Features | Education | 18 Mins Read | by AG Latto
The investor’s dilemma faces all of us: if we don’t invest, the purchasing power of our money will slowly decline; if we do invest, we are exposed to the risk of loss. It results in many sticking with cash.
A bank account feels safe. But the purchasing power of cash will slowly erode: a dollar ain’t what it used to be.
For many, a bank account is the lesser of two evils.
After all, investment offers no guaranteed return and no money-back guarantee. And there are always stories of investments that have gone wrong.
If someone is unable to invest in a way that preserves capital, is it any surprise they stick with a bank account? Losing money negates the purpose of investing.
It is rational to avoid investing if we do not know how to preserve capital. But it is also rational to learn how to invest in a way that preserves capital.
We can solve the investor’s dilemma if we invest in a way that preserves capital over the long term. This offers an investment-style return without the risk of a large and permanent loss of value. This article considers how to achieve this.
Short term risk: volatility
For those with a short-term horizon, volatility is risk.
A market slump is painful if you need to realise capital within the next couple of years. And market slumps happen from time to time. Investors with a short-term horizon are therefore advised to have a cash reserve.
All investors are at risk of market declines in the short term. But only investors with a short-term horizon need to realize a loss.
In the short term, we cannot solve the investor’s dilemma. This is because we cannot both invest and avoid the risk of loss within a narrow window of time.
Long term risk: capital preservation
Risk gets turned on its head when we are considering the long term.
Investors with a long-term time horizon are not forced to sell at a loss during a market slump. Risk is no longer volatility because markets eventually recover. Risk is now the preservation of capital over the long term.
Investors with a long-term time horizon instead need to avoid the risk of a large and permanent loss of value. This is a drawdown that we cannot easily recover from.
We need to invest while keeping the risk of a large and permanent loss negligible. This is how we seek to solve the investor’s dilemma over the long term.
Fund Hunter’s focus is on the long term.
Risk changes
It is hard to hold two contrary ideas on risk at the same time.
In the short term, don’t lose money means we need to own bonds and/or cash savings accounts. In the long term, don’t lose money (in real terms) means we need to invest in volatile asset classes like the stock market.
To paraphrase Warren Buffett:
Cash is less risky than stocks in the short term, but stocks are less risky than cash over the long term. [Provided you own good stocks].
In practice, academics and investors tend to view risk only as volatility i.e. what is the chance of losing money in the short term? Cash feels safe within this context.
The hard part is conceptualizing that a volatile stock market can be a safer place to be over the long term than a bank account.
Performance mitigates risk
Over the long term, the best protection is performance.
Investing in real assets will generate a higher return than a bank account. Good performance will lower our exposure to the risk of loss. This is because it builds a performance buffer.
By way of example, a 25% housing slump can happen at any time. But if you bought your house 15 years ago and are up 300% on the purchase price, would a 25% decline matter?
Solving the investor’s dilemma
Over the long term, the investment problem is to maximise our return while keeping the chance of a large and permanent loss of value at zero.
Capital preservation is the constraint under which we invest. Techniques that help to preserve capital include the following:
1) Diversification through funds
Diversification has been described as the only free lunch in investing.
It helps to reduce blow-up risk. In a portfolio of 25 stocks, a disaster for one company will only result in a 4% loss. Companies do blow up from time to time.
Investment funds deliver instant diversification. This takes a lot of work, and transaction costs, out of the investing process. Funds allow us to diversify on a global basis, which is something that is hard to achieve when buying stocks directly.
Funds were invented to solve the investor’s dilemma by offering low cost diversification.
Fund Hunter focuses on funds for this reason. If selected well, they will be able to preserve capital over the long term. They are a simple tool that helps meet an investing prerequisite.
2) Start with passive funds
Fund Hunter’s view is that passive funds are the default starting point.
A few active funds have gone very wrong in the past with Neil Woodford’s funds a case in point. Active managers take concentrated positions with the aim of outperforming. But this only works out if the underlying companies are sound.
