Investment: Success can lie in taking a long look at the risks

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THIS IS the story so far, as I see it. Anyone who wants to make money out of investing in the stock market needs to think carefully about several factors. They include: how much money you have, your investment objectives, the levels of risk you are comfortable with and how much you really know about the business of investing.

Many people can be quite comfortable with the first three factors, at least in a general way, yet overlook the fourth. That is unfortunate since it is fundamental to the strategy you choose to adopt.

All the available evidence, I fear, suggests that most people do not really understand the dynamics of the investment business. This is not necessarily their fault - life is too short to be an expert on everything - but it does make them susceptible to behaving in a sub-optimal way. (That is one reason why I happen to believe that some kind of civics course, which covers the basic principles of handling money, should be mandatory at all schools. The basic purpose of such a course should not be to make everyone an expert in finance, but to help everyone realise how much they do or do not know.)

As a broad generalisation, it seems most people in this country have sensibly decided that owning the stock market through a unit trust or other type of collectively managed fund is in principle superior to owning shares directly. Managed funds have the great advantage of being an efficient way to obtain diversification. They also save on the administrative hassle of owning shares and, if held in Pep or Isa format, can also easily be tax-exempt up to certain annual limits Funds are also the only practical way of gaining exposure to many overseas markets.

The trouble is, as regular readers of this column also know, is that the fund management business, for various reasons, some honourable, some less so, does not always give investors what they want. Funds generally are too expensive for what they provide. They incur wasteful transaction charges by turning over their portfolios too often; they incur excessive capital gains within their portfolios by the same token; and they also rake off in annual fees a significant chunk of the market return which they have done nothing to earn, and which is rightfully owed to the investor. What many people seem not to understand is that the reason that index funds, by contrast, have become so popular has very little to with investment skill, or lack of it, in the fund management business. Many fund managers are highly talented and impressively knowledgable about their area of expertise. The reason why index funds do so well is primarily a function of the fact that the costs you incur in buying funds (the bid/offer spread, the annual management fee, the hidden burden of transaction costs, and so on) consistently neutralise any edge the active fund managers can achieve in performance over time.

Smart investors are aware of this trap, which is one reason why even Warren Buffett, arguably the greatest active investor of them all, now says that for most ordinary investors without any great knowledge of the investment business, index funds are a sensible route into the stock market. "By periodically investing in an index fund" says the great man, "the know-nothing investor can actually outperform most investment professionals." As long as fund managers continue their high turnover, high-cost ways, the trend towards indexation will persist. Why then don't fund managers change their ways? That is a more complex question, but appears to have a lot to do with the tyranny of short-term performance measurement and the fact that consumers continue blindly to demand that their funds rank high in the performance tables each and every year, regardless of the fact that this is a next to impossible achievement.

But it is ludicrous to say indexation is, or can be, the only conceivable answer. Experience suggests it is possible to do better than indexing by trying to take advantage of the way the system works: for example, by buying funds run by skilled managers whose short-term performance has suffered unduly because of exceptional market conditions. Or by adding occasional active bets (where your conviction is high) to a core of indexed holdings. Many wealthy investors also think hedge funds are an answer, because in theory they are focused on absolute not relative returns (although the evidence of how successful investors are in these funds is mixed).

Then, of course, there is still the option of investing directly in the stock market yourself. There is no reason why you cannot create an actively managed portfolio of your own, provided you know what you are doing. As a private investor, you do not need to incur high transaction costs or turn over your portfolio by 100 per cent or more each year, as the average fund may do. A long- term buy and hold strategy, based on buying strong businesses at a reasonable price, is a fairly surefire way of producing superior long-term returns, provided you have the patience to ride out the inevitable market downturns during that time.

Just as good, if not better, if you know from your own experience how a particular industry or sector works (perhaps you work in it), is waiting for the inevitable periods when sectors are out of favour in one of the market's excessive swings from optimism to pessimism.

The common feature of all these approaches is that you do have to have knowledge of your own to bring to the party, and all involve commitment of time and energy. The interesting corollorary is that, if you do have that knowledge, then you are also likely to find yourself investing in a way markedly different from other investors. The difference may show up in the amount of diversification you adopt, the average holding period you own your shares for, or the amount of risk you are prepared to take (at least when measured by the conventional measures of deviation from the market).

An interesting recent study of a number of this century's most successful investors (included in The Warren Buffett Portfolio by Robert Hagstrom, published by John Wiley) demonstrates that many of the greatest investors diverge from conventional practice in just such a way. Maynard Keynes, who made a fortune for King's College, Cambridge through his investment skills, was one such investor. His college fund returned an average of 13 per cent over the period 1928 to 1945, when the market was essentially flat.

After some early reverses, Keynes adopted a strategy based on a relatively small and focused portfolio, low turnover rates and a willingness to take relatively big bets in cases where he was confident of his analysis. This produced a portfolio that was predictably much more volatile than the market as a whole, and included more down years than most investors would probably be happy with - one in three years were down years. At one point, Keynes' funds underperformed the UK market for three years in a row - a record that would likely lead to his sacking in today's performance- obsessed marketplace. Yet, of course, the college's willingness to back his judgement were rewarded in the long term by handsome returns above the market average.

The same combination of low turnover, narrow portfolio and long- term focus is exactly what characterises Buffett's investment strategy as well. At one point in the early 1990s, he had more than a third of his entire stock market holdings in just one stock, Coca-Cola. That is the kind of risk you can take only when you are supremely confident in your skills and in your assessment of the underlying probabilities. What really hurts you is trying to behave like a Keynes or Buffett when you are no such person.