By Lars Kroijer
Even if some people are able to outperform the market, most people are not.
In financial jargon, most people do not have an edge over the market. This means that they can’t consistently outperform the market by picking different securities/sectors/geographies from the market as a whole, especially after costs. Nor are they able to pick which of the thousands of fund managers have the ability to do it for them. Accepting, embracing, and acting on this absence of an edge should, in my view, be a key moment in most investors’ lives.
The absence of an edge does not mean that you should avoid investing.
Doing this would prevent you from realizing potentially exciting long-term returns in the equity markets or from benefiting from the safety of highly rated government bonds. Also, what else are you going to do — leave your money under the mattress or in a bank at zero interest? Instead, you should assume that the current market price of each security captures all available information and analysis and reflects each security’s future risk/return profile. In equities, you should pick the broadest possible selection of stocks — just as you don’t know which single stock will outperform, you don’t know which sector or geography will outperform.
And what is broader than an index that tracks equities from all over the world with respect to the various values that market forces have already put on them? With a world equity index tracker, you can maximize diversification and minimize exposure to any one geography, sector, or currency. And because you simply track one index (e.g., the MSCI All Country World Index), a portfolio is very cheap to put together for a product provider like Vanguard or iShares and thus cheap to you. If an all-equity exposure is too risky, you can combine this world equity portfolio with government bonds in the proportions that suit your risk profile. The lower the risk desired, the more bonds you want.
So, my key takeaways for most investors can be summarized as follows:
- You almost certainly do not have an edge over the market. That’s OK. Most people don’t, but you should plan and act accordingly.
- There is an easy and cheaply constructed portfolio that is close to optimal. It combines the highest-rated government bonds in your currency (e.g., pounds for British investors) with the most diversified world equity portfolio. If you get close to that in the right proportions (which depends mainly on your risk tolerance) and stick to it, then, in my view, you are doing better than 95% of all investors. That’s it — two securities: an index tracker of world equities and a security that represents government bonds of the maturity and currency that match your needs, with both equity and bond exposures via an ETF, for example. Simple, perhaps, but you capture an incredible diversification of exposures via the equities, and the portfolio reflects your risk appetite when you incorporate the bonds in a proportion that suits your risk tolerance. You can add other government and diversified corporate bonds if you have an appetite for a bit more complexity in your portfolio, but the portfolio is very powerful even without them.
- Your specific circumstances do matter a great deal. Think hard about your risk appetite and about optimizing your tax situation. But also pay attention to your noninvestment assets and liabilities — many people already have a disproportionate exposure to their domestic economy through their homes and to some sectors through their jobs. Don’t add to this concentration risk with your investment portfolio.
- Be a huge stickler for costs, don’t trade a lot, and keep your investments for the very long run. Your portfolio should be implemented only via extremely cheap index-tracking products that charge no more than 0.25% a year.
If you follow these steps, you will have a personal portfolio strategy that lets you sleep well at night, knowing that you have created a powerful and diversified portfolio cheaply, tailored to your risk appetite.
To emphasize the point about costs, suppose that you are a frugal saver who diligently invests 10% of your £50,000 ($83,790) annual income in world equities from the age of 25 until 67. Further assume that the market provides an annual real return of 5%, in line with historical returns (ignoring taxes). Assuming a typical 2% annual cost difference between an index-tracking product and an actively managed fund (potentially in addition to the cost of an adviser), the difference in the savings pot at age 67 is staggering. You are left better off by perhaps £250,000 ($418,550) in today’s money simply by investing with an index fund as opposed to an active manager.
If you think you have a great edge over the market and can easily make up the 2% annual cost difference, then by all means pick an active manager or your own stocks.
If not, then the sooner you shift out of expensive investment products or active stock picking and into cheap index-tracking products, the better off you will be. To put things in perspective, consider that these additional and unnecessary fees for just one saver over her investing life could buy six Porsches.
Paradoxically, this is money paid to the finance industry by a saver who could typically not afford to drive a Porsche.