Investment advice

Why do people keep giving financial advice that is biased and omits vital details?

 

I read an article in the Financial Mail on Sunday.  It’s not exactly a professional journal, but it reaches a lot of people and, sadly, a lot of the readers think it’s worth reading as it’s “independent”.

 

They’re talking about a “Dogs” portfolio (of the 10 highest yielding shares on the FTSE 100) which, allegedly, is beating the FTSE 100 index.  

 

It may be doing that – but what they don’t emphasise is that they’re investing a “notional” £10,000.

 

This, they allege, would have grown to £12,141 as distinct from £11,211 since Spring 2012.

 

Fine.  So it’s “notional”.  That means it’s ignoring all dealing costs.  It’s ignoring any bid/offer spread (on units if it’s a fund), initial charges, stamp duty, ongoing administration charges, any fund charges for management, transfer charges and anything else such as losses from delays in getting out of bad stocks and the tax charges and accountancy costs etc.

 

You might think that doesn’t make much difference.  But if you look at Barber & Odean’s classic paper “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” you find that it makes a lot of difference.  To quote:

 

Using account data for over 60,000 households from a large discount brokerage firm, we analyze the common stock investment performance of individual investors from February 1991 through December 1996. The average household tilts their common stock investment toward high-beta, small, value stocks, and turns over 80 per cent of their portfolio annually. On one hand, the gross returns (before accounting for transaction costs) earned by the average household are unremarkable; the average household earned an annualized geometric mean gross return of 17.7 per cent while the value-weighted market index earned 17.1 per cent. On the other hand, the net returns earned by the average household lag reasonable benchmarks by economically and statistically significant amounts; the average household earned an annualized geometric mean net return of 15.3 per cent. The 20 per cent of households that trade most (which average at least 9.6 per cent turnover per month) earned an annualized geometric mean net return of 10.0 per cent. The poor performance of those households that trade frequently is generally consistent with the implications of recent theoretical models of investor overconfidence. Our central message is that trading is hazardous to your wealth.”

 

So if average trading reduces the annual return from 17.7% to 15.3% when times are good, what do you figure it will do to costs of the Dogs when times are not so good?  Remember they have to trade periodically and they’ll certainly trade when shares rise so the yield falls and the yield drops out of the top ten, when shares fall and they cut their dividend etc.

 

As Warren Buffet said, over the last 35 years [this was to the late 1990’s] it “should have been easy for investors to earn juicy returns.  All they had to do was piggyback corporate America in a diversified, low-expense way.  An index fund that they never touched would have done the job.  Instead many investors have had experiences ranging from mediocre to disastrous.”

 

But people aren’t content with those returns, they try to find a way to do better, and usually do significantly worse (and, occasionally, do slightly better for a while, before they again do worse).

 

And the prime reason Buffet suggests for the experiences he describes:

high costs, usually because investors traded excessively or spent far too much non investment management”

 

With all the interest in human behaviour and decision making of late, you’d think it would be reflected in the way investment advice is given.  After all, there’s lots of talk about biases, mistakes in logic etc. nowadays.

 

But no, the fact that Thaler (who is a poster boy for the research by dint of being the Cabinet Office adviser and the author of “Nudge) and De Bondt produced a report that said that:

 

“75% of funds trail the index and of the ones that don’t half keep up only by luck”

 

is ignored and people still try to find ways to “beat the index”, pick fund managers who can, devise schemes, theoretical approaches, stock picking ideas etc. that ignore costs and other elements of reality.

 

If they were logical, they’d accept that they are biased, they are desperately trying to justify what they want to do, which is suggest a way to beat the index – but they don’t want to do it with their own money because they know they’ll lose it.  They want you to gamble your money on it, and quote selective details (such as those that avoid all the costs and work on a “notional” basis) to try to induce you to do something daft.

 

As a final word, let’s look at what Warren Buffet, the one person who actually has consistently beaten the market says is the best advice.   

 

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.”

 

 

 

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One Response to Investment advice

  1. Demos says:

    There has been a massive loss of market share from active management funds to index funds, so hopefully this will continue as a trend!

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