When reckoning with the sheer proliferation of funds available to invest in, many investors turn to the false notion that past performance can reliably indicate a fund’s outlook for the future. We sat down with financial academic and author DAVID PITT-WATSON to get his view on the benefits of reducing risk by prioritising diversification in your approach to investing.
TEBI: There are a huge number of funds that people can invest their money in. Roughly how many are there?
David Pitt-Watson: Last time I looked – in Britain, there were 28,000 funds that you could put your pension into. If you think: there’s only 1000 companies quoted on the stock exchange, it does seem extraordinary that it is economically efficient to have thousands and thousands of funds.
RP: So why are there so many?
DP: Everyone thinks they can do better than the last person, so they start a new fund. But also, if I was scratching the surface of this a little bit, people buy funds that have outperformed. And if I want to have a fund that has outperformed every year for the last five years – one way I can do that is to start off with 32 funds.
At the end of year one, I’ll have, just on the averages, 16 that have outperformed. At the end of year two, I’ll have eight that have outperformed every year. At the end of year three, I’ll have four. At the end of year four, I’ll have two. And at the end of year five, I will have a fund that has outperformed every year for five years. I mean, anyone buying that would say, “Well, that really can’t have happened by accident.” But actually, that was what happened.
Now, I don’t think that that is what is in people’s minds when they are setting up the fund. But you can see how, in a world where outperforming funds makes it easier to be able to sell something to somebody, this proliferates again and again.
I’m not saying that there’s some evil genius thinking behind all this. I don’t think that’s how it works. But you can see how markets just encourage lots and lots and lots of these things.
And by the way, it’s really inefficient. It’s quite expensive to run different funds than it is just to have just one.
RP: The problems emerge as well when people start piling into these funds.
DP: What happens of course – and again it happens systemically – is: you start off with a small amount of money and you outperform. And then in year two you get a bit more, and a bit more, and a bit more, and a bit more…
But that fund that outperformed for five years in a row is no more likely to outperform in year six than anything else. So then, when it’s got the most money, it can fall off the cliff. These things do happen, and they happen more often than they ought.
So if you’re a sensible retail investor, you want to just sit back and think about, “Okay. What’s this person invested in? Do these look like sensible companies for my pension, or for 10 years out or however long it is that I’m saving for?” Are the fees and the charges sensible? Are they looking after the shares and the equities and making sure that the companies are well run? That’s actually an important thing people often overlook. And when they do that, does it meet the liability that I’m looking at? Does that meet what I need in the future?
I would suggest that it’s those basic common sense questions that you want to look at. It’ll serve you far better than thinking that there is anyone out there that’s got a magic wand.
RP: One of the most important things that investors can focus on instead is diversification. So, why should that be more of a priority than chasing performance?
DP: If you diversify, you take out a lot of the risk. Imagine you toss a coin: the chance of it coming up heads is 50 / 50. If you toss a hundred coins – and let’s say you win the coin on the heads and you lose it on the tails – the chance of losing all your money is very, very low indeed. It won’t come up tails a hundred times. That’s the simple argument for diversification.
Therefore it makes sense to be invested in funds, which will then themselves be diversified. They’ll be diversified amongst the industries that they’re in, maybe amongst the geographies, and between bonds and equities.
You can go further into some very complicated maths on this and work out what is the maximal diversification. But to be honest, you’ll get 90 percent of the value from just thinking: am I invested, not in just half a dozen things, but in more than that?
RP: So when we hear in the financial media about conviction managers saying “this or that sector is THE sector to invest in”, why does that not necessarily make statistical sense?
DP: I’m not against conviction managers but, as an investor, you’d better understand really carefully what the conviction is. And what are they trying to do with that conviction? I ran a very peculiar fund myself that was a conviction fund: we had about 15 companies in it. But it was a shareholder activist fund. It was doing some very special things. So I’m not against them, but investors need to recognise one thing. If you’re only invested in 15 stocks, especially if they have common characteristics – the ups and downs that you’re likely to see will be much greater than if you’re invested in 150 or 1500 stocks.
RP: There’s an often-quoted piece of research from Hendrik Bessembinder in America. He looked at the proportion of stocks that actually outperform treasury bills in the long term, and found that it’s actually very small. About 4%. There’s some debate about whether that’s actually an argument in favour of active management as opposed to “owning the whole haystack”.
DP: It’s all well and good knowing that only 4% of stocks outperform but what can you do with that information? Have you found the active manager who knows what the 4% are? Even if you think you have, there are countless active managers who appear to have the Midas Touch, before it all disappears.
I wouldn’t be against a really sophisticated investor wanting to make investments in people that they genuinely believed had a skill in being able to find the companies of the future and those sorts of things. But even for the biggest investor, I think you would always want your core to be well diversified and at low cost. Ultimately: if what you want to do is not to have to worry about your investments, then I’d absolutely suggest you just stick with that core bit. The core part that’s well diversified by somebody who is looking after your money.
RP: Diversification has been famously described as “the one free lunch in investing”. What’s your view on that?
DP: I do think we’ve got to be a bit careful about this. We are now invested for most of our pension funds in thousands upon thousands of companies all around the world. We don’t even know the names of the companies that we’re invested in. That is simply astonishing. But my own sort of common sense would say to me, I really hope we’re thinking about the governance of those companies. Because imagine that those companies all turned around and said, “Well, I’m not wanting to pay a dividend any longer.” Questions like that. So, I don’t think it’s an entirely free lunch – but, of course, you are always better off being well diversified.
RP: How can a financial adviser help investors in this respect?
DP: One thing needs to be said. The big value that an adviser provides will not be in them telling you, “Oh, I’ve discovered this wonderful new fund. I’m sure you’re going to make loads of money out of it.”
Instead, they should start by asking you what you want to do with the rest of your life, what you want to do with your money. What’s your total balance sheet? How does what you have match with what you might want to do in the future? And then, with your investable cash, how can that be used to address any gaps that you might have in your expectations? So that’s the analysis that they go through..
The big value then is in saying: these are your particular characteristics. This is the portfolio of assets that you’ve got. Here are the liabilities and the expenses that you might have. We’ve matched those two to a reasonable degree at low cost. You can feel comfortable about what you’re doing.
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