Most people who invest their money for the long-term decide they should own some shares (or equities, as they’re also called).

This is a good idea. Over the past 116 years, the UK stock market has historically delivered an average after-inflation return of 5.5% a year. ((My data here on returns for UK shares, bonds, and cash all comes from the Credit Suisse Yearbook 2017.))

In comparison, bonds have returned on average just 1.8% after-inflation over the same period, and cash a puny 1% a year.

So shares look like a winner when it comes to money you plan to tuck away for long-term growth, such as in a pension.

But what is a share?

What a share is

Shares denote slivers of ownership of companies.

By owning a slice of a company via its shares, you’re entitled to a portion of the wealth that the company generates over time.

Your particular entitlement varies with the size of your stake – in other words, the number of shares in the company that you own.

Western economies have tended to expand over the decades (boosted by inflation).

This economic growth has been reflected in the performance of our publicly owned companies, which in aggregate have become much more valuable over time.

As a result, shares have provided the best gains for investors over the long-term compared to the fixed returns from assets such as cash and bonds.

Share prices can go up and down

To be clear, the shares we’re talking about here – shares in public companies – are those traded on the stock markets.

Such trading means that as well as often receiving an income from your shares – called a dividend – you can also sell your shares in the future. Hopefully at a higher price than you bought them for!

This combination of dividends and capital growth is how shares deliver their returns to investors.

However it’s important to realize that the value of shares does fluctuate both ways – that is, their prices go down as well as up. ((To a lesser extent the dividends they pay are volatile, too. Dividends can be reduced or even cancelled by a company if it hits hard times.))

In a stock market crash in particular, share prices can fall a lot.

Hitherto most Western markets have eventually bounced back, even from big slumps like we saw in 2008. This has rewarded investors who sat through the crashes rather than selling.

Nevertheless, until prices do recover your wealth has been reduced – even if you prefer to think of it as a paper loss because you haven’t sold.

Such volatility (and uncertainty) is what makes shares riskier investments than cash or bonds.

You simply don’t know what your shares will be worth on any given day or month, even if you believe that over the long-term you’ll be rewarded for owning them.

And when prices do fall, it can take years for them to recover.

Look at this graph showing how the UK stock market has behaved since the year 2000:

As you can see, since 2000 investors in the UK market have had to endure two big declines. There was a slow slide from 2000 to 2003, and a sharper slump around the financial crisis, beginning in 2007.

Indeed, if this graph were the only evidence you were ever shown about investing in shares, you might wonder why you’d bother.

The level of the market today (right hand side of the graph) is not hugely higher than where it was in 2000 (left hand side), even after enduring all those ups and downs.

Some reward!

It’s important to note though that this graph, like most stock market graphs you’ll see, only shows capital growth. It doesn’t include the dividend income I mentioned.

Dividends are worth about 3-4% a year from the UK market. The total return picture is much more attractive if you assume dividends paid were reinvested back into the market every year.

We saw that in the historical return figures I quoted at the start of the article, which do include dividends.

Also, even 17 years is only really just getting into the ‘long-term’ when it comes to shares.

For a wider perspective on how shares can deliver strong gains over time, here’s a graph of how the US market has performed since the late 1970s:

Since 1977, the US stock market is up more than twenty-fold. Again this does not include dividends, which would have massively boosted those capital returns if reinvested. ((Unfortunately most graphs of stock market returns don’t incorporate the impact of reinvested dividends.))

I know that 1977 may seem a very long time ago, particularly if you’re young.

But if you’re in your mid-20s, say, then you’ll probably be saving for your retirement for 40-odd years. Forty years would take you back to 1977, where many people like you began investing in US shares for their own retirement.

Certainly there would – in retrospect – have been better and worse times to invest over those long four decades.

But the main thing to notice is the pattern of slumps and recoveries. This is what you have to steel yourself for when you invest in shares.

Don’t lose it entirely

It’s also important to note we’ve been looking at overall stock market movements so far.

Put simply, when we say ‘markets’ in this context, we’re referring to the shares of all the companies listed and traded in a particular country.

So the UK market refers to the shares of companies listed on the London Stock Exchange.

Data providers further divvy these shares up into various stock market indices. These indices makes it easier to track the performance of groups of companies, among other things.

