Investment decisions

1. Facts ‘v’ Opinions

Your investment decisions are influenced by two factors: information that is factual and information which is based on opinion.

The value of your equity-based investments today, whether they be pensions, unit trusts or other collective investments is a historical fact based on share prices on the date of valuation. The value of your investments tomorrow is an unknown quantum because the future value of equities is uncertain and your capital is at risk. Markets are moved by news and news, by definition, is unpredictable and therefore random. Extensive studies based on the original “Random Walk” theory first discussed by Louis Bachelier in 1900, have found overwhelming evidence to support the view that the behaviour of stock prices is indeed random.  Whilst the reactions of investors to events may logical or emotional, well-informed or irrational, news is always unpredictable.  Therefore, share prices tomorrow may rise, fall, or remain about the same but the only certainty is that the outcome is uncertain. Therefore, your assessment of the suitability of an investment must be based on the degree of uncertainty you are prepared to face at any one time and the extent to which you can risk capital.

The future value of a portfolio primarily invested in Fixed Interest or Cash is still an unknown quantum because movements in interest rates will affect its value. However, being less volatile, returns are more predictable.  Interest rates may remain the same, fall or rise, but in building your own portfolio you need to determine whether removing uncertainty about future investment performance is the right decision for you.  If so, tempering your exposure to equities by the use of cash and fixed interest will remove some of that uncertainty, but you will need to accept that expected returns will be lower.

Investors who treat the opinions of others as if they were facts, however compelling they might sound, may well suffer serious consequences.  What matters is: your assessment of the amount of risk you can tolerate.  Our objective is to provide you with information, a means of assessing risk and, ultimately, the means for the removal of uncertainty.  In order to do this we must first distinguish between facts and opinions and, having done so, provide you with a decision-making process that treats each according to its merits.

2. The Decision Matrix

A huge amount of financial information enters the public domain each day. Without an effective filtering process, you could become so overloaded with data, or deafened by the noise, as to suffer “the paralysis of analysis” and take no effective decisions whatsoever.

Most of this financial information propagates the myth that individual fund managers or fund management companies can out-perform the market by stock selection and/or market timing.  Whilst this can happen over short periods of time, largely as a result of chance rather than skill, consistent long-term out-performance has been achieved by only a handful of fund managers.  Extensive, peer-reviewed, academic research has consistently exploded the myth that the market can be beaten, but yet the myth persists.

It is essential therefore to understand that the majority of information entering the investment arena is generated by the active fund management industry (stockbrokers, fund groups and financial advisers) and transmitted by the financial media in its many forms.  The former have a considerable vested interest in propagating the myth, as their primary function is to gather other people’s assets under their management and justify the high fees they charge. As for the latter, their main purpose is not to educate the investor, except in the most superficial way, but to generate advertising revenue from the active fund management industry.  If this were not so, the consumer financial press would publish a consistent message week-on-week: invest in a globally diversified portfolio of index funds and keep charges to the minimum.  Were they to do so, it would not take long for their advertising revenue to find its way to the competition, or disappear completely.

The truth is, as much as you may wish to know which funds will be hot, you can’t – and neither can the legions of advisers and publications that claim they can.  That’s why building a portfolio around index funds isn’t really settling for average. It’s just refusing to believe in magic.

Beverley McLean, “The Sceptic’s Guide to Mutual Funds,”Fortune

So where can you get reliable, and factual information? Answer: from the exceptional academics and researchers, some of them Nobel prize-winners, who have transformed our understanding of finance and the theory of investing.

A review of the collective research of Nobel Laureates and other academics shows a sharp contrast between what they and the average active investor understand about investing.  After 50 years of scientific research on 70 years of data the results are in and the evidence is overwhelming: active management does not work and is no longer the only game in town.

The conventional wisdom that a stock picker, armed with enough knowledge and research, can consistently beat the market has been completely discredited.  The problem is that investors continue to rely on information sources such as consumer financial publications rather than on empirical research – such as that available from the University of Chicago Centre for Research in Security Prices (CRSP) and published in the Journal of Finance. It is unfortunate that the great majority of investors are unaware of the tremendous amount of academic brain and computer power that has been applied to investing because it is this very lack of awareness makes them more susceptible to the siren calls of active management.  Most unfortunate of all is that they are unaware that the overwhelming conclusion arrived at by these academics points to investing in portfolios of index funds.

The Decision Matrix set out below should assist investors in deciding what sources of information are worth paying attention to.  In other words: to filter out the white noise and static coming from the active fund management industry on wavelengths 1-3 and tune into the clear signal on channel 4.

3. What is Active Fund Management and why should it be avoided?

Although many alchemists were indeed crackpots and charlatans, many were well-meaning and intelligent scholars, who were simply struggling to make sense of a subject which, as we now know, was far beyond the reach of their tools. They had to rely on unsystematic experimentation, traditional know-how, rules of thumb — and plenty of speculative thought to fill in the wide gaps in existing knowledge. The alchemists did not follow what is now known as the scientific method, and much of the “knowledge” they produced was later found to be banal, limited, wrong, or meaningless.

