Of all the charges levelled against those of us who advocate an evidence-based approach to investing, perhaps the most inapt is that we’re dogmatic. Zealots, fanatics, militants — those are some of the more polite terms I’ve seen used to describe us.
Evidence-based investing is surely the antithesis of dogma. It’s an approach that’s based on more than 60 years of independent, peer-reviewed and time-tested evidence. Nor is it set in stone; this is a living body of evidence that continues to grow and that’s being constantly refined and re-evaluated by academics around the world.
Some refer to this evidence as science, or the science of the capital markets, although interestingly, this is a point on which even those of us who broadly agree have differing views. When, for instance, during filming for How to Win the Loser’s Game, I raised the issue with Kenneth French, he was much less comfortable with the idea of his work being scientific as his colleague Eugene Fama was.
For me, the is-it-science-or-not? debate is irrelevant. Something that French and Fama do agree on is that the case for avoiding the high-fee, actively managed funds that the investing industry overwhelmingly wants to sell us is ultimately based on mathematics. No, not complicated mathematics, but arithmetic so basic that even I, a dunderhead at maths at school, can easily get my head around it.
That simple arithmetic is explained by the Nobel Prize-winning economist William Sharpe in his 1991 paper, The Arithmetic of Active Management. Do take time to read it — it’s very short — but here’s an even more abbreviated version.
— The investing community is divided into active and passive investors.
— Before costs, the return on the average actively managed pound/ euro/ dollar will equal the return on the average passively managed dollar.
— After costs, the return on the average actively managed pound/ euro/ dollar will be less than the return on the average passively managed dollar.
Therefore, the average active investor must — no ifs or maybes, must — underperform the average passive investor. Period.
To quote Professor Sharpe: “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
As Vanguard founder Jack Bogle has said, it all boils down to “the relentless rules of humble arithmetic” — a phrase he used for the title of a 2005 paper for The Financial Analysts Journal. In it he says: “The overarching reality is simple: Gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors.”
The investing industry is essentially an intermediator. Fund managers, brokers, consultants and advisers all want paying. But the bigger the total cost you pay, the smaller your net returns will be. Ultimately, says Bogle, it’s not about EMH, or the Efficient Market Hypothesis, but CMH – the Cost Matters Hypothesis.
It’s not surprising that the investing industry doesn’t like to talk about costs, or that it goes to such extraordinary lengths to hide the total costs that investors pay. Why? Because financial intermediation has become hugely profitable to those involved in it. As the author Upton Sinclair famously said, “It is difficult to get a man to understand something when his salary depends on him not understanding it.”
My experience is that most investors, and indeed many advisers and investment journalists, are simply unaware of the impact of compounded investment fees and charges over the long term. In his 2005 paper, Bogle stated that in the US at that time “50% or more of the real return on stocks can be consumed by costs”. In the UK, where the cost of investing is higher, the effect of charges can typically reduce your potential returns by two-thirds.
These are staggering numbers. Of course, you cannot eradicate costs altogether and, for the vast majority of people, dispensing with a financial adviser is definitely a bad idea. But costs are the one thing that you as an investor can control. Keep them to a minimum and you’ll end up with bigger returns than the vast majority of your peers. Believe me. It’s simple arithmetic.