Good reads from around the Web.

What a week it’s been in the markets! If you’re (sensibly) a passive investor, then hopefully the turmoil has passed you by.

But if like me you’re an active dabbler, then you probably know what I’m talking about.

The short summary is the US market has become much more volatile on a intra-day basis (though pretty flat on a weekly view), the oil price fell further than almost anyone thought possible, and to top it all the Swiss National Bank removed the cap on its currency – a dramatic and unexpected move akin to an elephant parascending onto a crowded kid-strewn bouncy castle.

The chaos left made some big name FX brokers reeling if not insolvent.

So the first lesson of the week is relevant for everyone, which is that things fail.

I’ve said before I would never have all my money with one fund group (not even Vanguard) nor one broker. This week shows why.

I still meet or read about people with nearly all their money in 1-2 shares, which is insanity unless you founded and run the company. Even then it’s extremely unwise.

But I’d also question the wisdom of running your entire diversified passive portfolio on just one cheap online platform.

Many do it. I wouldn’t.

Sure, the 50-1 leverage used by traders on those FX platforms was a clearly outsized risk compared to an online broker or platform with segregated accounts that supposedly keeps your money safe.

And yes there are investor compensation schemes.

But things can go wrong, and they’re always unexpected things. The fail-safes may fail.

As The Accumulator wrote in one of those articles on the subject:

Does it matter? Can the worst happen?

It’s rare, but yes it can.

It’s a personal choice, but for me paranoia is a price worth paying.

It doesn’t hurt to look, does it?

As for what you should do in light of this recent volatility, the house view is that most people are best off being passive investors and doing nothing.

Fiddle, and you’ll probably make things worse.

(Of course I’m assuming here that you’ve got an appropriate asset allocation for your temperament and long-term goals in the first place.)

At times of scary headlines, the best thing to do is often to just look the other way, as Morgan Housel said this week at the US Motley Fool:

Go do something else.

Maybe read more books and fewer articles.

Be more choosy about who you’re willing to listen to.

The amount of financial information available has exploded over the last decade, but the amount of financial information that you need to be informed has not.

You have to learn how to sift through the news, and filter out what you don’t need.

“A wealth of information creates a poverty of attention,” Herbert Simon said. It also creates a dangerous tendency to lose self-control over your ability to be a patient long-term investor.

Just look the other way.

It’s great advice. If you’re a passive investor then I suggest you skip straight down to the links below!

The gnomes of Zurich

Still here? Really? After seven years and ever fewer articles about active investing on Monevator, you still haven’t got the message?

Oh well, I can’t be a hypocrite. So for what it’s worth I’ll offer up a very brief bit of frothy speculation.

A few crazy long-time readers even asked me what I thought. (Careful! I am just a bloke on the Internet!)

To start with, I don’t think the heads of the Swiss National Bank suddenly woke up lobotomized. They knew the chaos their action would cause, and they knew it would inflict a lot of hardship on their own economy.

We also should keep in mind that there was only recently a (failed) referendum on returning Switzerland to a gold standard of sorts. Clearly a significant chunk of the Swiss population was growing wary of trying to fight the plunging Euro.

So I think it’s pretty much nailed-on that the ECB is going to announce full-blown quantitative easing in the next few days.

Either the Swiss got a heads up from Mario Draghi or took their cue from a recent EU lawyer’s decision on the legality of European QE, or else they spend all their days thinking about such things, and they’ve divined it ahead of the market.

(Of course people will say the market already expects QE from the ECB, too. But if certainty was really a widespread view, then we wouldn’t have seen the storms we saw following the Swiss move. I think more money would have already been positioned ahead of it, and hence the volatility would have been lower).

2015: A year of living dangerously

And what of the US intra-day volatility?

A few things are going on, I’m guessing.

Firstly, the collapse in energy prices was unforeseen, and it has wide macro-economic consequences as well as an impact on pretty much every listed company. So everything needs to be repriced in light of this development.

That is even leaving aside the fact that it may be telling us global growth is rolling over, because it’s really a demand shock. (I doubt it, but it is a risk).

Secondly, I suspect money is repositioning itself ahead of ECB action, possibly by buying into Europe (optimistic investors) or even more into bonds (pessimistic investors).

Thirdly, “everyone knows” (see Swedroe in the links below) that the US is an expensive stock market. So no wonder they dump it if they worry about the above.

Fourthly – and this is a gut feel thing – I think markets, including oil, are more illiquid or certainly less buffered than they used to be.