“Definition of Alchemy,” taken from Wikipedia

Just as the alchemists of old pursued a belief that base metal could be transformed into gold, active investors operate under the illusion that there is some special knowledge or understanding of the market that would enable them to predict the future direction of prices.  This activity could more accurately be described as speculation, or gambling, as by failing to realise just how much their investment performance depends on luck, most “investors” end up paying dearly for their mistake. Active fund management is no different, except to the extent that it involves gambling with other people’s money – and being paid handsomely for it.

In 1986 a report was published by a prestigious firm of pension consultants in the United States[1].  This firm had analysed the performance variations of 91 large pension funds and reached a profound conclusion – one which sent a collective shudder through the investment community.  The report’s authors found that of the three primary investment strategies that determine portfolio performance: market timing, stock selection and asset allocation, it is the latter – asset allocation – that accounts for over 90% of the variation in returns of a diversified portfolio.

In contrast, the activities and recommendations of most stockbrokers and fund managers are based on market timing and/or stock selections which are, in effect, attempts to predict the future.  Millions of dollars or pounds are spent by these firms each year to try and derive some competitive advantage.  However, the net result of this activity, which is ultimately paid for by investors in management fees, is that not only does it not add value, it is more likely to subtract it.

The evidence that market timing (the belief it is possible to pick the times to be in or out of the market) and stocking picking (attempting to find stocks that the market has mis-priced before the price is corrected) does not work is compelling and endorsed at the highest levels. In their exhaustive study of the performance of UK fund managers[2] Garret Quigley and Rex Sinquefield concluded:

This examination of UK equity unit trusts says that UK money managers are unable to outperform markets in any meaningful way, that is, once we take into account their exposure to market, value and size risk.  This result is analogous to most studies of US money managers.  Even more dramatic than these overall results are the findings for the small-company UTs.  Contrary to the notion that small-company shares offer abundant ‘beat-the-market’ opportunities, we find that small-company UTs are the worst performers.  In fact their performance failure is persistent and reliable.

The UK Financial Services Authority (FSA) has also reached its own conclusions as to the value of active fund management.  For example, the following exchange took place during a hearing of the House Treasury Committee at Westminster on 3rd May 2006. Giving evidence on behalf of the FSA was Mr Clive Briault, Managing Director, Retail Markets (source: Hansard).

Mr Newmark MP: I am just trying to understand, is there an advantage to going into actively managed funds and do those people whose funds are being managed benefit from more actively managed funds or is it just a means for active fund managers to make more money because the average consumer is not benefiting from that?

Mr Briault: Well, when you say “make more money”, of course there is also a cost to the firm of actively managing the fund and it is a question of how those costs are then reflected in the charging structure. In competitive markets, you would not expect the firm necessarily to make a lot more money —-

Mr Newmark: No, I understand that, but is there any evidence that actively managed funds are performing better than tracker funds?

Mr Briault: No.

Mr Newmark: You are saying no?

Mr Briault: Yes, absolutely.

Mr Newmark: So the only people benefiting from this are the fund managers?

Mr Briault: Well, depending on the charging structure related to the costs of running the actively managed fund, yes.

4. Yeah, but what about Anthony Bolton?

When faced with the overwhelming evidence which attests to the futility of following the market timing and stock picking activities of active management, investors often point to the results of superstar fund managers, like Fidelity’s Anthony Bolton[3], to justify their position. Rather like gamblers who decide which horses to back depending on the jockeys hired to ride them, “manager pickers” seek to maximise their chances of investment success by tracking and backing the most successful managers.  Indeed, there are whole publications devoted to this “cult of personality,” but the actual results are not encouraging.

Yes, it is true: a small number of managers do enjoy extended periods of market out-performance, greater than could be achieved by chance alone or attributed to the market, value and size risk effects described by Professors Eugene Fama and Kenneth French (covered in detail later).  However, it is the very scarcity of these star performers that should serve as a warning to investors.  Of the thousands of active managers, stockbrokers and analysts operating in the world’s financial marketplaces only a tiny fraction achieve any prominence based on their results.  Once achieved, however, their success breeds problems of its own, not least of which is the difficulty of managing the market impact of a large and unwieldy fund and the shortage of genuine opportunities to add value.

Ultimately, even the best performers recognise that there is a time to call it a day.  But for investors looking to their pension funds to support them in retirement, there remains the difficulty of seeking the next Anthony Bolton without knowing where or when he or she will emerge.

Having explored the challenges that face investors, we now move on to examine the solution – one which provides the highest probability of delivering a successful investing experience: a globally diversified portfolio of index funds, tilted to small and value and tempered with fixed interest investments, with fees kept to the minimum.

Let’s move on.

[1]     Brinson, Hood and Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal

(July-August 1986) pp.39-44.

[2]     Garrett Quigley and Rex A. Sinquefield “Performance of UK Equity Unit Trusts,” Journal of Asset Management February 2000.

[3]     Anthony Bolton managed Fidelity’s UK Special Situations Fund from 1979 to 2006.