For instance, in the UK we have the FTSE 100, which is the index of our 100 largest listed companies.

We also have indices that track the shares of energy and mining companies, indices of smaller companies, property companies, and so on.

Now, when I say markets have always bounced back from the worst crashes, that’s true in all but a handful of cases. ((The most important exceptions are Russia, China, and Germany, where markets were disrupted by revolution and war, and Japan, which is still well below the peak it reached in the late 1980s.))

But individual companies, in contrast, can and do go bust. And when a company goes bust, its shares can become worthless.

If you’re an investor in a company that goes bust – or one that simply goes down a lot in value and you sell, for that matter – then you will lose money.

There’s no compensation schemes or other protections in that case.

When you buy shares you are a true investor in a business venture. And when the business goes bust, the venture did not turn out well.

Diversify your shares

We see a picture then where stock markets overall have tended to post great long-term returns, even though some of the companies trading on those markets have delivered diabolical results.

In the worst cases big companies have gone bust, and their shares have become worthless.

What is happening here?

The seeming contradiction is simply down to the strong returns from the very best performing shares more than making up for the terrible returns of the worst.

• The most value that can be destroyed when a company goes bust is 100%.

• But if a business does very well or becomes very popular with investors (not always the same thing) it can go up in value by 200%, 300%, 10,000% or more.

This wide variation of returns from individual shares – together with the risk of permanently losing your capital in any that fail – is why it’s super important to diversify your holdings across many different companies.

Fortunately this is nowadays easily done.

The easiest way to invest in shares

As we’ve seen, deciding you should own some shares only opens another can of worms!

Besides preparing yourself for the market’s ups and downs, you might also consider:

• What amount of shares is it best to own for your age, income, aims, and attitudes towards risk?

• How do you decide which shares to own?

• What’s the best way to own them?

We can’t answer the first big question in this short piece, but other Monevator articles can help you create your own plan.

However for the other two questions, we’re convinced the simplest way for most people to own shares is via a global equity tracker fund.

Such a fund holds small stakes in many thousands of companies all over the world. This hugely diversifies your investments – not only across different shares, but also across different countries, currencies, and business types.

And as a tracker fund, it’s a low-cost passive investment that will leave more of your money free to compound over time.

• Before you invest you should read more about the benefits of a global equity tracker fund.

• We’ve also written about how to choose the right global tracker fund.

For much more on passive investing in general, head over to our passive HQ.

Key takeaways

• Shares are slices of ownership in publicly traded companies.

• Over the long-term, the returns from shares have outpaced those from bonds and cash.

• Share prices can go up and down, and in the worst case you can lose all your money.

• Overall though, stock markets have tended to go up over time.

• Diversifying your money across the shares of many different companies helps protect your investment from the worse outcomes.

• A global tracker fund is a cheap and effective way to invest into a diversified portfolio of global shares.

This article about shares is one of an occasional series on investing for beginners. Please subscribe to get our articles emailed to you and you’ll never miss a lesson. Why not tell a friend to help them get started?

Good reads from around the Web.

I believe humans are causing climate change. There is overwhelming consensus among scientists. Those who argue otherwise almost invariably come from a certain demographic, who I won’t name because I told reader @mathmo I’d try to be more sparing with labels.

Suffice to say, they might as well argue against gravity.

If Einstein wants to argue with scientists ((i.e. Propose a new working hypothesis.)) about gravity, I’m interested. If a middle-aged Top Gear fan wants to argue with scientists about climate change, they can do so elsewhere.

Liberal Snowflake credentials safely re-affirmed then, let me get to my own indignant outrage.

Why is the government’s workplace pension provider Nest making active investment decisions based on its employees’ opinions about climate change?

Nest knows best

In a short interview last week, Nest’s director of investment development explained to Share Radio that it had identified climate change as a key risk to returns.

According to The Guardian, the pension provider is therefore shifting around 10% of its members’ investments into a new climate change fund that dials back on fossil fuel firms and favours renewable energy:

Nest is now looking after the pension pots of more than four million UK workers, investing £1.5bn on their behalf, and has signed up more than 290,000 employers.

These numbers are expected to increase markedly over the next few years, making Nest a major shareholder and, it hopes, a difficult voice to ignore.

Why is Nest making such decisions for its members? Why does it need a voice? Why is it not just investing in tracker funds?

