Many people find it hard to accept an index tracking fund is the best way for them to invest their money.

And I have every sympathy for them.

It’s easy to forget just how counter-intuitive passive index fund investing really is.

Why would I choose a largely automated fund as the home for my hard-earned savings, merely on the grounds that it’s cheap? What if I am prepared to spend more for a touch of genius?

In most important aspects of your life, you go to the best experts you can afford. You expect superior results as you pay more. It doesn’t always hold, of course, but nobody would choose a burly man with a pair of pliers over a trained dentist on the basis of cost.

Active investing, though, is different. It’s a zero sum game. This simply means that for every winning pound – relative to the market – there must be a losing pound. In other words, winners and losers net out.

Subtract the cost of trading and the high salaries of those paid to choose the trades, and with active investing you’re in the hole and behind the market before you even start.

This means your active fund manager needs to at least recoup his or her costs just to keep up with the market. Research has repeatedly shown that over the medium to long-term, most fund managers don’t do this – which is no surprise, because fund managers are the market!

Average them all up, and they will achieve the same returns as the market, minus costs.

Hence fund managers lag the market on average, despite being paid a fortune and being in the main extremely clever and dedicated professionals.

Which really is weird, when you think about it.

Little costs make all the difference

Investing is also odd because few people think naturally in terms of compound interest. Active managers’ charges of 1-2% a year don’t sound like much when you start investing, but they make a massive difference when compounded over time.

The result of such charges is consistent market-lagging returns from the very firms that set out to beat it.

Which? for example found that only 38% of active fund managers in the UK managed to beat the market in the prior 10 years.

And as we know you know, this is the reason to be in tracker funds. Why risk being in the losing two-thirds?

We aren’t investing to give fund managers gainful employment. We just want exposure to the different asset classes in order to get a decent long-term return for our pensions or other goals.

Since most attempts to beat the market fail, it therefore makes sense to aim for an average return, if it means we can keep costs as low as possible to avoid reducing our returns more than we have to.

Thus the road leads to cheap index tracking funds with charges of less than 0.5% a year, which simply aim for that average return in order to keep as much of it in your hands as possible.

By aiming to be average, you paradoxically do better than the majority of investors who try for more.

Weird!

Top of the drops

Most Monevator readers are familiar with the tenets I’ve just run through. If we were the Boy Scouts, we’d chant some version of them every Tuesday before getting down to business.

But have you tried to explain the case for passive investing to others?

I have, and let me tell you it’s not easy.

I’ve already discussed how most people believe they’ll get a better result by paying more for an expert. It’s perfectly understandable if they don’t know any better.

But even outlining the ‘zero sum’ nature of investing often doesn’t change their view – because most people think they can do things they can’t, like picking a winning fund manager that will be better than average.

This shouldn’t surprise us either. People also think they are better than average drivers, lovers, humorists, and investment blog writers. We’re all deluded.

Emotions come into it, too. Our national sport revolves around a league of football teams dominated by four giants who’ve won nearly everything for many years. And yet up and down the country every Saturday, millions of fans believe something different will happen, and become despondent when it doesn’t. Year after year after year.

Still, even here investing is the funnier old game.

Looking at past results works really well in football. Anyone who studied the past couple of decades for ten minutes would see that supporting Arsenal, Chelsea, Manchester United, or Liverpool is the best bet for fewer tears.

Similarly, you wouldn’t bet against the Harlem Globetrotters or the All-Blacks or Roger Federer in their heyday.  If you see a top athlete or team win one week, you’ve every reason to expect them to win the next.

Yet a good spell for a fund is worse than useless as a guide to its future excellence.

S&P’s latest Persistence Scorecard in the US found that:

“Very few funds can consistently stay at the top.

Out of 703 funds that were in the top quartile as of March 2011, only 4.69% managed to stay in the top quartile over three consecutive 12-month periods at the end of March 2013.”

Read that again. Less than 5% of the top quarter of funds stayed that way for three straight years.

In football terms – in spirit if not in exact mathematics – this is like all but one Premier League team being relegated at some point within just three years.

It’s like Andy Murray winning Wimbledon this year, and this year’s world number #43 winning next year, and then someone we’ve never heard of winning it in three year’s time.

