Canadian author Margaret Atwood features on most lists of the best living writers. The worldwide success of the recent adaptation of The Handmaid’s Tale further enhanced her status. Atwood tells a story about a brain surgeon who she met at a party. On learning her identity, the surgeon said: “I've always wanted to be a writer, and when I retire, I'm going to become one.” Atwood replied: “Well, that’s a coincidence. When I retire, I'm planning to become a brain surgeon.”
It was Atwood’s way of saying that writing is a craft that takes years to master. Almost anyone can write, but few people can write well without years of practice honing their skills.
What about the skills required for investing, and in particular, assembling a portfolio of assets and selecting shares or funds to match or outperform the market?
Anyone can do their own investing
More than one million Australians are trustees of their own superannuation fund. They have all signed a 70-page trust deed which makes them legally responsible for their own retirement savings and investment strategy. According to the Australian Securities Exchange (ASX), almost 40% of adults hold ‘on-exchange investments’ outside of institutional super funds, making listed shares more popular than investment property and cash as a retail investment.
The vast majority of these people would not dream of fixing the engine on their car, playing a piano concerto or doing the dental work for their children. Those skills take years of dedicated study and practice to acquire.
What makes teachers or electricians or doctors believe they can assemble a portfolio and trade shares successfully when they retire, most of them with little or no training?
Even the experts struggle
I recently received two emails from different market experts within a couple of hours of each other. Both had analysed the shopping centre company, Scentre, owner of 40 Westfield malls. A broker warned revenue may be ‘deteriorating’ as specialty store rents were ‘going backwards’. The latest results were weak in the food and dining out areas. SELL! Then a fund manager said Scentre owns great real estate with huge barriers to entry with ‘an extraordinary diversity of sources of income’. It was as attractive as any property company. BUY!
Who’s right? I have no idea, but I know one thing – despite the days and months both these experts have spent analysing Scentre, flying around the country inspecting the properties, meeting management and dissecting the numbers, at least one of them will be wrong.
To become a professional share market analyst working for a fund manager, broker or research firm requires considerable training. After university, most attend specialist courses that are tough and take years of study to pass. Then they work in the finance industry for years more before being given portfolio responsibilities. Yet despite this intense training, most of these analysts managing active share portfolios cannot beat the market index consistently.
While there are criticisms of the methodology, the Standard & Poor’s (SP) scorecard of Index Versus Active (IVA) performance is at least a pointer to the number of active managers who struggle. Measured over 10 years, SPIVA says 85% of active global equity fund managers and 74% of active Australian equity fund managers fail to beat the index.
In fact, about half of all institutional share funds established do not survive longer than 15 years.
It’s a counter-intuitive result. Active managers need only pick a few winners and avoid a few losers, and they would perform better than the index.
No doubt, there are some special people with such a talent, but it's not easy to identify them among all the highly-qualified people who spend 12 hours a day sitting in their offices studying markets and stocks.
A recent report estimated there are almost 10,000 professional fund managers in the US. Rather than being poor investors, it’s more likely that most of them are good, making it difficult for anyone to outperform the market. After all, the market is simply the sum of all participants.
The problems with stock tips
Most stock tips from fund managers in the media or at conferences are buys, not sells. Relatively few investors short stocks (that is, sell stocks they do not own by borrowing them from a broker) and market analysis is buy-side dominated.
This ignores the fact that most listed companies will not survive in the long term. Amazingly, of the 2,300 companies currently listed on the ASX (which is 6% of all the companies ever listed), only 580 make a profit. Jason Orthman of Hyperion Asset Management told The Australian Financial Review on 25 January 2020 that Chief Investment Officer, Mark Arnold, thinks many companies are worthless:
"Mark thinks most small caps have zero intrinsic value in the long term as they don't have sustainable business models. This means they don't have sustainable earnings, which means the valuations will go down."
At conferences for retail investors, I always wonder what audience members achieve by filling pages with notes on share tips from stock-pickers on the stage. If people believe a fund manager has some special talent, attendees should simply invest in the relevant fund. Or do they plan to ring the company CEO for a private chat to check the numbers, or carry out more extensive research for additional clarifying insights?
Others watch business television, read daily newsletters or hear company gossip from mates. It’s easy to collect four or five great ideas every day. That’s 20 a week or 1,000 tips a year. How on earth is anyone supposed to filter all these bits of information?
Nikki Thomas, Portfolio Manager at Alphinity, told The Australian Financial Review on 12 January 2019: "I always told people who asked for a stock tip that unless they were prepared to ring me every week for the sell decision, a stock tip was worthless."
I once attended a conference where a high-profile fund manager recommended one stock from the thousands of listed companies available to him. Over the next six months, the stock fell heavily. When I next spoke to him, I asked him about it. "I was out of that months ago," he said.
One thing you can guarantee about fund manager stock tips. The person giving the tip already owns the stock and would like others to be convinced of its merits.
We all love stock stories but unless they form part of a regular update and rating process, including a sell signal, they are of dubious value.
What does Warren say?
The world’s most famous investor is Warren Buffet. Each year, he writes his famous letter to shareholders in his investment company, Berkshire Hathaway. He wrote this in 2013:
“Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power. I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial.
The goal of the non-professional should not be to pick winners – neither he nor his ‘helpers’ can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
So the good news is that investing is different from plumbing or dentistry. With some basic learning and understanding, most people can assemble an appropriate portfolio at little cost. A mix of inexpensive index funds across different asset types, supplemented by some active managers and quality direct shares, should perform well over time. Avoiding over-trading and sticking to a long-term strategy further minimises costs.
Asset allocation matters most, not share selection
The second-largest fund manager in the world, Vanguard, estimates that 90% of the return from a portfolio comes from the mix of assets in a diversified portfolio, not the share selection. Even if someone has a special talent for picking shares, it matters little ultimately if the overall asset allocation between cash, property, bonds, domestic and global shares and other alternatives is inappropriate.
How do you construct a portfolio that meets your goals? That’s the subject for another day.
Of course, if you enjoy investing in shares, or you have skill and knowledge, or even if it’s just something to do in retirement, then go for it. It will help if you use detailed analysis from experienced researchers rather than going for a hot tip or rumour. Otherwise, pick some index funds or select a talented active fund manager if there is someone you especially admire.
What will you do with all the extra time if you’re no longer pretending to be an expert stock-picker? You could follow Margaret Atwood’s advice and try something you've always wanted to do, such as brain surgery.
Graham Hand is Managing Editor of Firstlinks. This article is general information and does not consider the circumstances of any investor. Graham will be presenting on portfolio construction at the Australian Shareholders Association Conference in May 2020.