As we all know around here, most active funds fail to beat the market. Why is the default option for auto-enrolled workers not just a cheap and effective global index fund, paired with a bunch of gilts?

Climate change is hardly a hidden risk. Even Exxon Mobil’s new chief executive recently reiterated the company’s call for a carbon tax to help address it.

The market price of Exxon, Shell, BP, and other fossil fuel firms will normally reflect these known risks – as well as the potential rewards of owning vast reserves of a super-potent fuel.

What do Nest’s decision makers know that the market does not? Nothing, I would suggest. As far as I am aware they are not drawn from the sliver of proven billionaires who’ve made their fortunes reading the market’s runes.

They are no doubt perfectly decent salaried employees, doing what they think is right. But I think they’re getting it very wrong in the process.

I agree environmental degradation is a huge threat. But the market will determine over the next couple of decades whether the reserves of big oil companies and the like will end up ‘stranded’ and left in the ground, and if so which alternative energy will take up the slack.

My own hunch is solar, but I wouldn’t bet four million citizens’ retirements on it.

Whose retirement is it, anyway?

Incidentally, we get a lot of emails from people who want to invest passively but don’t want to invest in, say, big oil companies, or banks, or bomb makers.

We’re overdue an article on this. I understand the thinking, even if I’d suggest your views are perhaps better expressed outside of your portfolio. But the point is it’s your personal decision.

I can’t find recent figures, but as of 2013 the stats showed that 99% of Nest savers were in the default fund. These people are not making an active choice to bet against the market on fossil fuels. I doubt most realise their pension provider is, either.

Pension auto-enrollment is a great initiative, but making these active decisions risks undermining the whole project. Tracker funds exist and they do the job best for the greatest number of people. It’s maths.

I think the government should go to Vanguard, Blackrock, and the other leading tracker providers and play them off against each other to get a special deal for bringing four million new customers to the table. Then get out of the way.

[continue reading…]

I am not sure what I’d have to be smoking to make a public bet against Warren Buffett in the field of investing. But I am sure a libel laywer would have a view.

So let’s just say Ted Seides was overconfident when he took the other side of a wager against Buffett back in 2007.

The bet? That no investment professional could pick five hedge funds that would beat a cheap Vanguard S&P 500 index tracker fund over a 10-year period.

Warren Buffett has dedicated his long life to becoming the world’s richest man ((On and off.)) through investing. The proof is in the pudding. He has very little to gain from winning this bet – even today his firm is a quasi-active investment vehicle, and he promotes index funds for fun not profit – whereas the downside is a lot of egg on his face. You’ve got to think he was confident.

Cue warning lights.

I mean, making an investment bet against some hypothetically nervy, sleep-deprived, drug-addled Buffett might be conceivable.

But Warren Buffett confidently writing to his faithful shareholders in his annual report that nobody would win such a bet?

Back away slowly, keeping a tight hold of your wallet.

Sweaty Bet-ty

Here are some things where I’d back myself in a bet against Buffett:

• Who can eat the most vegetables from the salad counter.

• Who can talk the longest about investing without mentioning American exceptionalism, Benjamin Graham, Coca-Cola, being greedy when others are fearful, or how a farm will be productive for 30 years regardless of the going rate for farms that week.

• A 100m sprint (no golf buggies or other vehicles allowed).

• First to find your seat on a commercial flight.

• FIFA 2017 on the PlayStation 4.

Here are some things where I wouldn’t bet against Buffett:

• No-limits Texas Hold ’em poker.

• Who can eat the most hamburger dinners in a row before cracking and ordering sushi.

• Investing.

Buffett is a stock market genius. Trackers are cheap and their returns trounce most active funds over 10-year periods. Hedge funds are insanely expensive, and even their best managers face a mighty struggle in overcoming the hurdle imposed by the high fees they charge.

Talk about a loaded deck.

Seriously, it’s one thing to get rich selling active management magic that costs your clients 2-and-20.

It’s another thing to actually believe in it.

Fee high foe fun

On a personal level, Buffett says he likes his opponent in this wager. Seides does come across as a decent sort, and I certainly admire the fact that he – as a co-founder of investment firm Protégé Partners – put his money where his professional mouth was.

