It’s hard to resist the temptation of shiny things, says Richard Wood. But resist we must.
Investing is simple, but not easy. The important thing is to do the right thing in the right way. From the start, it’s important to have the foresight to make decisions for the long term, as well as the discipline to avoid spending all your wealth now and having to eat own-brand baked beans out of the tin in retirement.
Secondly, you need to decide how much you want, need, and are able to invest in equities, which will act as the drivers of positive above-inflation returns that will help fund your future spending goals. Getting this right is vital and is where a good adviser can be worth their weight in gold.
Next, an investor has to decide how to structure the equity and bond components of their portfolio. A good place to start is the World Equity, which defines the basic country, sector and company weights, and offers broad diversification.
Any decision to move away from this structure needs to be based on evidence that it will improve the risk and return characteristics of your portfolio. As Eugene Fama, the 2013 Nobel Laureate in Economic Sciences said, “You need to be able to talk your way out of a market cap-weighted portfolio.”
That’s not easy and requires a reasonable degree of investment knowledge. Occam’s Razor suggests that the best answer to a complex problem is often the simplest one, and this is certainly the case in investing. So, start with market capitalisation, as defined by the World Equity Index.
Don’t be your own worst enemy
Picking funds to implement the strategy should be your final step – yet for many DIY investors, this is one of the first things they do, heading to the ‘best buy’ fund lists in the Sunday papers or some investment website. Here is where the fun – and the danger – begins.
Some funds, usually measured over short time frames (say three years) can have great-looking track records. They can seem impressive enough to influence your decision-making away from the evidence-based route.
Don’t blame yourself: many investors’ decisions are driven by common behavioural biases. They’re hard to avoid and take iron discipline to resist (another reason why a good adviser can keep you on the straight and narrow).
Hindsight bias is the most obvious – it’s easy to identify a fund that has done well in the past, but difficult to pick one that will do well in the years ahead. Extrapolating the past into the future is rarely a successful strategy. There’s a reason we say that past performance is no guarantee of future results.
Other biases include the fear of missing out, and overconfidence in our ability to spot a ‘market-beating’ fund manager. This particular bias goes against the bulk of the evidence. Over the past 20 years, for example, over 85 Richard Wood is the managing director of Barnett Ravenscroft Wealth Management.3 The Dentist August 2021 Finance per cent of all US equity funds failed to beat the market index and only around one third actually survived the whole period.
Different parts of the market do well at different times, but no-one – not even the professionals – knows who the future winners are. Naïve investors take good short-term performance as a sign of skill. Yet the reality is that much of the seemingly ‘good’ performance may be down to the fact that the part of the market that has performed well happens to gel with the style of a specific fund.
There is an old industry saying that markets pick managers, not the other way around. ‘Good’ performance may also simply be luck. You need at least 16 years’ worth of performance data to be 95 per cent certain that skill rather than luck is the driver of outperformance, even for highly skilled managers. Three or five-year performance records are largely worthless in identifying good funds, but that is where ‘best buy’ lists (and many IFAs) tend to focus.
‘Spot the dog’ and ‘expert picks’
One example of the noise investors face is the ‘Spot the dog’ report published by Bestinvest every six months, naming and shaming a list of ‘dog’ funds (usually value funds with cheaper stocks), that have performed poorly over three years; and ‘pedigree’ funds (mainly growth stocks) that are celebrated based on strong recent outperformance. Over the most recent three-year period, growth stocks in general outperformed value stocks, so the funds merely reflected short term market performance. But so far this year, many of the UK ‘dogs’ have outperformed the ‘pedigree’ funds, as value stocks have performed better than growth stocks.
Investors Chronicle provides an annual ‘Top 100 Funds’ list by broad investment category. Its 2012 global growth list identified nine funds and investment trusts. Yet only two out of the nine selected funds beat the market index over the past 10 years. One of them suffered a fund-specific 50 per cent fall within the period, which would have taken a strong stomach to live with. The other has experienced a couple of years of explosive growth, driven by a handful of companies and one electric car manufacturer in particular.
Will they continue to do so well in the future? No-one knows, not even the managers of these funds and certainly not the pundits creating ‘best buy’ lists. And that is the point. Basing an investment strategy on ‘I don’t really know’ seems a bit like gambling.
Capturing the market return with a well-diversified, low cost, systematic fund makes good sense and allows investors to ignore the ‘best buy’ and fund ‘tips tables’ noise. Thank goodness for Occam and his razor.