The poor persistence for winning funds gets even worse over the long-term. For example, S&P found that fewer than one in 25 large-cap funds managed to stay in the top half of the tables for five years in a row.

We know why it happens, but it’s still downright contrary to our everyday reality.

Passive parasites

Finally, there’s the contradiction at the heart of passive investing.

This is that passive investors need active investors to be out there hunting for superior companies in order for the market to be efficient.

No active fund managers, no tracker funds – or at least not any that I’d like to invest in.1

To quote Tardas Viskanta of Abnormal Returns:

“The passive investing crowd should be wary of trying to derail active management. The fact is that active managers make the market, to the degree to which it is efficient, efficient.

We can all declaim the hordes of hedge funds out there that are charging their investors 2&20% with little to show for it. But they are the crowd that tries to keep thing from getting too far out of whack.”

Again, this runs totally different to most of our real-world experience.

Doctors do not rely on quacks for a living. And we don’t appreciate a top restaurant only because we are forced to eat cardboard the rest of the week (well, at least not in my house).

Those aren’t great analogies, because I’m struggling to find a real-world parallel. Perhaps quantum mechanics has something similar in the uncertainty principle.

Yes, it’s that weird!

Weird science

Passive index fund investing is logically right, but emotionally and in terms of common sense, it often feels wrong.

I’m not suggesting we abandon it!

But I do think it’s worth remembering now and then just how strange it actually is, particularly when trying to persuade others to the cause.

It’s also perhaps worth feeling just a smidgeon of pride at circumventing your human emotions and apparent common sense to make the leap to passive investing.

It’s logical, after all.

Spock would be a passive investor. Kirk would run a hedge fund.

1. Theoretically passive funds would still win provided there were at least two active funds trading against each other to make a market, and charging for it. But I strongly suspect the asset class would have become un-investable long before that philosophical point! [↩]

Good reads from around the Web.

I learned an amusing bit of trivia about high I.Q. investors from Monevator fave Larry Swedroe this week.

In an article for CBS Moneywatch on the woeful performance of investment clubs, Larry notes:

 If any group should be capable of showing that more heads are better than one and that intelligence translates into market-beating returns, it should be Mensa.

The June 2001 issue of Smart Money reported that over the prior 15 years the Mensa investment club returned just 2.5 percent, under-performing the S&P 500 Index by almost 13 percent per annum.

Warren Smith, an investor for thirty-five years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in the S&P 500 Index would have produced almost $300,000.

One investor described their strategy as buy low, sell lower.

I’m pretty sure even cash would have beaten this brainy bunch. And it backs up my own observations about I.Q. and intelligence.

Though he’s no fan of stockpicking of any kind, Swedroe’s charge here is particularly against investment clubs. It seems about the only thing that can do worse than a private investor at beating the market is a committee of private investors.

But I think the point applies to high IQ lone rangers, too.

Clearly there are a few very smart individuals running successful hedge funds or wot not. Monevator has unusually clever readers, for sure. And modesty forbids me revealing my own…etc.

But as a generalisation, I’ve noticed many extra clever people make extra terrible stockpickers.

The worst are probably engineers. If I was charged with recruiting for a hedge fund by degree alone, I’d pick maths and physics grads first, then high-flying arts students – as in history, philosophy, and so on. Not as in Tracey Emin.

Engineers would come last.

This is no disrespect to engineers, who play one of the least appreciated roles in modern society – heck, they pretty much gave us modern society.

But boy do they get themselves in a muddle with investing.

I suspect it’s an innate distaste for uncertainty and fuzziness that’s helpful for engineering but lethal to active investing.

If you’re a structural engineer, you build a bridge that will take several times the maximum load you can imagine passing over it, just to make sure.

Apply that mindset to active investing and you’ll either cower in cash, or else you’ll become wedded to certainties: “I just KNOW this stock is good enough!”

Certainty has no place in the murky – and for most futile – world of stockpicking.

Other kinds of engineers construct very elaborate machines, and their skill set can lend itself to spurious precision about business and economic cycles, and how they intersect with the stock market.

Yes, they all affect each other, but your path is like that of a cyclist negotiating a roundabout at rush hour in Rome. Much better to trust instinct and quick reflexes than to think you can plot a precise path in advance.

