Saturday 22 July 2006

Which investment approach has the right stuff?

You read a lot of conflicting opinions about the *best* investment method for equity investments. Often these opinions are backed up by testemonials, back-calculated results, or rigorous academic research. For instance, you may be told that it is best to
a) Put your money into managed funds. The theory is that professional managers with huge research resources can do a better job than you. Supporting evidence would be out-performing funds or fund managers (eg. Peter Lynch, Warren Buffett). Debunking evidence would be studies that have shown that most managed funds, after allowing for fees, do worse than the market average. This seems logical because, as a group, managed funds must approx. to be the same as the market, but with the overhead of management fees. Some, of course, probably will outperform the market, either by luck or skill (more studies have attempted to quantify how many funds outperform due to skill - I haven't got a clear sense of the actual percentage, but it seems clear that not all outperforming funds are due to skill). The problem is that there doesn't seem to be any way to pick the winning funds in advance - chasing last years winners has been shown to be a poor strategy. Another problem is that the skill of a fund is, presumably, tied up in a few key personnel - and they can leave, taking their skill with them. Chasing managers (rather than funds) would also be a poor strategy, due to the costs of moving from fund to fund.
b) Pick your own stocks. Here you would save on fees associated with managed funds, and can control costs by using online discount brokers and minimimal trading (to eliminate tax events). The cons are that you probably do not have the resources (time, knowledge, data, contacts) to do as good a job as Warren Buffett, so any outperformance is quite likely going to be due to luck more than skill. Subsets of this option are
b-1) select on a couple of stocks to invest in - ie. "put all your eggs in one basket and what it carefully". Too bad if your stock-picking ability turns out to be poor.
b-2) select at least 10-15 stocks to benefit from diversification. With this many stocks, provided you pick sensibly (and are not too greedy - eg. chasing IPOs, tech stocks or whatever) you should not be too far off the market performance (but there have been studies showing that most personal investors tend to overtrade, and do a poor job or market timing - so the chances are that you will underperform the market even when diversified).
c) Use index funds, EFTs or similar. This approach should minimise tax and fees. Cons are that you are only going to achieve market performance.

Now, if it's not clear which is the *best* approach why pick on ANY one method?

Personally, I have my retirement funds (superannuation) in a mix of local and overseas equity funds. The superannuation provider only offers a range of managed funds (no index funds), so you are paying 1%+ extra for the dubious benefits of active management - but I get cheaper group life insurance rates through the superannuation fund, and, in Australia at least, the tax breaks make it worthwhile.

I also have some direct share investments and index fund investments, via three different margin lending accounts, as geared share investments should perform roughly the same as ungeared superannuation investments. The added benefits of this are that I can be 100% invested and use my spare margin loan capacity as my 'emergency fund' - rather than leaving 6 months salary sitting in a cash account as some people advise.

I also have some 'exotic' investments - eg. hedge funds (OMIP, Equinox), agricultural unit investments (pine plantation, almonds, sandle wood, films), private equity fund. These ARE high risk, but, again, with adequate diversification, I have seen studies that purport to show that these should be worthwhile in the long run - 1 or 2 going broke (like my film investment) will be offset by the performance of the other 8 or more areas. The cons of all exotic investments appears to be that, for the small, individual investor, management fees range from high to astronomical.

The benefit of using a 'scatter gun' approach to picking investment methods is that they can't ALL turn our to be the worst possible choice. Whereas, sticking to one particular approach could end up being a disaster.

As they say, life isn't a rehearsal. So, it's much better being partly right than risking being entirely wrong.

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