Passive funds are low cost ‘plain vanilla’ investments. They require less monitoring than active funds. Companies that are performing badly will become a smaller part of an index. Passive funds are also lower cost and well-diversified.
In short, active funds have blow-up risk due to the nature of active fund management.
Active fund management is a zero-sum game. This means that after fees, most active managers will underperform their benchmarks. An additional reason why low-cost passive funds should be our starting point.
3) Start with the world
People tend to invest in the stock market of their home country.
We are most familiar with the companies listed in the country in which we live. There is also a perceived currency risk to invest overseas.
But unless your country has the world’s best stock market, it pays to invest on a global basis. A national stock market may also be higher risk because it is less diversified and exposed to the economy of one country.
Currency risk is short-term volatility. It doesn’t matter if you have a long enough time horizon. If a global fund performs well, it will provide a buffer to absorb short-term currency volatility.
A prominent global passive fund is the iShares MSCI World ETF (SWDA) equity fund, with £20 billion in assets. It acts as a useful starting point.
See: A) What’s your default, dummy? B) The case for global funds
The iShares MSCI World ETF (£)
Seeking to outperform: Fund Hunter’s approach
Fund Hunter seeks to add value over a global passive equity fund.
The aim is to generate a higher return while keeping the chance of a large and permanent loss of value close to zero. This is achieved by owning funds with attractive companies and that avoid weak companies.
When it comes to fund investing, we do not have to pick individual stocks. We only have to 1) identify where winners are likely to be (e.g. sectors) or 2) identify investment managers that can pick winners.
We only have to be roughly right. Investing in individual stocks investing is not so forgiving. To quote the economist John Maynard Keynes:
It is better to be roughly right than precisely wrong.
The following outlines Fund Hunter’s approach to fund selection.
1) Select passive first; active funds second
Passive funds remain the default starting point.
There are a host of passive alternatives to the iShares MSCI World ETF. We can take positions on passive country, sector, subsector and factor funds.
New passive funds come to the market all the time. While most are ill-conceived, there have been some gems.
The next stage is to consider active funds. Their performance needs to offset the higher fees. The allure of active funds is that they can avoid lower quality companies and potentially pick stock market winners.
Active funds can be lower risk than an index if they own stocks that are less likely to blow up. In 2020, for example, we have seen significant setbacks in the banking, mining and leisure sectors.
2) Identify the best default fund
It is helpful to identify a ‘default fund.' This is what we would invest in for the long term if we could only invest in one fund.
It serves as a benchmark to judge other funds. In other words, it acts as an opportunity cost fund. Are you willing to sell the default fund to invest in an alternative?
We cannot add other funds just for the sake of it. They have to add value versus the default. The starting default fund is a passive world tracker like the iShares MSCI World ETF. But there are likely to be better default funds.
The better the default fund the higher the benchmark for other funds. It acts as a powerful decision-making tool.
3) When choosing funds, own good companies
Fund that owns good companies will inevitably do well over the long term.
It is possible to overpay. But the biggest danger is owning companies that do not survive. Buying cheap companies is much like buying cheap used cars, they tend to go wrong.
Fund Hunter, therefore, looks for funds that own good companies.
We can do this either by analysing the companies or by analysing investment managers. When it comes to passive funds, we start with the stocks. When it comes to active funds, we can analyze the stocks and the process.
It is impossible to follow every company that a fund manager owns. The question is whether they have what it takes to pick winners and avoid losers. Do they have an edge over rivals?
Fund Hunter model portfolio
The Fund Hunter model portfolio started life at the beginning of 2019.
This means that there is not a long period of time to judge it by. But the relative performance versus the iShares MSCI World ETF is reasonable.
Fund Hunter model portfolio versus the MSCI World ETF
What are good companies?
If the aim is to own good companies, we need to consider what they are.
We want to own companies that have the wind at the back rather than a headwind. The hard part about investing is that it concerns the future. We cannot adopt rules based only on what has worked in the past.