As Warren Buffett – himself no intellectual slouch – puts it:

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

I wonder how an investment club of investing blog writers would fare?

[continue reading…]

Some of you who read the headline above are wondering what revelation Monevator will bring you next.

Magic beans aren’t legal tender? Money doesn’t grow on trees?

Of course your house is an investment. Of course it’s an asset.

But from experience I know other people are up in arms:

“My house is not an investment! I will not consider it part of my net worth. My house is my home. It is not for sale. I have to live somewhere!”

The best that can be said for their viewpoint is that unlike much wrongheaded financial thinking, this particular form of fiscal foolishness doesn’t do much harm (aside from raising my blood pressure).

It’s not like thinking you borrow money from a bank (no, you borrow from your future self) or ignoring the impact of compound interest (clue: it’s enormous) or ignoring the time value of money.

In fact it’s likely a beneficial delusion.

Treating your home as a long-term commitment rather than a token to trade is a big reason why people usually do much better owning their own property than they do investing in shares.

But that doesn’t make them right.

Your house is an investment, an asset, and a big part of your financial net worth, regardless of what imaginary friends you had as a child or whether you avoid walking under ladders or whether you Feng Shui your home, or any other irrational thoughts you have about money.

The things they say

It’s so blatantly obvious to me that your own house is an investment, I’ve put off writing this post for years because I’m afraid I’ll sound like a patronising nursery school teacher asking if everyone is happy.

“Yes miss, I’m very happy today as I haven’t yet fully integrated my prefrontal cortex. Also, I think I’ve wet my trousers.”

Instead I’ve decided to just sound angry.

Twice in the past month alone, two financially astute people who I have a lot of time for declared to me that their house was not an investment.

And something snapped.

This madness has to stop!

Since by any normal measure it’s abundantly clear that your house is an investment – you go and buy a house, it increases in value, one day you likely sell it – normal weapons clearly don’t work on this form of muddy thinking.

Instead, we’re going to turn their own puny but persistent arsenal back on itself, by tackling each of their feeble defences in turn.

So let’s run through the things they tend to say, and why they’re wrong.

Incidentally, I’ll use the words investment and asset interchangeably, because they both apply.

You can also insert “part of my net worth” because they also claim a house that’s worth many multiples of their annual salary is not part of their net worth, too (I know! And these are sane people!) but it’s very clumsy to write that out.

“My house is not an investment because I don’t intend to sell it.”

Just because you don’t have plans to sell your house, that doesn’t mean it’s not an investment.

It’s an investment that you’re not selling right now. Simple.

Many of Warren Buffett’s friends and family never sold all their Berkshire Hathaway shares, and they became mega-rich because of that. They’d maybe borrow against shares to buy homes or similar, but they never sold out completely.

And you’ll notice that financial journalists don’t tend to write:

“What a shame Warren Buffett’s early friends and family didn’t make an investment in Berkshire Hathaway, because it looks suspiciously like they’re very wealthy on the back of those shares they didn’t sell. I guess it’s some sort of money illusion. Nice sports car, mind.”

Most people move houses several times. Strangely enough, when they come to buy a new house, they usually sell the current one.

When they do sell, they expect not to see change from a twenty. And the rest.

They want paying! From the sale of their house that isn’t an asset or part of their net worth. (Right…)

Young people renting houses up and down the country are not priced out of the market because estate agents will only sell to people who’ve painted their own walls and visited a Dunelm.

They are priced out of the property market because people bought houses, and those houses have gone up in value – like good investments do – and sure enough those homeowners want paying if somebody else would like to own their house.

If it walks like a duck…

Your house is an investment.

“My house is not an investment because I need it to live.”

No, your house is a very valuable investment because you need it to live.

It’s funny how people don’t consider their homes an investment, and yet they’ve no such confusion about pensions.

One day you’ll need to live on your pension, too. It’ll prove a good investment. Like buying your own home.

“My house is not an asset because I need to live somewhere.”

I know this will shock the smugger homeowners out there, but everybody needs to live somewhere. Those of us who haven’t bought our own homes don’t retreat to the woods at night to forage for snails and sleep upside down with the bats.

The fact that you need to live somewhere is one of the very good reasons to buy your own home. It can be the cheapest way to pay for living somewhere, in the long-term, not least because you end up owning a valuable asset. (Oh the irony).

