I met with the managing director of a very well-known company here in Ireland last week. He contacted me because he just turned 50 and he felt now was the time to get a good handle on his finances and he wanted me to review where he was at.
One of the areas we began to look at was his investments. He had built up a reasonable amount of savings over the years and they were split into different types of accounts with different institutions. In one of these accounts he had the sum of €32,000 which was being managed by a firm calling themselves “wealth managers”.
He had given them €30,000 five years ago which had grown by just €2,000 in that space of time.
He gave them complete authority over the €30,000 so they could buy and sell shares as they thought appropriate. He had confidence in them – they were the experts, after all – and the report they furnished to him back in 2010 looked good. There were lots of very impressive looking bar charts and graphs. This company assured him back in 2010 that the way they actively manage funds, will outperform the stock market all the time and that was the reason they were charging him 1.5% per annum, in management fees.
Every year, by the way, investment companies throughout the world collectively sell thousands of these managed funds and collect billions in fees. Now I don’t mind paying someone if they are making me money, but I have a serious problem paying someone if they are losing me money. Who is taking the risk here?
But my question is: how smart are these so called fund manager experts?
Why do so many people hand their money over to them? If they are really that good and so knowledgeable, how come a complete novice on the stock market could make as much money for you as they could?
In 1988, economist Burton Malkiel, claimed a “blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do as well as one selected by experts”.
The Wall Street Journal decided to test his theory and got employees of the journal to dress up as monkeys, then throw darts blindfolded at a page with companies listed on the stock exchange.
Whatever company the dart landed closest to, they would invest money in.
Alongside this they got a number of experts to carefully select stocks they would recommend to their clients based on their knowledge and expertise.
They carried out this exercise 100 times so they had a large sample size.
After six months, the results were in. The experts won 61% of the time but of course that also meant they lost 39% of the time to an investment strategy made up of blindfolded monkeys throwing darts at a board.
Before you consider going to Petmania this weekend, looking to see if they have monkeys that can throw darts, consider this.
Having an animal as your financial advisor may not be the best strategy, but maybe you don’t need a human to pick stocks for you either.
If you want to invest in stocks and shares, you have two options – you can get the advice from a firm of stockbrokers, a wealth management firm or even your local financial advisor and if you want to invest in managed funds, they will pick stocks based on your risk profile and manage them for you.
They will charge you a higher fee for doing this. Their objective would be to beat a particular index like the S&P 500, FTSE 100 etc. and that is how they benchmark their performance.
Your second option is just passively tracking these type of indexes, and investing in a basket of funds that mirror a predetermined index.
The goal here is to match the index performance, not to beat it. This type of investment is called Index Tracking Funds and because there is less work involved the fees are lower, a lot lower.
The greatest investor of our time, Warren Buffett, says that most investors should choose to invest in index funds.
There are literally hundreds of studies that demonstrate the vast majority of actively managed funds by experts fail to match the performance of a particular index.
The moral of the story is that you could be paying someone to do a job for you where they are not even beating the index they are benchmarking against but you still have to pay them for their failure.
That gentleman I was referring to earlier made just €2,000 in five years – that’s a return of 1.32% per year and when you factor in inflation over those 5 years which averaged 0.97% per year.
His real return, therefore was 0.34% – whoopee. So he made €102 every year – guess what his “wealth managers” made every year: €450. That’s a lot of bananas.
If he had simply tracked the performance of, for example, the S&P 500 over the past five years, he would have seen his return increase by 90.54% and his €30,000 would now be worth €57,162.
There are advantages and disadvantages to every type of investment and depending on who you talk you are likely to get a different opinion all the time.
That’s why understanding the difference between any type investment you are considering making is so important.