Over the next few posts we’re going to try something a little bit different on Monevator.

We’re going to confront the tension that sits at the heart of this website. The fact that – despite commanding a bastion of passive investing – Monevator’s own head honcho, The Investor, has a foot, arm, leg, indeed his very heart and soul in the active camp.

Not to mention a large chunk of his portfolio.

What’s more, many of Monevator’s readers are similarly permissive when it comes to their investing philosophy.

So let’s have it out. Let’s cross wits and cerebellums. On the one side sits I, The Accumulator, High Priest of the Purely Passive. On the other sits The Investor, a Promiscuous Pursuer of Profit. Let’s talk about our competing philosophies, the risks we face, the opportunities at stake, and the rationale for our choices.

And after three such head-to-head posts from us, let’s open it up to you lot for a – sporting and well-mannered – end-of-year ding dong.

Hopefully we can still all be friends at the end of it. Although I’ll warn you – discussions between The Investor and I can go one of two ways. We’ll either have a cosy fireside chat or a knife fight in a telephone box.

Let’s see what happens next.

Have at thee!

The Accumulator: So you started out investing in index trackers but, like Anakin Skywalker before you, you couldn’t resist the lure of the Dark Side. What happened to turn you into an active investor?

The Investor: Hmm, my failure in the cave? No, I don’t think there was any one event or moment of insight – probably like Anakin I always had the Dark Side within me. I did run a high yield portfolio of shares alongside my early trackers, and I did find them far more fascinating.

I then started investing in small cap value shares of the sort that did well around 2000 to 2003. On the whole mine didn’t do that well – I lost the lot on one! So I wasn’t won over by some magical profitable trade, that’s for sure, although no doubt the thrill of seeing others go up did spark something.

Probably it’s a combination of my innate, sometimes annoying personal traits, together with the fact that the devil has the best tunes.

On the former, you observed once that some people just aren’t cut out to be passive investors, even if they see the logical case, and I’m probably one of them. I’d note to readers: This does not imply doing better! It’s about not being cut out for the process, not the results. Most active investors do worse – whatever delusions they harbour.

On the latter, those tunes, I like reading Buffett, Slater, Greenblatt, Graham, histories of hedge funds, and reports from the Great Crash. In contrast, as you know I failed to finish Hale. If only I’d made it to those last few pages, eh?

The Accumulator: Interesting. So you were drawn into the part of the forest that excited you? And if we flicked through our big book of behavioural finance we’d no doubt find the cognitive bias that confirms that people like to invest in securities that are more familiar to them or that give them more pleasure.

In the first instance, there is a comfort to be found in the idea that you know a firm inside out – you can create a more credible rationale for its future performance.

In the second instance, we know that people love the lottery. There’s catnip in the notion that you might hit the jackpot.

The thing is, isn’t investing a cold, hard calculation? We invest now to secure a stream of income in the future. We want that income to be as high as possible, and anything that undermines that (like a bad bet) should be avoided like a Jawa with syphilis.

In other words, you should get your thrills from the dog track and your intellectual stimulation from the Ancient Greeks, but not the stock market?

You are using Bonetti’s defence against me, uh?

The Investor: I suppose there’s several answers to that – but first let’s just put in a standing statement that I agree with everything you say! That’s why Monevator touts passive investing, not active, as an investor’s core strategy.

I am not going to try to ‘turn’ you, or anyone else, here. This is just how I developed, not a recommended course of action.

The big thing is I find it trivially easy to save, so I’m not gambling my retirement if I do a little worse than the market for the price of entry into the stock market casino. So I don’t see a lot of downside, given how enthralling I find my intellectual poison of choice.

One thing that does frustrate me about passive investing writing, is a writer will say something like “Why gamble your retirement on active funds that could leave you eating beans in your old age,” whereas in reality, you’re still likely to be able to retire following an active path, especially now trail commission to advisers has been abolished.

Of course you will probably do worse – compounded to say 20% worse – than if you’d been passive, or maybe at some point you’d realise that shortfall was coming and decide to save more money to avert it. But anyway it’s not passive or penury.

