Successful active investing takes a lot of work – and even then, it’s difficult to beat the market. The answer? Be as passive as possible, says former hedge-fund manager Lars Kroijer.
Investors are bombarded with stock tips promising to reveal the next Apple or Google; articles on how India or biotech are the next hot thing; and interviews with the latest star investment manager, explaining why his or her outstanding performance is bound to continue.
It’s a confusing environment – particularly for anyone new to investing – and it can be very easy for inexperienced investors to imagine that all of this information matters or has value, which in turn makes it very hard to know where to start.
It’s not easy to find an edge
What if we started with a very different premise – that markets are actually quite efficient? By this I mean that, even if some people are able to outperform the markets, most are not. In financial jargon, most people do not have an “edge” – they can’t consistently outperform by picking different securities, sectors or geographies from the market as a whole, especially after costs. Nor are they able to figure out which of the thousands of fund managers on offer are most likely to have the ability to do it for them.
I’m not saying that beating the market consistently is impossible (indeed, one key goal of MoneyWeek is to highlight areas where you might be able to find an edge). But I am saying that it is very difficult, and requires more commitment than most of us are willing to give. Accepting, embracing and acting on this absence of edge is, to me, crucial for most investors.
However, the absence of edge does not mean that you should avoid investing. Doing so would exclude you from the potentially inflation-beating long-term returns in the equity markets. Also, what else are you going to do – leave your money under the mattress or in a bank at near-zero interest? Those aren’t very attractive outcomes. Instead, a good starting point is to assume that the current market prices of securities capture all available information and analysis, and reflect the balance of risk versus reward. In other words, we accept that the market is basically right, and that we can’t second guess it.
That implies that, if we want to invest in equities, then we should pick the broadest possible selection of stocks – because we don’t know which individual stocks or markets will outperform. And what is broader than an index that tracks equities from all over the world, in the proportion of value that market forces have already put on them? By using a world equity index tracker we can maximise diversification and minimise exposure to any one geography, sector, or currency.
And since we are simply tracking an index (such as the MSCI All Country World index, for example), the product is very cheap to put together. If an all-equity exposure is too risky (which depends largely on your time horizon), then you can combine this with government bonds in the proportions that suit your risk profile. The lower the risk desired, the more bonds you want.
The ultimate passive portfolio
Now, if you want to try to beat the market and spend a lot of time reading about investing, and figuring out how to manage your emotions, then that of course is your prerogative. But even then, I believe that it’s not a bad idea to have at least a core part of your wealth invested in as passive a portfolio as possible – at the very least, it gives you a benchmark to measure your efforts against. And if, like many people, you would prefer to find a solution to your long-term investing concerns that requires as little effort as possible from you over the long run, then I’d suggest that this is the best answer.
The good news is that it’s easy and cheap to construct a portfolio along these lines. On the equity side, you can invest in the most diversified possible world equity portfolio using just one security – there are several options, but the Vanguard FTSE All-World exchange-traded fund (LSE: VWRL), for example, charges just 0.25% a year. The rest of your portfolio should comprise the highest-rated government bonds in your currency (so gilts for British investors), and a mix of maturities (the average period before the bond repays its face value) that suits your needs.
Your specific circumstances do matter a great deal. Think hard about your risk appetite and about ensuring that your portfolio is organised as tax-efficiently as possible. Also pay attention to your non-investment assets and liabilities – many people already have a disproportionate exposure to their domestic economy through their house, and to a specific sector via their job.
To my mind, that’s another good reason to ensure you are as diversified as possible in your investment portfolio. You can add other government and diversified corporate bonds if you have an appetite for a bit more complexity, but this ultra-simple passive portfolio is very powerful even without those.
Keep your costs as low as you can
Follow these steps and I think you will have a personal portfolio strategy that lets you sleep well at night, knowing that you have created a powerful, diversified portfolio, tailored to your risk appetite, at very low cost. To emphasise this point about costs – perhaps the most important factor of all – suppose you were to save 10% of a £50,000 annual income from age 25 to 67.
You invest it all in world equities, at an average return of 5% a year (after inflation), which is in line with historical returns. Imagine that you manage to save 2% a year on costs, by doing less trading and paying fewer fees than a more active investor. By the time you come to retire at age 67, you would be better off by something in the region of £250,000.
To put things in perspective, that’s enough money saved on unnecessary fees to buy yourself a couple of high-end Porsches with money left over for a very nice holiday. Regardless of how you feel about sports cars, it’s much nicer to buy your own than to pay for your fund manager’s.
• Lars Kroijer (@larskroijer) is the author of Investing Demystified – How to Invest Without Speculation and Sleepless Nights (Financial Times Publishing). He founded Holte Capital in 2002. Visit his YouTube channel.