Perhaps it’s down to investment banks scrapping trading desks. Perhaps there’s less leverage in the system at hedge funds or similar. I can’t quantify it and it might be a misleading path to go down – because things have been so placid for so long, as volatility has been smothered by low interest rates, that we may have just forgotten what real volatility feels like.

But with that caveat, I think something has changed.

Fifthly, related, the Swiss National Bank move, the role of leverage at the brokers, and the associated fallout gives us an insight that you can’t regulate away risks, which regulators seem hell bent on trying to do.

As I’ve written before, risk cannot be eliminate, it can only be transformed.

Fifth-and-a-half-ly – It also gives us an insight into what happens when risk is effectively taken out of the markets and placed with Central Banks. Calmer most of the time, but the ever-present danger of big Central Bank initiated dislocations.

Finally, I don’t want to scare anyone but when stock markets crash, it’s my belief and experience that they behave in the way that the US market has been acting over the past six months.

Leadership narrows (fewer stocks go up) and at the end of the run you get violent swings up and down.

The US market has had a terrific six years. We don’t need to see a massive bear market crash, but a significant correction is well overdue, in my view.

It may be as I say that money is repositioning itself out of expensive US shares and into European equities ahead of the ECB move. It may even be that the volatility doesn’t presage a crash, but rather a lurch higher – that’s possible.

Think of an old engine juddering and coughing as it either roars to life or else conks out. I suspect that may be where we are with the US bull run at the moment.

Don’t do what I do

What have I been doing?

With most of my portfolio – nothing.

At the margin, at a portfolio level: Reducing US exposure, trading energy stocks, building up a position in commodity producers (from near-zero!), and adding more European exposure. (I waited a long time to buy more into Europe as I was and still am fearful of the currency risk).

Caveat: The active share of my active investing is active. This might all be different by next Saturday!

The bottom line is that if you aren’t a well-diversified investor because it has seemed pointless in the past few years of placid markets, you might consider this a wake-up call.

Or at the least, know all the risks you’re taking, however you’re invested.

[continue reading…]

One problem with writing an educational sort of blog is you never know who you’re talking to.

The same is true with a book or a movie, but the difference with blogging is a reader usually pops up right in the middle of things, having been sent to some article on the whim of Google.

This means you can’t assume anyone knows anything just because you’ve written about it before. And you can’t assume they’ll ever come back.

It all presents some challenges, including the one I am going to discuss today, which is how to answer the question: “Is investing a zero sum game?”

On the one hand, I might be talking to someone steeped in years of active fund propaganda, who genuinely believes it’s smart to pay up for a portfolio of actively managed funds because they think that clever active fund managers who work hard will obviously beat a dumb ‘buy everything’ strategy.

It sounds so logical. Whereas passive index investing just feels wrong.

To these people, we need to explain that while it’s certainly true that many active funds will beat the market in any given year, it’s impossible for a majority of actively managed money to do so, and also that vanishingly few funds have long-term records of outperformance. (Just 1% or so, according to some studies. Good luck picking them in advance!)

On the other hand, we might be visited by a new investor who wants a better return than from cash, but who has got the impression from movies and newspapers that the stock market is a winner-takes-all casino – that it’s like playing poker against Gordon Gecko and The Wolf of Wall Street.

To these people we need to explain that passively investing in equities gives you a stake in the growth and output of productive business.

Investing need not have anything to do with trying to pick winners or with regularly making bets – trades – unless you want it to.

The super market

At the crux of it all is the ‘market return’. This the return that a particular market returns in a particular year.

For instance, if the UK’s FTSE 100 index of the top 100 largest companies goes up 10% this year and pays out 4% in dividends, then the market return would be 14% for the year.

You can get the vast majority of this return by owning a cheap passive fund that tracks the index (with a little bit deducted for the costs of running the fund).

• At financial cocktail parties, the lingo for this return from the market is beta.

• Any additional return you get that beats the market – from stock picking or borrowing to invest or what have you – is called alpha.

Let’s say you own an active fund that delivers an 18% return by investing in a superior selection of FTSE 100 companies in the same year the UK market goes up 14%.

In this case, 14% of the return was beta – the market return – with another 4% (that is, 18 minus 14) chalked up to alpha.

On the other hand, if your active investing does worse than the market, then the return reduction is sometimes called ‘negative alpha’.

Let’s say another active fund you own achieves 10% in the same year.

