Alan’s Blog March 2012

March has arrived and with it the lighter mornings make it appear that Spring is not too far away. One client made a comment that I was “always away from the office” and it made me review my diary. In February all day business meetings took me to Bristol, London, Droitwich, and Tamworth so I was out of the office on average one day a week. [The sole purpose to my days out and nights away is to gain knowledge and expertise to pass on to clients.] Add to that the eleven business meetings held in the office plus client meetings and it looks like a fairly typical month.

I am still reflecting on a story told to me by one client whose parents have both died and they searched everywhere for their Wills. They scoured the bank, their local solicitor, the house, indeed everywhere they could think of. They were sure that their parents had written Wills but they could not be found and after several months they processed their estate without Wills. Three years later the original Wills appeared from under their noses but of course by that time the estate had been settled and the Wills were no longer of any use.

The professional system of document storage that we recommend to our clients ensures that everyone knows where the Wills and other legal documents are at the time that they are needed. Wills are registered on The National Wills Register, the originals are stored by a National company in a highly secure building, and the Executors and Attorneys receive a convenient ‘credit card’ size plastic card which provides the storage details. The storage service is also independent of me so that you do not have to depend on my being around when needed. There are too many tales of Wills being lost by banks when they keep documents in ‘open storage’; or Wills being moved from office to office when local solicitors are taken over, they retire, or they go out of business. Documents being kept at home is definitely not the answer because they could be lost, damaged in a fire, or destroyed during a quarrel (all of which I have experience of): the best story that I heard from clients was of a separated partner arriving at the ex-partner’s home after death, finding and destroying the current Will and producing the old Will in her favour – and because they could not prove anything she got away with it. When you reflect on all of the potential problems our recommended life-time document storage option at The Society of Will Writers at a one off cost of £75 seems like the obvious choice.

You cannot beat the market is the subject of my continuing discussion of the “The 7 Secrets of Money”. This is a book that I strongly recommend: you can get your own copy from Amazon and for more information you could look at the authors’ website at www.7secretsofmoney.co.uk.

Secret Number 3: You cannot beat the market

Chapter 3 starts off with a quotation from Nobel Laureate: Daniel Kahneman and it is a quote worth repeating:

“What is really quite remarkable in the investment world is that people are playing a game which, in some sense, cannot be played. There are so many people out there in the market; the idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them. This is one of the great mysteries of finance: why do people believe they can do the impossible?”

Secret number 3 is one of the most important and I make no excuse for it being a little longer than usual.

The financial pornography produces two main arguments: Either ‘Clever’ managers move in and out of rising and falling markets to get the best return  – Or: Specialist firms have research facilities and very clever people which enables them to get the best return. Both options require expensive resources and if you opt for a different solution which does not require their expensive fees your returns will almost definitely rise.

The ‘active’ management approach assumes that the market price is incorrect and can be beaten whereas in fact stocks are priced very efficiently. With today’s communication, prices react almost instantly so being able to buy a stock when its price is too low or sell a stock when its price is too high is extremely unlikely. The evidence shows that over significant periods of time traditional active management has delivered far less than the market return in the vast majority of cases.

“If we accept the Efficient Market Hypothesis we would certainly expect to find managers who perform better than the market from time to time. We would also expect to find those who underperform from time to time. It is only useful to an investor to know who is likely to outperform if he knows that information in advance of the outperformance. Sadly manager performance to date has almost no predictive power in respect of future manager performance.”

The results show that on average managers perform worse than a random stock selection probably because managers have quite high fees. I love the line: “Throwing darts at the FT will produce returns that are comparable with professional managers’ returns; factor in fees and you are better off with the darts, depending on what you charge for dart throwing.”

An active manager has only two tools: market timing and stock picking – both of these rely on predicting the future – unfortunately results show that their crystal balls provide neither clarity or reliability.

The Efficient Market Hypothesis suggests that current market prices are the best estimate of fair value based upon available information. This is not to say that prices are always correct. The market may get prices wrong from time to time – some prices are too high and others are too low – but it does so randomly and unpredictably.

The last 50-year history of professional investment management shows that the beat-the-market efforts of professionals are impressively and overwhelmingly negative. In any asset class, the only consistently superior performer is the market itself.

As an alternative to active management passive investment recognises that it is intellectually illiterate to think that for most of the time the majority of the active managers can outperform the market. Instead they decide on which asset classes to own, and then own them in a highly diversified index-type fund or structure. This reduces costs and avoids the risk of owning the wrong stocks so leads to superior performance over time compared to a typically active managed fund.

William Sharpe (Nobel Laureate) says unambiguously:

“If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that:

1              Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

2              After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication, and division. Nothing else is required. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

There are many who recognise the wisdom of this approach for example Warren Buffett said in 1996: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”

When you learn that you and your advisers cannot predict or beat the market this can be a relief. With that knowledge all that we have to do is devise a way of investing that acknowledges that we cannot predict the market. A well thought out passive approach to investment will top the odds of success in your favour. By keeping things simple and focussing on the aspects that you can control you develop a portfolio that you can understand and makes sense:  This will be revealed in Secret number 7.

Risk is a primary driver and it is risk that I will focus on next month in secret number 4.