What caught my eye this week.

Passive investing is a solved problem. Invest regularly into index funds or their ETF equivalents, allow your money to compound for 30 years, and then enjoy the fruits of the market’s return by spending down your portfolio in your later years.

Sorted. Next!

Well maybe. It’s been hundreds of years since much of anything stayed the same for long. So it seems likely to me our kids and grandkids (maybe future Monevator readers?) will be doing it their own savvy way.

Live and direct

Direct indexing seems very likely to replace index funds in time, for a start.

The idea is simple. Rather than put your money into an index fund, a robo-platform basically buys the index for you via the appropriate mix of shares (or fractions of shares). This approach cuts out the middleman and makes you a direct shareholder in all the companies in the index (rather than via a proxy, such as Vanguard).

One advantage if you do this outside of tax shelters is more opportunity to defuse capital gains and exploit capital losses to reduce your tax bill, since you’ll hold the index’s winners and losers at the individual level.

But I believe it is the push towards ESG ((Environmental, Social, and Governance)) investing that will drive the industry towards direct indexing.

I don’t want that one!

I’ve sat through at least a dozen start-up pitches over the past few years from fintechs arguing that millennials and their younger siblings want a way to invest that’s as easy as buying an ETF but without having exposure to a fossil fuel producer or an arm’s manufacturer.

Fair enough, target ESG investing towards them then. But understand that ESG is a moving target.

For instance in the past month, fast fashion darling BooHoo has been painted as a ruthless exploiter of workers after some investigations into aspects of the UK garment industry.

I’m not convinced this picture is fair – and I own shares in BooHoo – but I don’t intend arguing the toss today.

The point is, if I was an ESG-minded investor than a company I might have considered as previously no problemo I might now wince at owning.

I’m not saying that’s a very rationale way to think about shareholder democracy. I’m saying it’s how millions of people do think.

With a traditional ESG fund – active or following some ESG index – you’d have to wait weeks or months for a third-party to kick out BooHoo of the fund, assuming they do at all.

All the time your money in the company, ruthlessly exploiting away on your behalf…

But with direct indexing, you could do it yourself. You could own the market minus BooHoo after just a couple of clicks.

Everyone of us is different. You might believe that BP and Shell are transitioning to green energy, but you hate pharmaceutical companies for what you see as high drug prices – and you want extra-exposure to High Street retail because you believe it’s important for local communities.

Good luck getting an ESG fund to reflect that view!

However start with the index, dial up energy companies and retail exposure, dial down pharma, press the ‘Direct Index Me Up’ button and you’re away.

Coming soon

According to some, direct indexing could do for investing what Napster and the iPod did for music – and sooner rather than later.

Quoted in an article on MarketWatch this week, Dave Nadig, an index industry veteran, said the technology to do this is already available for the rich or institutional, and it will soon reach oiks like us:

“All that’s changed over time is the thresholds for accessing an index have gotten lower and lower.

It’s just a software problem. And the technology required to produce that customized account has plummeted to the point where it’s almost retail.

It’s not quite mom-and-pop, but it’s heading there.”

I doubt Vanguard and Blackrock and the other big passive fund investors are quaking in their boots just yet.

For direct indexing to truly take off it will need to be as easy to do as buying a tracker fund. And people will need to understand what they’re doing, too, which adds an educational burden. (Think how long it took to get investors to shift towards a passive mindset. Decades.)

Also, the potential for financial services industry chicanery is high.

I therefore expect it will take a while before the landscape is one where direct indexing is really challenging our favourite passive fund approach. But be aware you might well retire investing differently to how you first got started.

Have a great heatwave weekend, everyone!

[continue reading…]

Let’s say you have £10,000. There’s no rule that says you have to invest it.

In fact, many people would spend it!

Why not put it under the mattress, and leave it for a rainy day?

One word: Inflation.

Take a look at this graph:

This graph shows how what you can buy with £10,000 falls over the years, due to the impact of inflation.

Inflation is the tendency for the cost of things – bread, houses, wages – to rise.

As such it reduces the spending power of your money each year.

• In 25 years time, you will still have £10,000 in nominal terms. Your twenty £500 notes will still be under your mattress, and the Queen of England will still be frowning at you.

• But in real terms the spending power of your money will be diminished.

The graph shows the impact of just 2% annual inflation on your money.

2% reduces the value of your money by only a little bit each year, but it adds up to a 40% loss in real terms over 25 years.

The inflation rate can rise and fall

The Bank of England and many other countries target a 2% inflation rate.

But sometimes, such as in the 1970s, inflation can rise to 5-10%. Such a high inflation rate can halve the value of your money in less than a decade.

Inflation can get even worse in extreme situations, such as 1920s Germany or Zimbabwe more recently. Hyper inflation in a crisis can hit triple digits or more.

The first reason we invest is to maintain the spending power of our money. Every year we need to grow our savings by at least the rate of inflation.

Generally – but not always, and especially not in recent years – you can keep up with the rate of inflation by keeping your money in a good cash savings account.

Cash accounts pay interest on your total savings. By adding this interest to your existing pile of money, you can grow your savings over time.

This may seem trivially obvious, but it’s an important point.