I mean, with trillions under management for their clients, and millions – if not billions – in the bank, you’d expect a scrum of hedge fund managers would have been falling over each other to put the yokel from Nebraska back in his place.

What a great advert for the hedge fund industry beating Buffett would be! Surely they all jumped at the chance?

Of course not. Hedge fund managers are not dumb.

Seides stepped up though, and you have to admire that. I always have a soft spot for the trooper who volunteers to take the pistol with two bullets from the Captain and heads out into the snow to seek a miracle while the rest of his comrades huddle safely in the bunker.

But where Seides really made life hard for himself in his suicidal bet against Buffett was that he didn’t just pick five hedge funds. He picked five funds of hedge funds.

This means Seides’ selections compounded the high fees charged by hedge funds with another layer of fees on top, from the fund of fund managers.

This is a bit like inviting termites onto your leaking rowboat. Money is soon pouring out of every (mixed) metaphorical orifice.

Lars Kroijer wrote an article for us about fund of fund fees. He estimated that for every $10 of return generated by the underlying funds, the actual investor might get to keep $3.

Staggering. Go check the maths.

Against all odds

To be fair, we must remember that back in 2007 hedge funds as an asset class hadn’t yet wracked up a diabolical decade of market-lagging returns.

They have now. When Pension Partners surveyed the scene in 2016, it found that:

…since the start of 2005, the HFRX Global Hedge Fund Index and HFRX Equity Hedge Index (two investable indices widely used as benchmarks in the industry) have posted negative returns (-1% and -6.4% respectively).

Over that same time period, the Barclays Aggregate Bond Index was up 62.1% and the S&P 500 up 97.6%.

Negative. Returns.

The odds were against Seides. But he might still have had a tiny chance of winning if he’d tried to somehow alight upon those few funds in the $4-trillion industry that delivered decent returns after fees over the past nine years.

However by opting for funds of funds, Seides reinforced that huge cost hurdle by condemning his returns to mediocrity, via five flocks of mutton dressed as lamb.

In his annual letter to shareholders, Buffett reveals the gory results with just one year to go:

Source: Berkshire Hathaway Shareholder Letter 2016

Forget beating the S&P 500 as a group. Only one fund of funds has got within shooting distance of the index, and even it trails it. The rest are woeful laggards.

It’s safe to say that Buffett’s nominated charity can already start to think about how they will spend his winnings.

Buffett writes:

Buffett also mentioned that he always recommends index funds to friends, but that only those of modest means and little business knowledge follow up on the idea. The financially successful feel short-changed, and seek better returns elsewhere.

This has been my experience, too. While I’d obviously wish my own friends better, from a societal perspective long may this vanity tax on the rich continue.

Work it out

I happened to see an interview on CNBC with a City professional on Monday morning, after Buffett’s letter had been released.

The gist of the interviewer’s question was that if investing legend Warren Buffett says people should use index funds, then why shouldn’t people use index funds?

To his credit, the Cityboy looked momentarily terrified.

(Note to Ted Seides: When you’re up against Warren Buffett on the subject of investment advice, terrified is the appropriate posture to adopt).

Perhaps remembering who buttered his bread, the sacrificial lamb eventually spluttered back to life. He agreed that trackers were okay for those without financial advice, but that “hard work” and professional expertise would always be able to find you those funds that outperformed.

This is nonsense. The correct statement is they might, but the odds are against it.

Hard work is always trotted out by active apologists, but almost everyone in finance works hard. And picking market-beating fund managers is the same zero sum game that active investing is, only the downside has extra knobs on due to even more fees.

Ted Seides’ superb CV includes Yale and Harvard, time spent working with David Swensen, and experience co-founding a multi-billion dollar investment shop. (His biography also sportingly references his aspirational bet with Buffett.)

By any measure Seides is an accomplished professional. If he can’t find five funds that will beat an S&P Index fund – with $500,000 of his own money on the line – then do you think it’s likely your local financial advisor on the High Street in an office above a kebab shop will do any better?

Buffy the vampire slayer

Warren Buffett is a rare kind of unicorn. Rather than tell you there’s a whole pasture of his type over the next green hill, he advises you to look for a workhorse instead.

Buffett readily agrees that some fund managers will beat the market. Besides himself, he believes that in his lifetime he’s identified – at that start of their careers, when it actually mattered – a whole ten!

He continues: