Which is more important in your world: knowledge or skills? This question is the fulcrum of an ideological battle being fought over our education system, and it’s a debate that also has ramifications for DIY investors.
- The champions of knowledge believe we need to command certain basic facts to operate effectively in society – the essentials of science, literature, history, and geography. Without these fundamentals, you’re like a driver who can’t read road signs or markings.
- The advocates of skill argue that a robotic recall of verb conjugations and the Kings of England should take a back seat. They favour building prowess in problem-solving, debating, hypothesising, and so on.
While the obvious answer to my opening question is “Can I have both, please?”, I believe that knowledge is far more important to a DIY investor than skill.
Licence to skill
I spent a long time at the beginning of my investment journey furrowing my brow over the fact that I didn’t know how to read company accounts, or work out the discount rate of future cash flows, or have the seemingly God-given ability of my peers to declare the market ‘fair value’.
Such skills seemed like concealed weapons. You’d only glimpse a flash, enough to let you know ‘they’ could slip through the investing maze like ninjas. But the application of these powers was as shadowy as their utterances of success.
Now I just don’t worry about it.
Even talking heads in the fund management industry are happy to go on record to say that skill is so abundant in their field that the winners and losers are mostly separated by luck.
And that suits me. Because whereas skill might let you play in the deep end of the pool, knowledge enables you to stay safe in the shallows.
It’s the difference between taking a couple of martial arts lessons and walking in to the wrong pub shouting “I’ll take you all on”, and knowing enough to avoid staring at the shaven-headed gentleman with a spider-web tattoo on his face.
The basic facts are much easier to acquire for an amateur than superior skills. Knowledge is an all-you-can-eat buffet in the digital age. You can stuff your face with it via blogs and books.
The only question is what you choose to swallow.
Knowledge Base Alpha
My research quickly taught me to stop asking the question that all my non-investing friends ask:
“What’s hot?”
It doesn’t matter. By the time an asset class is hot, it’s probably already too late to make big money.
I don’t worry about tips from commentators or newspapers. Even if they throw the dart in the right direction, the smart money has already moved on.
The market is the consensus of expectations on the future of a stock. Only unexpected events can shift the price. How can you predict the unexpected? The short answer is: you can’t.
I know that diversification is the only free lunch going. I load up on all the useful asset classes while resisting the siren call of ‘the next big thing’.
I understand how asset classes work. I know that equities are volatile and that nothing is truly safe. If the market crashes I won’t panic because I know it will probably recover. I won’t hunker down in cash, refusing to believe in inflation.
BRICs? Gold? Hedge funds? The Fear Index? Low vol ETFs? High yield funds? I know that keeping up with fashion and labels will cost me dear.
Behavioural finance tells me that I’m a pitiful collection of psychological defects, about as capable of self-discipline as a bonobo at a swinger’s party.
The more we learn, the less we know
In the face of all the evidence that I can’t market-time, pick winners or even trust myself, passive investing using index funds is the only strategy I feel confident enough to stake my financial future on.
Sure, I love reading yarns about the prospects for gold, timber, or Lego bricks, but I now know that’s no basis for a portfolio.
My best bet is to invest in a diversified portfolio of low-cost trackers and sit tight.
Doing very little sounds too easy. In some ways it is. Portfolio maintenance costs me less than an hour a month.
But it’s simultaneously the hardest part of passive investing.
Surely I should be doing something? Anything? Surely I’ve got enough skill by now to test my mettle in the market with more active investment strategies?
No. I’d be better off composing a passive investor’s prayer that wards off temptation.
Staying on the straight and narrow is hard, but knowledge and education are the best way to keep on track.
Take it steady,
The Accumulator
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Good post, I used to be always chasing the next hot sector fund or researching companies but in the last 12-18 months I have moved entirely to index tracker funds when I realised my previous investing style was not working. Too much chopping and changing, buying into hot sectors just as they went off the boil. This change was a combination of personal experience over the last several years, backed up by a read of The Bogleheads Guide To Investing and Tim Hales Smarter Investing.