In this case, the alpha is negative 4.0 – this time the fund manager’s decisions (and/or costs) reduced the return you got from the market (beta) by 4%.

(Note: I am necessarily simplifying here for brevity. In particular I am ignoring risk. We’ll look at that more deeply in a future article.)

Alpha, beta, and beating the market

While introducing Greek isn’t usually a recipe for clarity (there’s only so many Popadopolouses that an Anglo-Saxon mind can process) in this case I think it’s worthwhile in attempting to explaining what investing is, and what it isn’t.

Because what we’re really talking about when it comes to the zero sum game question is alpha, not beta.

As I say, you can get beta from a tracker fund, or via the market-mirroring elements of an actively managed portfolio.

But where does alpha come from?

At someone else’s expense, that’s where.

What is a zero sum game?

Let’s go back to first principles. Wikipedia describes a zero sum game as:

…a mathematical representation of a situation in which a participant’s gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s).

If the total gains of the participants are added up and the total losses are subtracted, they will sum to zero.

Confused?

Luckily the author swiftly appeals to our stomachs:

Cutting a cake, where taking a larger piece reduces the amount of cake available for others, is a zero-sum game if all participants value each unit of cake equally

There’s only so many pieces of cake to go around. If eight of us divide a cake into eight pieces and you swiftly gobble down two pieces, then someone will go without cake.

That’s a zero sum game.

Is investing a zero sum game?

A lot of people have the impression that investing in equities (shares) is a zero-sum game.

They hear about Wall Street and the City of London’s winner-takes-all mentality, and they think investing must be like a poker game.

In typical poker games, everyone brings the same wodge of cash to play. As they win and lose their money, it is redistributed around the table between the players.

Often players bow out of the game when they run out of money, leaving fewer players to compete for that same total ‘pot’ in circulation. Often one player goes home with everything – that is, they take home all the money the players together brought to the table.

Poker is a zero sum game. You win money by taking it from someone else.

And that is is not necessarily what happens when you invest in equities.

Equities are small slivers of ownership of companies.

To simplify for the sake of today’s discussion, in any particular year a single company may do badly or do well, but over the long-term you would expect companies as a whole – the ‘market’ – to grow their earnings as the economy expands and companies become more productive, and also because inflation boosts their sales numbers in nominal terms.

This is the reason why stock market indices – a measure of the value of all the companies listed in a particular stock market – have overwhelmingly tended to increase in value over the long-term, provided those markets haven’t been struck down by hyper-inflation or a communist revolution.

For example, the following graph shows how the total value of stock market listed US companies has increased in real terms over the past century or so – i.e. even after backing out the illusory growth from inflation:

The black line rises as US companies have collectively become more valuable, although the spikes and troughs show it hasn’t been a smooth ride.

Sometimes people get carried away and pay too much for companies. Sometimes they are frightened and prices plunge.

This kind of volatility is another reason why some people think investing in equities is like gambling, incidentally. Over the short-term, luck does play more of a factor as a consequence of these gyrations.

But over the long-term, the growth in value is clear.

In addition, as well as this rise in the long-term value of their shares, investors in equities also benefit from dividends – regular payouts of cash.

You can see in the following graph that reinvesting dividends (the green line) makes an enormous difference to long-term returns, as well as dampening down that short-term volatility.

As an investor in equities then, you expect to benefit from the growth in the value of your shareholdings, and also from receiving those regular cash dividends.

This is because you own stakes in businesses. It’s exactly the same as if you owned a pub or an ice-cream van or a buy-to-let property. You are making your money by investing in productive businesses, not by trading or gambling.

Earning a beta return from the stock market

A quick look at the long-term record shows that the UK stock market has delivered an annualized real1 return better than 5% over the past 100 years or so.

Now, this does not mean you are guaranteed to get a 5% real return in the next 12 months from the UK stock market – as we saw in the graphs above, in the short-term anything can happen.

But it does mean that over the long-term – say 30 years of saving for a pension – then if history is a guide you might expect an annualized 5% real return from UK shares.2

If you own the market (via a tracker fund) then you will get the market return.

You can hopefully see therefore that investing in equities via an index tracker fund is not a zero sum game.

All investors in the UK market in aggregate can expect that long-term 5% annual real return3, before costs, provided the economy keeps growing and stock market listed companies get their share of that growth and the investors are invested in such a way as to capture the return from the market (the beta).

Everyone’s a winner! No zero sum game here.