Companies that have done well in the past may struggle in future; companies that are loss-making may be future stock market winners.
Apple was dismissed by a number of active fund managers but is now the world’s largest company. Tobacco was one of the top-performing sectors but is now struggling with weak growth and regulatory change.
The end goal of Fund Hunter is to own companies that can both generate and grow free cash flow per share. This means strong customer relationships (franchise power) and a growth runway.
Companies are valued in-line with the scope to generate free cash flow. But if stock-picking were only about the historic financial numbers, it would be easy.
Summary
Fund Hunter seeks to better solve the investor’s dilemma.
Our aim is to generate the highest return possible while keeping the chance of a large and permanent loss of value at zero. Funds a powerful tool to achieve this. They deliver instant diversification and we only need to be roughly right.
The investor’s dilemma has led to many sticking with low-interest bank accounts. Fund Hunter’s objective is to show that there is another way. For those with a long-term time horizon, the real risk is not investing.
Additional Comments
Fund Hunter's aim is to identify and follow the top 0.1% of investment funds (passive and active): How to subscribe
1) Where will the market go next?
This is a question that tends to get asked a lot. People want to know if it is a good time to invest.
No one wants to invest just before a market slump. But it would be great to invest just when markets have hit a low and are set to recover.
Given that this is a popular question, there is no shortage of people willing to answer it. After all, the investment management business is marketing driven.
Fund Hunter has been asked the question a number of times. Unfortunately, predicting where the market will go in the short term is challenging.
The trouble is that there are too many variables that can impact the direction of markets and economies in the short term.
One way of mitigating a market decline is to buy over time. Those who invest while they work do this by default, making the short-term market direction unimportant.
Those with a lump sum to invest are in a different position. It is still possible to invest over time but it may mean missing out on strong market gains.
It is certainly possible to invest a lump sum at a poor time. If you had invested at the market peak in 2000 you would have had to wait over a decade to be made even.
But the dotcom boom was a once-in-a-generation bubble. It was also followed by the financial crisis, which was a once-in-a-generation slump.
In other words, it is unlikely we will invest at a March 2000-style top. Fund Hunter's view is that the market today is not comparable to the dotcom boom.
2) Do stock markets inevitably go up over the long term?
The underlying assumption in stock market investing is that markets tend to go up.
This has indeed been the case for over 100 years. But we cannot assume that the past is always a good guide to the future.
Stocks go up because company earnings and free cash flow tend to go up. The stock market winners, like Amazon, more than offset the stock market losers.
The danger for stock market investors is that the largest companies go into decline. This appears to have happened for many of the largest UK companies.
But the largest global companies appear to be winners. They include Apple, Amazon, Microsoft, Alphabet and Facebook.
When looking at some stock market indices, investors often choose the time period from 2000. This shows how badly markets like the UK have done.
But what they ignore is that stock market indices generally exclude dividend reinvesting. Factoring this in, the UK stock market has delivered a positive return.
3) What about direct stock investing?
Direct stock market investing is harder than it appears.
While it is easy with the benefit of hindsight it is not easy in practice. This is in part because relatively few stocks do well over the long term, making it is easy to pick duds.
See: Do Stocks Outperform Treasury Bills? Bessembinder
With relatively few active funds beating the market, the obvious question is why should private investors fare any better? Some will point out that private investors have advantages over institutions, but they also have disadvantages.
Private investors have limited access to research and management. Broker research on companies has become heavily restricted. Investing institutions have easy access while the public does not.
To do well in stocks you need experience, expertise, the right temperament, time and a passion for it. It uncommon to have all of these attributes.
If we only own stocks, we need to pick at least 10 good companies and preferably 20-25. We then need to monitor their performance and look out for better opportunities.
The best stock pickers are full time and have at least a decade of experience. But the general view put out there is that someone can do well in stocks overnight.
Fund Hunter’s view is that a core/satellite system is the best way to approach stocks for the vast majority of people. The stock component is only a minor part of a portfolio and focuses on a few exceptional companies.