Ok, I still have some BRIC exposure via an emerging markets tracker, but now its proportionate to my asset allocation and (credit crunch tested) risk appetite, so I won’t sell when the markets tank.
Oh drat, I just ruined everything and bought my first individual corporate bond…one I thought would do better than a bond tracker fund.
Are you not taking some viewpoint in terms of which sectors you are investing in, which company sizes, etc? Or ar you investing across the entire world investable universe, scaled by capitalisation. Come to think of it, why is scaling by cap such a great idea, surely you are biasing towards megaco?
A collection of passive funds each of a subset of the investable universe is not necessarily a passive investment IMO 😉
Nice post, this is soothing music to my investing ears. Doing little requires a lot of courage while all around are flapping and making noises.
@ Semi – Good to hear your tale and your last line made me laugh. It’s not easy doing nothing.
@ Drew – couldn’t agree more.
@ Ermine – Passive investing doesn’t mean you don’t think, or don’t have a view. Investing by market cap is a passive investor’s way of saying, “I can’t outsmart the market.” We’re free-riding on the coat-tails of the efficient market. Not that I’m saying it’s perfectly efficient. Marketcap investing also happens to be the lowest cost method of investing – another important tenet of the strategy.
Then you tilt according to your taste in risk factors – small-cap, value etc because you’re convinced by the evidence that you can earn a premium for owning these equities. Taking on that extra risk (or not) is a personal decision, not an auto-generated one. As determining your asset allocation or your rebalancing criteria.
You might even decide to stay out of bonds or at least to keep them short-term given the unprecedented interventions in that market.
Passive is a label not a holy ritual.
“Surely I should be doing something?”
For passive investors I think they’re best off if the idleness is enforced. So for example a pension fund in which you have no real knowledge of what they’re doing much beyond the top level asset allocation split, and no way of influencing it. There are costs involved in those funds, but they may well outweigh the cost of bad decisions by a lot of private investors.
Another interesting point is that apparently investors in high-load funds (i.e. those with large up front entry fees) outperform investors in no-load funds! As crazy as it sounds, the high-load investors do better because the entry fee stops them buying high and selling low. Once they’ve bought the fund they’re typically reluctant to sell in a crash because they have spent that 5% fee up front and so tend to stick with the fund. That means they don’t lose the 5% per annum that other investors lose through bad buy and sell timing.
That’s one of the reasons that Buffett has the ‘A’ class Berkshire shares at an astronomical price, so that people buy it like they buy a house, rather than as a bit of electronic paper to be flipped in a few months.
Liquidity in the stock market is both its biggest benefit and its worst drawback.
— John
Isn’t being able to call the market(future)as fund managers say they can,a one-way bet.Your returns should be off the scale
Yet most fail to match market
Asset allocation with a low-fee index trackers easily win the argument
Thanks for a really sensible article followed by really constructive comments. The voice of experience, and critical analysis from those not ‘in the business’ is worth a small fortune..the difficulty is being smart and staying ‘relatively’ passive.
Fair point about giving up on valuing individual companies.
When Hewlett Packard apparently make an 80% error in valuing Autonomy what hope for the rest of us?
So diversify yes but tilt things a little surely?
And reduce/ increase exposure to risky asssets at obvious high/low points using long term valuation measures (e.g yield or CAPE)
Hewlett Packard v Autonomy
KPMG/Barclays/Perella Wienberg v Deloitte
Huge Reputations at stake
p.s.–former C.E.O 0f Autonomy Mike Lynch sounded very confident on sky news 21/11/12
Accumulator..you hit the nail on the head when you said ” Nothing is truly safe ” , beyond diversification & asset classes has to be now the integrity of the entire financial system..as an investor my biggest concern is the unpunished criminality going on where the rules at the top are different than for the rest of us.