I think a lot of nasty things were in the same pot when I started investing – financial advisers taking a big cut, opaque management fees, and little choice for pension funds and the like. It all reduced investor returns but the active part was only one portion of the comprehensively terrible picture.

In reality many people have done perfectly well as far as they’re concerned from a portfolio of large well-known active funds, or perhaps investment trusts. We know they almost certainly would have done better with passive equivalents, but they may not and they probably don’t care.

Having said that, I invest most of my money in shares, not funds. I think if you have a fairly good grasp of what you’re doing, it’s arguably not too hard to do at least as well as active funds, after costs, due to their various limitations – and I know that contradicts the standard “they have all the brains and better information” message.

The thing is, I think professional active managers are plenty hamstrung, too. No, it’s not an equal fight – we’re using different weapons – but it’s perhaps more of a fair one than some think.

I stress again that you do need a good grasp of what you’re doing. Crucially – and it’s probably going to sound arrogant to say so – I don’t think many people have that, even if they’ve been investing for years. Picking shares is easy to do, but hard to do well. So again most will be better off passive.

I have the feeling I didn’t answer your question.

To further avoid doing so, perhaps I could turn it around and ask why you didn’t have a crack at active investing yourself?

I know you were bewildered like most of us when you first surveyed the investing landscape, but it’s clearly not beyond you. And you have many of the same personality traits that I do, albeit in a more rounded and socially-acceptable form. And you’ve got the competitive spirit, and have wanted to win – and have won – in other fields in the past.

Were you not – are you not – even a tiny bit tempted? Why did you assume you’d lose without trying?

Now read Episode II of this titanic struggle to see the couch potato investors strike back! Remember, comments are turned off until the third and final post.

Good reads from around the Web.

The Americans are going nuts about a stock market bubble.

I know – it’s hard to keep up!

Only 18 months ago you couldn’t say something nice about US equities on TV without getting laughed back to the cab rank. But now everyone is bullish – and simultaneously nervous.

It’s not like that in Blighty. The FTSE 100 is ‘only’ up 11% or so in 2013, not counting dividends1. Whereas say house prices are rising and most people know it, I don’t get the sense the wider public is thinking about the stock market yet.

In contrast, the S&P 500 is nearly 28% ahead for the year. American investors, like most, have massive home bias, so they’ve seen their portfolios surge. In that sense, they are right to be wary.

There’s pretty much no correlation between one year’s returns and the next. However when prices rise, value goes down. It can’t be any other way. In that sense, I agree the US stock market is becoming less attractive – without having to consult my crystal ball.

Can you spot a stock market bubble in advance?

It’s been a good few years since people had to worry about a bubble in the overall stock market, so it might be worth brushing up on the basics.

This video interview by the every reliable Morgan Housel gives a nice bit of background:

I find this sort of thing endlessly fascinating, because I am an investing nerd.

But at the risk of sending regular readers to sleep, I also think that rather than playing poker, most people are best passively investing via a diversified portfolio, rebalancing annually, and getting on with their life.

True, that approach will guarantee you’ll never match the best performing asset in any given year. Sometimes you’ll trail quite considerably – like our model portfolio was versus UK equities as of our last update – but that’s the price of a very likely good result in the end.

The other reminder is to take short-term predictions of doom with a bag of salt – and those of rosy times forever, too, when such predictions finally do arrive.

As I wrote in November 2012 after the UK financial regulator predicted lower returns for as far as the eye can see:

Here we have the regulator rolling up to the scene of the crime not long after the worst decade for equities relative to bonds (the worst two decades, even) to warn us – wait for it – to temper our expectations.

As far as useful advice goes, this is a bit like Eva Braun showing up in London in the middle of the Blitz to warn Churchill that her boyfriend seems a bit obsessed with guns.

What was the regulator doing in 1999, when the UK stock market peaked at nearly 7,000 and shares traded on a P/E of around 30?

[…]

In my view equity returns will likely be at least average, if not higher, from here.

Depending which index you track, the US stock market has more than doubled since its 2009 lows. (And yes, one could see it might be good value back then).

Missing out on doubling your money because you listened to doomsters who said the world was ending or deflationists who said that the new normal was returns of 2% forever cost you dear. It will take many decades for cash savings to make up for those missed returns.

