academic Investor, "about departing from our traditional simple policy. We hope that in future years we will see no reason against reverting to a simple policy which involves no attempt to be clever about predicting movements in market prices." Now they have moved some of their equity holdings into low-cost tracker funds - but are still using a put on the Footsie index to reduce their exposure to equities still further. Will they look smarter next year? It will be interesting to see.
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