The leverage is also frightening , can we have any real confidence when the likes of goldman sachs to name but one with total assets under 90 billion is allowed to have derivatives exposure of over 48 trillion , which is 545 times leverage relative to it’s assets.
The gdp of the entire planet is only around 70 trillion , does that give it some perspective.
Or where HFT computer programs account for 70 % of all transactions..traded in milliseconds to which the liquidity in the markets are now dependent.
But it’s ok , everything will work out just fine , no need to worry about these alarm bells ringing all around us..let’s just keep feeding them our money card after card as the stack builds higher & these prevailing winds blow stronger.
Solution.. ” Rip it Up & Start Again ”
Am really enjoying the comments here – thanks all (even as I shudder at the slight sense of helplessness in the face of global finance). It’s strange how we generally feel exhilarated when dwarfed by nature, yet feel scared and out-of-control when dwarfed by the man-made.
Don’t just do something, stand there!
Sometimes Wisdom (and Luck) triumph over Knowledge and Skill.
@TA – great post. It’s blog entries like this which keep me on the straight and narrow of passive investing in my VLS60 – I just feed it (monthly installments) and then forget it.
Not really relevant to the article, but I noticed one of the comments from 2012 mentioning the HP vs Mike Lynch (Autonomy) court case…which still isn’t concluded. The only winner in that case will be lawyers. I guess the financial lesson in that is either a) be a corporate lawyer or b) avoid court!
@TA, thanks from me too. It is a message that needs reinforcing from time to time, for us amateurs to retain confidence when there is turmoil. When my wife asks me if our investments are OK given the latest headline news about the FTSE or whatever, I just smile contentedly and tell her I will check them again on the first of January.
And @TI, a confession of guilt from one of those who has indulged in Covid-related comments on this website. To be fair, that is often in response to your own insightful views and good links – and I have found this website a fairly sane place for serious discussion of what it all means by those motivated by genuine curiosity to explore facts and ideas, rather than the conspiracy-peddlers.
To quote Homer simpson; “whenever I learn something new it pushes some old stuff out of my brain”
Which it true, you might forget fundamentals or develop a bias or panic if over involved. Only people who analyse as a job really have a good read, even then active management could be more about avoiding risks than generating alpha.
To quote Gru from despicable me 3; “you have no idea how difficult it is to sit there and do nothing, touch nothing”
Indeed it’s boredom that gets us in trouble at work, where the only conversation starter you have is something extreme/controversial or you feel a need to entertain your colleagues. I also think people argue because of gossip/ hostilities that start out of boredom.
I’m sure a lot of wars start because in bordom people fall into/dwell on extreme ideologies and grand plans about how the world should be rather than focussing on survival, but likewise it may be behind more people caring about the environment.
Even now I scroll through TV and see nothing on that I have a reason to learn/care about – some things I expect to be preachy too, like on the environment, or maybe on other things have no ability to affect change and there’s not even a reason for the public to know (ie astronomy). When I see newspapers I think “why do I need to be updated on all this?” And also ” if it’s going to change anyway tomorrow and by then we’ll have a clearer picture of the world, what’s the point in reading in depth now? ” – I just view the news as pure entertainment
Reputations at stake, yes.
But
Each agent involved may face sifferent reward curves, often they are gambling a bit where other people (investors) get most of the losses and the agents reap a higher % of the rewards if things work out. Add in some optimism bias, et voila, smart people and smart companies wns up doing really stupid things…
Yep I am happy to put more than half of my pension money in passive index funds, with a slice each for two other things:
– 20% or so in individual stocks, a broad cross section, just avoiding some risky /ropey sectors (mining, banks, airlines, telcos, maybe retail). Buy and hold. Churn rate under 10% pa. Zero OCF.