Reminder: A cheap and easy way to capture the return from the stock market (minus modest costs) is via passive investing in index funds.

The confusion arises because active investing is a zero sum game when it comes to trying to beat the market.4

To learn why read the follow-up post: Is active investing a zero sum game?

1. That is, after taking out the illusory growth in value from inflation. [↩]
2. I am not going to get into the various caveats about prospective returns or whether we’re in a environment of low returns or what have you right now. That is irrelevant for the purposes of this article. And also I don’t believe it’s true. [↩]
3. Or whatever the long-term annualized return for UK shares turns out to be. [↩]
4. You can argue that you’re happy to take less risk for a lower return, say, but then you’re not beating the market so that’s a different question. [↩]

The internet can swamp the best of intentions. When you want to know how to do something, there’s nothing like 274 million Google hits to make you think that you’re never going to find the time.

This fire hose of human knowledge can all too quickly become a water cannon.

But one of investing’s oft-neglected truisms is that the important stuff is actually very simple.

If you get the basics right and resist the urge to ‘optimise’ before you even know where to start then you’re likely to do just fine.

Know why you’re doing it

Are you investing:

• For retirement?

• To pay off a mortgage?

• For your kids?

• To create a nest egg?

Is investing success critical to your future happiness or would it just be nice to have?

Only by knowing how big the task is will you be able to calculate what it will take to achieve it.

Only by knowing how important it is will you find the gumption to stick with it.

Save enough to make a difference

A big goal – a comfortable retirement, for example – takes many years to achieve. It will soak up a lot of your financial firepower.

Thanks to the power of compound interest , the more you save now, the less money it will require overall.

Also, the more you save now, the less income you will need to live on, too – reducing the scale of the money mountain you need to climb.

Don’t listen to sticking-plaster merchants who bandy around some random percentage of your salary to put away. That kind of advice is aimed at winning your business, rather than helping you win your financial freedom.

It’s not hard to work out your own plan once you know how.

Keep costs low

The only worthwhile predictor of future investment performance is cost. That’s why we recommend most people narrow the field of investment options to low-cost index trackers.

The best trackers are cheap, simple, and will beat the majority of expensive alternatives.

You can buy them yourself using an online broker.

Diversify

Famously, diversification is the only free lunch in investing. Spreading your bets across the main asset classes is the best way to future-proof yourself against dire loss for any one of them.

Choose an asset allocation that invests in funds offering broad exposure to equities, government bonds, and property. These are the assets that have a long history of solid returns.

Invest across as many regions of the world and types of company as you can for a reasonable cost.

Don’t get sucked into believing that some guru can predict whether Russia will make you a killing next year, or that an aging population means that drugs companies a sure-fire bet.

If forecasters were any better than Mystic Meg then they would make a fortune by acting on their secrets for themselves, not sharing them.

Also understand that there’s no special gain to be made from predicting future trends. Everyone else has the same information so it’s already factored into the price.

Take cover from tax

Use your pension options (workplace, SIPP, stakeholder and so on), employer matches, and ISA allowances to maximise your returns.

Every pound that someone gives you – or doesn’t nab from you – is a pound that’s working for you and not someone else.

Automate it

The less you interfere the better. Humans are psychologically geared to goof up investing.

• Use direct debits and your broker’s regular investment scheme to automatically invest monthly.

• Use accumulation funds to reinvest your dividends.

• Rebalance your funds once a year but otherwise leave your bread in the oven to rise.

The more you tinker, over-complicate and second-guess the future, the more likely you are to end up making the wrong decisions.

Don’t panic

The world always seems to be on the brink of some disaster. Slowdowns and recessions lurk around the corner. Some region or other is gonna blow. War, Famine, Pestilence and Death are always due in town.

Yet somehow civilisation soldiers on.

The media is designed to feed our fears. Ignore it, or better still don’t listen to it and then it won’t bother you.

You can expect equities to fall often: one year in every three on average. But they have always bounced back. Your allocation of bonds is there to cushion the blow in the meantime.

Rebalancing is the self-righting mechanism that ensures you buy asset classes when they’re cheap and you cash in when they bounce back.

Despite two World Wars, the flu pandemic, the Great Depression, the Great Recession, the loss of Empire, stagflation and The Krankies, UK equities have delivered an annualised 5% real growth over the long-term.

Stick to the plan, keep things simple, and remember investing is a long-term game.

Oh, and picking up a good book to help you learn more is a capital idea, too.

Take it steady,

The Accumulator