16 February 2018

What should we make of the latest market volatility? Part 2: Mum versus the hedge fund industry.

In his previous blog, former hedge fund manager Lars Kroijer, author of Investing Demystified, shared his views on the recent market turbulence, concluding that the overwhelming number of investors have absolutely no chance of outperforming the financial markets. So what, he asks, by way of example, “should my mum do?”. We would be wise to take note of his advice.

Let’s say you weren’t prepared for what happened last week. What should you do to ensure that you can withstand the volatility we’re inevitably going to see in the future?

Let’s take a super simple world where you can either invest in equities or government bonds (which, by the way, I don’t think is a bad portfolio to be thinking about). Everyone should decide, can I beat the markets or not? My argument is that the overwhelming number of people have no chance whatsoever of outperforming the financial markets. I often think of it as my mum versus the people I know from my time in the hedge fund industry, and it’s certainly not a fair match. My mum should never be in there, buying Facebook versus Google, or anything like that.

So, what should my mum do? If she wants equity exposure, she should buy the cheapest, broadest, most tax-efficient exposure to the equity markets that she can find. She needs to look for a product (and there are many index-tracking products that do this) that buys her the world in proportion to the market caps that the markets have ascribed to them. That’s equities done. That was easy!

Then you should combine that with something of little or no risk — perhaps a government bond that has roughly the same time horizons as you have for your investments. So it might be a five-, 10- or 20-year bond, or a number of them. Now you have two products. One is very high risk and the other is very low risk.

So, what next? My mum should think about her risk. Her risk is what determines how much she should own of each. If she is a very high-risk investor, she should buy a lot of equities, and if she is a very low-risk investor, she should buy a lot of government bonds. And if she’s in between, she should be somewhere in between. This is why it’s a hard question, because it depends on who you are and what your time horizon is.

If you look at the financial markets overall, there is a tremendous tendency to make all of that really, really complex, with lots of different products. There’s also this agenda to charge you a lot of money to sort through that myriad of opportunities. What I’m saying is that it doesn’t have to be that hard. You can create a very powerful portfolio, very cheaply and very simply. But that does not mean that you can predict which way the markets are going to go.

In your book, a key theme is the importance of diversification — not just across different asset classes, but also different geographical regions. Why are you so keen on a global approach?

Your risk is something that you should think continually about. In fact, it’s something that most people are guilty of not thinking enough about. And I think this is why a world equity index tracker is so sensible. If you think about the portfolio of most individuals, very often it’s their house, their education, their job, their spouse. Those are all things that correlate highly in value. They’re all tremendously dependent on the local economy. So, if you add to that concentration by buying local stock, that’s an unnecessary lack of diversification. You should absolutely diversify, and a global equity index tracker is the most diversified investment, in terms of equities, that you can possibly get your hands on.

That’s such a sensible and logical piece of advice. Why, then, is home bias — the tendency to overweight stocks from our country — so pervasive?

To a certain extent I think it’s historical. In the past it’s just been very expensive to trade abroad. Most people couldn’t just gain exposure to an Australian mining company, for example; it would take weeks, hundreds of years ago, to sail your gold down there. Now it’s instant. You can invest in crowd-funding campaigns around the world very cheaply, and with blockchain technology, currency exchanges are going to be much easier and cheaper going forward.

I think there’s still a mindset that we should do stuff close to home. But you can’t diversify those things I mentioned — your house, your job, your future inheritance, your spouse’s career. All those assets are hard to diversify. Yet if you look at the portfolio of institutional investors in the UK, for instance, you might find that they hold 40% or 50% of it in UK stocks. Why is that? Very often there is no good answer.

So, it’s pretty simple really. A low cost, globally diversified portfolio of assets that have low correlation with each other, held for the long-term without constant tinkering, is the secret of investment success. Understanding this will also help reduce your stress levels in the face of market volatility.

Risk Warning

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

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