– 20%-30% with individual fund manager teams, who i think do know their stuff. Long track record. Good performance. Risks look lower than average (ie they do at least as well as the index, when markets dip). Fees hmm a bit high but under 1% pa // under 20% of their outperformance. Good governance. Eat their own cooking. Somw.of them not recommended by HL, despite their record, so they clearly don’t buy the good opinions of intermediaries. And their back story re why their approach works is credible or even very impressive. Can count these on fingers of one hand so far. Hens teeth!
Question: Am i being naive in believing that the outperformance of this latter group will continue? How can I tell?
That is one scary amount of leverage.
Maybe … go underweight in the sectors that are very highly geared.
Banks, especially investment banks. Bonkers. You invest, they gamble, the execs keep a lot of the winnings.
You might go underweight, or exit from, a few other sectors too:
– Airlines. Long term investments, lots of non rational competitors, cheap effective differentiation at scale is hard.
– commodities and miners. Sunk costs. Wild optimism isnt punished quickly. Profits sensitive to market prices. Execs know a lot more than investors. Maybe not a terrible bet, especially if you look at directors dealings, and you pick the commodity with care, but not great.
– physical retail for goods (not leisure). Differentiation is hard. Online is eating retail’s lunch. Being underweight looks sensible, dependong on valuations.
– fixed line telcos. expensive infrastructure. Optimistic mindsets, advancing tech, new entrants keep coming. Differentiation is hard and profitable monopolies often get regulated heavily.
Yep hard. Just think ‘friction’… it may help. Round trip costs of buying and selling mean thst you are burning your money.
Ditto high fund mgmt fees and costs and IFA fees for average performance. 1% pa on £1m, over 30-40 years, eats a lot of the value. At 2-3% pa, its £25k pa nett, which is enough for a person to live on (most people) / pay for a lot of nice holidays (for an affluent 1% or 0.1%).
Cap-based index funds have, of course, an in-built weakness in over-dependence on big companies and sectors. However, even the financially knowledgeable readers of this forum would be tested finding an alternative to such highly diversified funds. It is, of course, very possible but not that easy. Such difficulty precludes the vast majority of the population who lack the necessary knowledge or motivation. As a result, these trackers are one of the few practical options for “the man in the street”.
To a limited extent, long term holders have some protection in that the funds, by their very nature, react to changes in fortune in the big companies or sectors. Investment automatically moves to other options. There is a potential danger in assuming that index funds are, somehow, static victims of change.
TP2.
good post.
Although market timing is judged next to impossible , for the long term investor being able to minimise the chance of being a forced seller in the future can reduce some market risks.
Oh, there’s so much land on Earth.
Oh there’s so many planets on this universe.
Let’s stop growing and start back from monkeys.
I agree, but I also don’t agree 😉
I have made active decisions between passive asset classes, @TA you call this thinking, but I agree with @ermine this is an active decision. As would an active decision, to be in short term bonds, because of current climate, etc. Why is that any different to an investor that decides that Alternatives or “hunkering down in cash” have a role to play as asset classes?
I think passive vs. active are not really useful descriptions any more. Is that sacrilege on Monevator? We all sit somewhere on a continuum, with LS80 (when will they switch to LS60?) at one end and day trading at the other.
My own “strategy” is to use a passive core with active satellites, I think active can work and beat the market (shoosh) in certain sectors. For example I have held about 8 global trusts / funds (this is about 40% of my global allocation, remainder passive) over the last five years, one of these has seriously lagged the global index (I have stuck with it because I’m hoping long term its style will work and its a diversifier), another 2 have “hugged” the index pretty closely (and I’m therefore overpaying for them, one of these is on the “naughty step” the other I believe is still justified because of its strategy), the other 5 have all beaten the market (significantly for two of them) and in my opinion all justified their fee. I rebalance so their “additional” performance has increased my passive “pot”. Picking these Trusts / Funds did require some research / consideration, but certainly not any paricular skill or knowledge, not available to any amateur investor.
I have of course illustrated this with the global sector where my active satellites have worked, other sectors active choices, have not been so kind to my forever fund 🙁