(Definitely not) Investment Advice for Humans

After waste, the great money sin is idleness - so best then to keep your money working? Lots of reading, validated by good and (expensive!) bad experiences, led me — and lots of other people — to my current thinking:

• Having some cash around is an excellent idea — you need that immediately-available buffer. You should never need to worry about unexpected expenses.
• …but too much cash is really a waste of money! There you go, off to work every day, while your cash yawns, rolls over, and goes back to sleep, inflation steadily atrophying its purchasing power.

How exactly to put your money to work? You can use it to buy some asset that will make you more money; a popular choice is an apartment, a house, or even an apartment building, which is then rented out. The drawbacks here include lumpiness — you can’t just sell 1/10th of a house to raise some cash — and a lack of diversity — unless you own a lot of houses, it is hard to control the risk that some area just becomes very unpopular. In money jargon, houses are “illiquid”, and it is very difficult to achieve diversification; if you really want to own that kind of thing, probably better to buy units in a Real Estate Investment Trust or similar so that you own a small fraction of many properties (and never have to take calls from tenants).

The other big obvious thing to do is to buy a slice of a company; the returns to owning shares are historically better than cash and better than houses (which makes some sense — this is where the money driving house prices comes from).

The fact that everybody knows this is what makes it interesting; on the average, a share price reflects the net opinion of a lot of people as to the future value of a company. This means that if you buy or sell a share because you think it is under/over-valued… then you are a very confident person. Any mid-to-large company is carefully studied by many people with very strong incentives to get the price right (because they can make money by finding under- or over-valued companies). The metaphor here is that when you think of trying to do something like this, you are in roughly the position of a sporting spectator taking to the pitch to play against professionals. Making the game even tougher: the higher returns from shares are driven by a small fraction of the total market — miss those few super-star companies when they are young and cheap (and risky!) and you might as well have stuck with property or bonds.

You could rent your own professionals — invest in a fund managed by pros who try to beat the market (“actively managed” funds); the problem here is that the professionals themselves are engaged in a hyper-competitive game, and most them don’t have an edge that is larger than their fees. The net results of all this competition is actually a pretty useful thing; the price of a company, by and large, reflects the future earning potential — the price is fair (because the pros eventually sniff out the real duds and the real winners… on average… probably!). Most funds end up just delivering about the average market returns — but that is before fees of, say, 1.5 %to 2.0% — not trivial on an average market return of 7% to 9%.

This leads us neatly to the obvious conclusion; we shouldn’t try to pick individual shares. It would be better just to buy lots, on the assumption they are, on average, fairly valued. Forget about beating the market, and instead, just take market returns — 7% — 9% or so. There is now a very easy way to do this — it is called an index tracker. It is the “shotgun” approach — the fund simply owns all the shares, in proportion to the current total value of each company. I used to own one that tracked all Irish shares, and one that tracked all UK shares; then I realised that I was being silly and parochial, and just bought one that tracks all stock markets of any size. No decision-making, and so the costs are low — perhaps 0.15%. The best bit is that the funds themselves can be bought and sold just like ordinary shares, through your stockbroker.

To get the same returns from an actively-managed fund, you need to find one that beats the market by more than the cost of its fees (this is actually rare!). There are statistical reasons which may bore you that make identifying such excellent managers very, very difficult, even in hindsight (“was she good, or was she lucky?”).

A note on company stock: readers like myself will already be benefiting from generous employee benefits that include stock. It is a family policy that we never hold company stock beyond whatever vesting period or tax break or what have you requires: we figure we’ve got enough financial exposure already (in that a really big adverse event would affect not only stock, but salary). We are grateful — but we are diversified.

This ends the “technical part”; much the most difficult bit is actually the “human” element. The greatest danger to the amateur investor, after over-confidence (and the better we are at our own “game”, the greater the danger of this), is emotions. Check your shares, and what do you find? You are richer or poorer by thousands or tens of thousands! If richer, you feel yourself a genius; every crazy idea for buying and selling seems like inspiration from the gods — call my broker at once! If poorer, you feel the stock market is about to bankrupt you — sell everything at once! Both these reactions will damage you financially.

Professional traders gain by long experience a thicker emotional skin that helps them to deal with the ups and downs, a bit like the professional detachment of a doctor that irritates many patients — but saves the doctor from disintegrating under the burden of all that suffering. The single smartest thing an amateur investor can do is to not check on their investments, Once a year is about the right tempo.

I thought that I was over these emotional difficulties until I found myself needing to make share purchases worth more than my own annual income; then I struggled; my rational side knew what needed to be done, but the other side was craven. The solution was to treat the investment like a hot bath, and to ease into it slowly, buying the shares in tranches. Financially, it made no real difference; psychologically, it was much, much easier.

Do a little of your own reading; convince yourself. Then, after that, make allowance for your thin amateur skin and those treacherous emotions. My own greatest moment as an investor came during the financial crisis in 2008, when I did… absolutely nothing. Time past, nothing we held went to zero, and eventually, we saw great gains. Your money should work hard, but your own strategy should be masterly inactivity.