Investment: Success Can Lie in Taking a Long Look at the Risks
Davis, Jonathan, The Independent (London, England)
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 …
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Publication information: Article title: Investment: Success Can Lie in Taking a Long Look at the Risks. Contributors: Davis, Jonathan - Author. Newspaper title: The Independent (London, England). Publication date: August 4, 1999. Page number: 5. © 2009 The Independent - London. Provided by ProQuest LLC. All Rights Reserved.