See: Investor’s edge - Satellite Driven Returns
4) Property investing analogy
When explaining to a British person investing, the best way to do it seemed to be using property as an example.
The British are property obsessed and not without reason. The UK has a growing population and fairly strict rules on a new building. Property is seen as a safe investment.
Property can go down in value right after you buy it due to a downturn. But if you buy well located and high-quality property you will do well over the long term. This means avoiding off-plan flats in Bulgaria and instead investing in quality UK cities.
It is the same for stock market investing. Early-stage companies are unlikely to preserve capital. Established businesses with a tailwind are well placed to preserve capital.
In short, if you invest in the equivalent of Mayfair when you invest in stocks, you are unlikely to go far wrong over the long term.
Unlike Mayfair, the fortunes of individual companies wax and wane. Stocks, therefore, need to be more closely monitored. Microsoft is likely to remain a strong company, but this cannot be taken as a given.
5) Case studies
Considering real people helps to highlight the investor’s dilemma in real life. The names have been changed but the stories are accurate.
Building Society Bob – Bob only invests in property and a Building Society account. The latter seems safe versus the stock market. But the interest on Building Society accounts has fallen to next to nothing in the UK.
Bob still views himself as a safe investor. But the value of his capital is declining in real terms over time. Hardly a safe thing to let happen. But Bob cannot accept that the stock market might be a good place to invest.
Web developer Dave – Dave is someone I nagged to invest for around a year. In the end, I just said, just start off with £1,000 and see how you find it. Dave did eventually open an investment account.
To start with Dave traded a lot. He looked for patterns and in particular resistance and support levels, although he didn’t call them that. When a fund got to a certain level he would sell and when it fell to a certain level he would buy.
But this missed out on the big moves and Dave now tends to hold on for longer.
Tennis Tim – Both Tim and his wife had all of their money in bank savings accounts. I mentioned to him a reasonable fund at tennis and he bought into it after reading a few newspaper articles.
Tim did ok but traded too much. His wife traded less and did much better. Tim never subscribed to Fund Hunter! This was a shame as the website has identified better funds than the one I mentioned to him.
Tim also has a young child and it would be good to set up a fund for him to pay for University fees and other costs. Unfortunately, Tim appears to be in the school of thought that investing in the stock market is risky.
Safe Sarah – Sarah is in her 70s and has had a significant amount of money in Building Society accounts. These are earning next to no interest. Sarah is a Fund Hunter subscriber and put a certain amount into a fund that was profiled on the site.
Her timing was fortuitous as she bought it after the March 2020 sell-off. Sarah recently invested more in the same fund. Fund Hunter cannot give advice but did discuss investing principles with Sarah.
Sarah asked what the return from an investment fund would be. The three drivers for the return on a stock are earnings growth, dividend payments and the change in the P/E ratio (the rating). We do not know for certain how any of them will perform.
Over time, if earnings grow and dividend are paid, investors will do well. But it depends on investing in good companies. Much like buying a good property. If you buy right and hold for a reasonable period, you will do well.
Not now Nina - I tend to mention the website Fund Hunter to everyone. The reactions are interesting. Some people do seem to equate investing with gambling. Others do not seem to trust anyone involved in the investment industry.
One person I live near had an interesting reaction. Given what she had read in the news, she said: "who would want to invest now?"
In other words, the uncertainty with Covid-19, the US election, Brexit etc surely makes investing a fool's errand at the current time. The trouble with this view is that what we currently know tends to be priced in.
In fact, the Fund Hunter model portfolio has performed better in 2020 year-to-date than in 2019. So much for "now being a terrible time to invest."
6) Timing the market
When people do invest they often seek to time the market.
This is both for capital preservation and to take advantage of a bull market run. In other words, sell at the bottom and buy at the top.
The best thing to do with a sound investment fund tends to be nothing. Unless the underlying investment thesis has been shown to be flawed.