The spending power of each £1 still goes down over time. But by growing the total amount of £1s in your savings pot by earning interest and reinvesting it, you can aim to offset the impact of inflation and maintain the spending power of your total savings.

In the graph above:

• The blue line shows how your £10,000 grows over 25 years with 2% interest. This is the amount you see piling up in your bank account.

• The red line shows how £10,000 would lose its value in real terms at 0% interest. For example, if kept under your mattress!

In reality you will get interest and see your wealth rise but – invisibly – each pound in your bank account will also lose some of its spending power due to the impact of inflation at the same time.

If inflation was running at 2% for the entire 25 years and interest rates were also 2%, then the two would cancel each other out.

This is shown in the green bar in the following graph, which is the real spending power of your money, with 2% interest and 2% inflation.

You’d very rarely see inflation and the interest rate on your cash savings exactly matched like this, of course, let alone for 25 years! ((Some interesting products such as the government’s sadly suspended index-linked savings certificates did enable this, plus a bit of icing on top.))

Some times interest rates will easily outpace inflation. At other times it will be very hard to get a real return, especially if you pay tax on your savings.

But the principle is clear. At the very least, you need to grow your money in nominal terms, just to offset the corrosion of inflation.

Investing like this will at least maintain the spending power of your money.

Key takeaways

• The real value of £1 decreases over time, due to inflation.

• Over the long-term, this can seriously reduce your wealth.

• At the least, we need to invest to offset the rate of inflation.

This updated post is from our occasional series on investing for beginners. Subscribe to get our articles emailed to you (we publish three times a week) and you’ll never miss a lesson! And why not tell a friend to help them get started?

What caught my eye this week.

I always stress to friends who know of my investing obsession that – from the position of pure cost-benefit analysis – my stockpicking has been an unproductive waste of time.

Me and The Accumulator thrashed this out in debate years ago. I invest actively for the fun and challenge, I said. He wasn’t convinced.

And it’s true, I probably wouldn’t do it if I didn’t – naughtily, preposterously – think I had a chance of beating the market.

Luckily, I have done, the way I measure it, over the medium to long-term. (Unitised and against a few 100% equity benchmarks, but I don’t adjust for risk, which could make things look better or worse, depending on the year).

2020 has been particularly ridiculous. Everything has worked! It usually doesn’t. Luck has loomed large, too. It doesn’t always, either! It went against me in late 2018 / early 2019, for example, and I spent the year trying to claw back and making things worse.

Swings and roundabouts.

The point is I always caution my friends it’s only in recent years (especially this year) that earning an extra 1%, 5% or for much of the time even 10% has compared at all favourably to trying to earn more money from a traditional route.

Focusing on a career and boosting my salary would have paid far better, if I was wired that way. (I’m not!)

I started with mid five-figures in savings less than two decades ago. I’ve never earned a lot, by the standards of my peers. Compound interest takes time. The metaphor is a slow rolling snowball for a reason.

Even putting more effort into monetizing that perennial underachiever, Monevator, might have been more profitable.

The irony of alpha

Nick Maggiulli did his usual brilliant job tackling all this in a post this week. Explaining why You Don’t Need Alpha, Nick writes:

How many people have earned alpha (net of fees) consistently for multiple decades?

Conservatively, I would say there have been a couple hundred throughout history.

Being one of those people (or trying to select them ahead of time) is near impossible.

More importantly, how much will that alpha change your financial life even if you do happen to acquire it?

For a little bit of annual alpha, the answer is very little.

For example, let’s assume that the market will return 4% a year (after-inflation) going forward and you can earn 1% above this (net of fees) over the next 10 years.  How much more money would you have 10 years from now?

About 10% more.

Pfft!

Obviously you can play with these figures. You can model higher (and even more unlikely) alpha.

More – cough – realistically you can run the experiment for 30 years. It does add up.

But then you spent 30 years trying to beat the market when you might have been doing something else instead.

Where’s my novel, eh? That’s what the teenage me would want to know.

The irrelevance of alpha

I should mention my friends have typically needed little persuasion that I’ve wasted my time obsessing over the stock market.

I was living like a graduate student well into my 40s. My friends didn’t see the sports cars they expected from an obsession with the stock market. (Because they didn’t understand that compounding your own modest wealth sensibly takes time. If you need a sports car in a hurry, get hold of other people’s money and take a cut…)

There was a particularly delusional air about proceedings as my last rental place was run down before I finally bought my flat.

“Where did it all go wrong?” they gently wondered.

The other reason they need little persuasion I’ve been a dud is I try to mostly talk about my mistakes and bad calls.

Superstitious! It’s grounding.

And… luck, luck, luck.

But despite all this I don’t feel I’ve wasted my time pursuing alpha. While I didn’t end up trying to launch/run a fund (another story) it’s led me in interesting directions, career-wise.

It also resulted in this blog, which judging by the generous feedback is my best contribution to the world so far.

Finally, shepherding my nest egg so closely has really made me care about my nest. I’ve added more eggs over time than perhaps I would have, too, and I’ve been careful – big picture – not to break them.

“It is the time you have wasted for your rose that makes your rose so important.”

– The Little Prince

Have a great weekend.

[continue reading…]