Jonathan Davis: Look at risks, not just rewards

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The Independent Online

As this week's column is the last in this particular section – it will be moving to a different day and place in the paper – it seems as good a moment as any to reflect on some of the lessons that have struck me most forcibly about investment in the six years I have been producing this column. During this time, I have had the good fortune to share the thoughts of many leading practitioners in the City and beyond, particularly in the United States, where much of the pioneering work in investment theory and practice has been done over the past 30 years.

As this week's column is the last in this particular section – it will be moving to a different day and place in the paper – it seems as good a moment as any to reflect on some of the lessons that have struck me most forcibly about investment in the six years I have been producing this column. During this time, I have had the good fortune to share the thoughts of many leading practitioners in the City and beyond, particularly in the United States, where much of the pioneering work in investment theory and practice has been done over the past 30 years.

Observation number one is that anyone who thinks that mastering the investing business is easy is either a fool or a knave, or probably both. Ken Fisher, the West Coast money manager whose views I greatly respect, calls the stock market The Great Humiliator. Even the biggest and most justly famous names in the business are readily confounded by events. Anyone who can get even 60 per cent of their decisions right is likely to become feted for his or her perspicacity and skill. Even then it may be as much down to luck as anything else.

When I asked Michael Hart, the veteran manager of the Foreign & Colonial Investment Trust, for his abiding memory of his long career as an investment manager, his reply was simply: "How difficult it all is." The American bond expert Bill Gross, says in his recent compendium of investment advice: "When you think you have found the answer – think again" ( Investing Rules, Harriman House).

And that, when you think about it, is not as surprising as it seems. Financial markets exist to allow millions of participants, whether individuals or corporate investors, to trade their differing perceptions about what, by definition, are uncertain future economic events. Neither economies nor financial markets can be controlled by any participant, which is why chaos theory and the academic notion that markets follow a "random walk" are not as far-fetched or implausible as they first appear, though it is true that some players in the markets (such as central bankers) have a much greater influence over the direction of markets than most of us.

Observation number two, which follows from this, is that a good deal of investment business – perhaps the majority of it – is conducted on a false premise, namely that impressive and above-average favourable outcomes can be predicted with rewarding accuracy. There is a continual and costly contrast between the honest professional's opinion that investment is about the measured exercise of risk in a highly uncertain environment and a popular belief that easy pickings are there to be had "if only" you know where to look. Such a belief is of course sedulously propagated by the providers of financial products of all sorts, including those who employ the selfsame honest professionals, whose often tacit silence is ensured by the handsome commercial fruits that are the rewards of successful myth propagation. It matters not whether you take as evidence the advertising copy for actively managed investment funds, the breathless "come hither" headlines of the personal finance trade press, or the shameless overpromotion of unproven new issues by top-notch investment banks and brokers.

The same lesson is there for all to see. Financial decision-making – and this is observation three – is arguably the place where the principle of caveat emptor is most urgently needed, yet, sadly, most frequently forgotten. Mortgages, pensions and savings are such a big part of our financial experience that regulators and lawmakers often end up having to bail out people from the consequences of their own ignorance and folly. The only successful long-term answer to this problem, which is not confined to hapless individuals (look at the scores of large and supposedly sophisticated companies slaughtered for dabbling in derivatives they did not understand), lies in transparency, competitive markets and universal investor education.

That message, I believe, is now slowly being taken on board, by the industry and its regulators, and even by consumers. The growing popularity of index tracking funds, which owe their existence solely to the empirically unchallengeable fact that a predictable average return from the stock market is a better bet than an odds-against promise of superior performance, is one encouraging sign of growing investor sophistication. So too are the signs of greater consumer activism among mortgage-holders, pension policyholders and so on.

Observation four is that success as an investor can reliably be achieved only by those who approach the task with a realistic view: (a) of how markets operate, and (b) what they as investors are capable of achieving. Most people systematically underestimate the underlying risks in their investment strategies, and overestimate the potential rewards. They are typically underdiversified and too urgent in their demands for returns. Time is the greatest asset that investors have on their side. Costs and taxes should also play a bigger part in their thinking than they do.

Observation number five, though hardly a novel one, is that all successful investment strategies are to some extent, and necessarily, contrarian ones. At its most mundane, this means ignoring historic price performance – except in the short term, where trend following can be rewarding – and, at a more elevated level, being sure to avoid basing your decisions on consensus opinions, especially those relayed in all good faith by the financial media.

Remember how all the experts predicted that the euro would be a strong currency when it was launched? Or that the Y2K phenomenon was going to be a serious risk for investors? The examples could be repeated endlessly (and yes, before anyone with a long memory writes in, I have made some of the same mistakes myself).

Remember finally that, as Fidelity's star fund manager in London Anthony Bolton told me, there is surprisingly little new in investment. That is one reason why reading financial history is, given the choice, a more productive aid to decision-making in investment than reading today's financial press. I can recommend David Kynaston's masterly four-volume history of the City of London in this respect. Making investment decisions is not easy, but those with a grasp of history at least have the comfort of knowing that they need never be taken by surprise, or fall foul of the claim that "this time it's different", which Sir John Templeton calls "the four most dangerous words in history".

davisbiz@aol.com

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