Get fearful as others get greedy

But all that was then, and this is now.

I’m obviously – doubled-underlined – not predicting an imminent crash. I don’t think anyone can do that, even if I thought it was wise to try – or likely.

However I think it’s safe to say the time for heroic over-allocations to US – and to a lesser extent other developed world equities – is over. Looking dumb now could plant the seeds for strong returns later.

Be diversified or be contrarian, but don’t be a clueless latecomer.

[continue reading…]

1. Though small to mid-cap UK shares have done a lot better. [↩]

I suspect investors of the John Lee variety are becoming a vanishing breed. Now 71-years old, Lee grew up seeing his father sprawled on the drawing room floor, pipe in hand and fortune on the horizon, scouring defunct publications like the Stock Exchange Gazette for bargains.

“Money is not for spending, it’s for buying shares,” his late father used to say, and while Lee – today Lord Lee of Trafford – claims it was meant as a joke, he’s still followed in his father’s footsteps.

In 2003, Lee revealed to readers of his long-running Financial Times column that he was an ISA millionaire. Quite an achievement given that the maximum PEP and ISA contribution possible between 1987 and 2003 was £126,0001 and the main market had crashed just three years prior.

What’s more, Lee’s ISAs contain just a portion of his total holdings; his writings are scattered with rueful comments about capital gains tax due outside of tax shelters. (I regularly see investors who think they are either too poor or too rich to bother with ISAs – all are wrong, unless they plan on dire long-term returns.)

Lee’s shareholdings have likely multiplied several times since 2003, too. As a long-time follower I know his favourite companies, and his particular brand of small cap share has had a splendid 2013.

Assuming he hasn’t started liquidating his assets, his portfolio must be well into the multi-million pound range by now.

Golden oldie

Lee is a wealthy investor, then, yet he’s one who doesn’t use the Internet. Who still attends AGMs and quizzes company management over British tea and biscuits. Who pours through paper-based annual reports for hidden clues to his companies’ prospects. Who doesn’t invest any of his fortune in active funds, index trackers – or overseas at all.

No, John Lee is a Lord of the Realm, a successful businessman, and a sitter-on-boards whose heart ticks fastest on discovering a small, family-run UK firm with a large cash pile and an heirless octogenarian in the chairman’s seat, pondering selling the business to the highest bidder.

He’s an old-fashioned and super-successful investor who is venerable enough to have learned the word ‘alpha’ in Greek in pre-school and for all I know takes beta-blockers for an ageing heart, but who doesn’t let either alpha or beta get in the way of his investment decisions.

Not smarter, but sexier

Given all that, plus his upbringing and his many years spent at Westminster, it’s no surprise that this is an old-fashioned book, too.

In fact, much of How to Make a Million – Slowly is plain ‘old’, full stop, as the book contains numerous reprints of Lee’s columns for the FT.

Some of these are already a decade out-of-date. Obviously they will become ever more irrelevant to modern investors over time, in terms of the facts they contain.

But the reason they’re in the book is because of the messages they convey, not the facts.2 These messages should only become more relevant over the years, as the specifics are long forgotten and cease to cloud the picture.

And in some ways that’s true of the book itself.

You see How to Make a Million – Slowly is about as far from, say, the passive workhorse Smarter Investing as you could imagine.

Hale’s book is heavy on data, and to my mind light on charm. I’ve even told my co-blogger that I’m not sure I’d be investing if Smarter Investing was the only book on the subject I’d read.

Of course my co-blogger The Accumulator is a big fan of it partly because he believes that charm is the last thing you need when looking to secure your fortune. Rather, being beaten over the head with the key messages and a vaccination against the wiles of the financial services industry is what people need to swallow.

I agree. And yet, personally, I caught the investing bug not from the thought of a risk-adjusted well-diversified annually rebalanced 5-8% nominal return a year, but from the writings of Jim Slater, Warren Buffett, Peter Lynch, and other articulate – and undoubtedly survivorship biased – active investors.

It’s down that end of the bookshelf where Lee’s book belongs. Indeed, the whole thing reads more like a chat with an avuncular grandfather (who knows, perhaps Lee’s own father?) than a modern treatise on discovering your edge or exploring the efficient frontier.