If you chose to you could sell your house tomorrow, bank the cash, and start renting. You wouldn’t die like a clownfish flapping about on the High Street pavement, gasping for air.

You’d have traded one investment (a house) for another (cash in the bank).

“My house is not an investment because it doesn’t generate a return.”

Yes, people really do say this. Push them and they might say:

“Well I don’t even know how much prices have gone up, I don’t even look in the estate agent’s window. I don’t even check on Rightmove three times a week. Not usually. Not before lunchtime! My house is not an investment”.

Well, good for you, but even if that’s true, your ignorance about the value of your investment doesn’t mean it’s not an investment.

Warren Buffett says he wouldn’t care if the stock market didn’t open for a decade. He doesn’t care about day-to-day prices either. But every one of his shares is an investment.

It’s one of the biggest divisions in this country that those who’ve owned property for more than 20 years can utter this sort of nonsense with a straight face, having bought their homes for the equivalent of couple of iPhones and a pint of fancy cider.

But there you go. Their house has been an outstanding investment – likely multiplying their initial deposits five to 30-fold or more – but, I know, it’s a home!

That long-term tax-free capital gain is only one part of the return that you get from owning your own house, by the way.

You can also rent out rooms in a house. You happen to rent out rooms to yourself and your family. Economists call it imputed rent.

As we all agree, you have to live somewhere, and generally you have to pay rent for that somewhere, too. (Don’t tell your parents, generation boomerang…)

If you own your own home, it’s imputed rent all the way for you. Which means you’re a money-grabbing landlord (to yourself) as well as a moony-eyed homeowner.

The truth is you’re killing it in this investment game by owning your own home!

“I have to spend money doing up my house.”

This doesn’t mean it’s not an investment.

It means you have to spend money maintaining (or increasing) its value.

It means it’s not as lucrative as it might seem. It means it’s a less convenient asset than a fund held in an online broking account.

It’s still an investment.

“A house is illiquid.”

I agree. It’s an illiquid investment.

I have small cap shares that I bought in batches of a few hundred at a time to avoid moving the price. They’re still investments, too.

In the midst of the credit crisis, the Qataris and other sovereign wealth funds bought half-finished skyscrapers across London that nobody else wanted. They got them cheap, and it’ll be years before they sell. They’re investments.

I could go on for hours.

“My house is not an asset – I have a huge mortgage!”

Aha! At least here we have an appreciation of assets and liabilities. However it’s still wrong.

The fact that you have a £200,000 mortgage, say, on your £300,000 house does not mean you don’t have an investment in property worth £300,000.

You do. It’s just you also have a debt secured against that property to the tune of £200,000. The net asset value of your investment in property is £100,000.

This is true even if you’re in negative equity, incidentally. In this case you have a negative net asset value. Not good, though a lot better than if you had no house at all to net against the £200,000 of debt.

By the way, your bank won’t make the mistake of not counting your house as an asset if push comes to shove.

Despite the fact you live in it, that you have to live somewhere, that you have pictures of your kids on the walls and you painted those walls yourself – ah the memories! – your bank sees your repository of dreams as an entry on a spreadsheet that enables it to lend you the money to buy a house in the first place.

Just ask somebody who’s had their house repossessed.

Alternatively, go to the bank tomorrow and explain to them that you don’t want to buy a house at all. You’ve read on some different blog that a house is NOT an asset and NOT part of your net worth – I know, bizarre – so you really can’t see the point of owning one.

But you would like to borrow £200,000 to spend on a fancy tent and a lot of camping fees.

Oddly enough, your bank won’t lend money against your vagabond dreams.

“I don’t pay tax if I sell my house, so even the government knows it’s not an investment.”

Someone actually said this to me once. I didn’t know whether to laugh or commandeer a bus to run him over, and then reverse to make sure.

I know I’m inclined to take this one personally, given I juggle capital gains tax on a few puny thousands of pounds worth of shares while countless friends have made six-figure sums on their homes tax-free over the past two decades – and then I even take stick on this blog for trying to minimise my CGT bill – but anyway, for the love of all that’s Holy, just because you have an almighty tax break on your house doesn’t mean it’s not an investment.

It’s just another way in which it’s potentially a great investment.