I hadn’t met anyone who’d ever bought a share until I was into my 20s. For me, that’s a gap worth filling.

How to make a million – really?

What the book also isn’t, really, is what it claims to be in the title – or at least not exactly.

Lee does summarise his approach, which is essentially to buy small to micro-sized niche companies that you judge to be trustworthy when they’re paying a good dividend yield and look cheap on a P/E basis. Then hold for as long as you feel able.

There are only a dozen or so pages that boil down to anything like a checklist. Anyone hoping for the new Zulu Principle might be disappointed.

Nor is it, as I’ve hinted above, terrifically introspective about exactly how Lee’s gains were achieved. There is a lot of conjecture about quizzing directors and reinvesting dividends, but there’s not much questioning about risk and returns, or comparing Lee’s annual returns on a compounded basis with an appropriate benchmark.

If John Lee was Warren Buffett, no doubt some quant or academic would come along and explain it could all have been achieved by, say, borrowing money to buy a boatload of shares in a small cap investment trust or what have you (small cap ETFs not having been around for most of Lee’s lifetime, and barely today in the UK).

So let me be clear, rigour is not on offer here. Don’t buy this book expecting a formula, a secret, or even a How To plan.

Nor is this the book for you if you’ve read everything John Lee has ever written, you have a photographic memory, and you don’t want it all compiled in one convenient place (as I myself do), with a bit of intra-book repetition thrown in for good measure.

However if you want to feel like you’re spending time with a successful active investor, picking up plenty of wisdom through osmosis, and that you can learn from even his throwaway lines, then it will prove a worthwhile purchase.

If you love small caps and believe there’s more to risk than volatility – and more to judging a company than the numbers in a database – then this is absolutely the book for you.

That’s doubly true if you invest in the UK, where books by investment legends are very thin on the ground.

A book for lovers

It would be easy to follow Lee’s high dividend, low P/E approach to small caps yet be unlucky enough to invest in many more of the sort of duff shares he candidly reveals buying in his chapter entitled ‘My Mistakes’.

That’s why I stress there’s – patently, obviously – no formula to success. What cynics of stock picking might call his “special magic pixie dust” has surely made a difference to his returns. You won’t become the next John Lee purely by reading his book.

Should you try? I think Lee himself nails it when he writes:

In my view, to be a successful investor requires commitment and time, and you’re only going to put in the required effort if you find the stock market enjoyable and absorbing.

To be blunt, either you fall in love with investing – its fascination and its mysteries – or you don’t. You will know soon enough which it is.

If you don’t, there is no shame in this, just forget it – leave the investing of your money to others, either by choosing a mutual fund / investment or unit trust, or giving a stockbroker or bank discretion to handle your portfolio on an agreed basis.

I disagree with the last bit – if you don’t love investing, I suggest investing passively through trackers, rebalancing annually, and taking the other 364 and three-quarter days of the year off. There’s no need to waste money on brokers, bank managers, or expensive fund managers.

But I agree completely with the first two paragraphs.

If you do love active investing – that is, picking stocks, following companies, and trying to outdo the brightest minds in the business – then like me you’re probably already beyond help, and reading and absorbing this book will I think prove useful, as well as enjoyable.

The Accumulator asked me recently why I invest actively, given that I think most people should invest passively. I said it was because I love it. Some probing revealed that sure enough I was motivated by the possibility of doing better, but I maintain that’s a vital scoring mechanism, not a means to an end.

It’s like a game of golf. Without the chance of achieving a hole in one, golf is just a walk in the park – even if you do it for the comradeship, the challenge, fitness, or simply to get out of the house.

John Lee has done very nicely from his investing, but I suspect he would have kept it up even if he’d done half as well. His passion is what comes through most strongly in this book.

Active investing will never be a walk in the park – but for some of us the slog is the sweeter for it.

Note: You can buy How to Make a Million – Slowly right now from Amazon.

1. According to Guy Thomas in the Lee biography in Free Capital. [↩]
2. Well, and because at 145 pages How to Make a Million – Slowly is not the world’s longest book to begin with! [↩]