“There’s no point me considering my house an investment, because it would make up most of my net worth!”

This doesn’t mean it’s not an investment.

If you actually totted up your own personal balance sheet properly, you might better appreciate that you’re very exposed to one asset class – property – and very light in most of the others – cash, bonds, and equities.

“House prices don’t go up so much once you take into account costs and inflation.”

An interesting point. But while I’d take a lot of persuading that houses are a bad investment, presuming you don’t buy in the middle of a bubble – I’m not actually arguing in this article that houses are a good investment.

I’m arguing that houses are an investment, good or bad. Which they are.

“It’s only worth something when you sell it. Otherwise it’s all paper.”

An ex-girlfriend used to say this all the time. She was smart but had some funny views about money.

By this measure only people who keep all their money in cash are rich, and the rest of the world’s wealthy are phonies.

This means Forbes will have to rewrite its rich list to focus on drug dealers, prostitutes, tin can millionaires, and Scrooge McDuck.

While it’d make for an interesting read, it’d also be wrong.

As rich people everywhere know, you don’t have to sell something for it to be worth something.

Another brick in the wall

It’s very simple. You invest in a property, you probably bought it with a mortgage that you pay off over the years. Eventually you own the house and you can live in it or roll the money into a new one.

While owning it you live seemingly rent-free (or more accurately enjoying that imputed rent, and please note I didn’t say ‘cost-free’) until the day you die or achieve immortality by cryogenically freezing your brain and encamping yourself in your living room amongst all those lovely things you own and those nails you hammered into the walls (“my house is not an investment, I just don’t want to ask a landlord for permission to bang in a nail!”) for all eternity.

And you can sell or downsize or trade-up your investment along the way, too.

If a 70-year old woman sells her rectory to buy a smaller and more manageable two-bed flat, she is not obligated to pretend she hasn’t got a six-figure sum in the bank that doesn’t really exist because her house was a home not an investment.

She’s allowed to spend the money she gets from selling her investment, including the capital gain she made it.

Somebody else might end up renting all their lives (foolishly, in my opinion, but it’s what I’ve done so far so there you go), investing in shares or other assets, and eventually have a portfolio that pays their rent when they retire.

Their share portfolio is an investment, too, even though it pays for them to live somewhere, which we agree is essential.

The fact that your house’s gains roll-up capital gains tax free, or that it’s illiquid, or that you bought it using leverage (a mortgage) does not mean it’s not an investment or an asset – it just tells you more about what kind of an asset it is.

The last time I tried to convince a good blogging buddy of mine that his house was an asset, he retorted that his house had:

“… absorbed capital that I cannot liquidate without exposing us to hazardous renting and the UK housing market that appreciates above the rate of inflation – that’s a dangerous thing for a retiree to do financially.”

Talk about making my case for me!

Yes, a house is not some useless consumable item – it’s a damn useful asset/investment to have when you’re retired for exactly the reasons he states.

Just ask the old boy who rents next door.

Things that aren’t assets:

• dishcloths
• mistresses and toy-boys
• budgerigars
• leftover pizza

Something that is an asset:

• a house

Our property-disowning, home owning democracy

The worst thing about this whole nonsense is it infects social policy, too.

We live in a crowded country where we’re invited to feel sorry for wealthy pensioners living alone in four-bedroom houses whose Council Tax has risen because their home, well, it’s not like a big house is an asset they could sell, is it?1

We also have situations where old person A doesn’t have to sell his house to pay for care, but old person B who saved the money in cash instead is judged as having the means to pay for it. (I paraphrase, but that’s the gist – and it applies to all sorts of means-tested benefits).

The incredible thing is that even after getting through these 2,541 words (count ’em!) someone, somewhere, is thinking:

“Yeah, but that’s rubbish, because my house is not an investment”.

Look, I get it. You like the security of owning your own home. You don’t intend to sell. You dealt with the dry rot. You love the wisteria. You haven’t considered what you’d get for the house if you put it on the market since the day you bought it and carried an IKEA bag over the threshold.

Fine, that all makes sense.

Just don’t tell me that your house is not an investment or an asset. Because that’s exactly what it is.

1. Seriously, why do we feel sorry for a homeowner who has to sell up, but not for a renter who is already renting? It’s muddled. [↩]