Personal Money Management 101 Blog

We are bombarded with advertisements for managed fund (mutual fund) investments. They implore us to entrust our hard earned cash to them with the promise that their expert managers will reward us with above average returns.

On the face of it managed funds do appear to offer benefits. They allow the smaller investor to diversify (and thus reduce risk) to a much greater degree than if they invested in individual stocks. A managed fund can spread an investment across 30 or more stocks whereas the small investor might be limited to just 2 or 3 by direct investment. And they should ensure that the stocks are being chosen by intelligent individuals with access to the latest and best information.

But all of this comes at a cost, ie the manager’s commission.

And there’s the rub. By the time the manager’s fees are taken out the average returns don’t beat the the market average.

An example of this is reported by the U.K. Daily Mail (Oct 25, 2006) – “Research from independent advisers Bestinvest shows that over the past three years 73pc of actively managed funds investing in UK companies to increase your capital have failed to beat the FTSE All Share Index.”

As a further example, Clive Briault of The United Kingdom Financial Services Authority says: “Our research shows there is no evidence, on average, over time, that actively managed funds outperform tracker funds if you take into account the difference in charges between the two.” (The Mail on Sunday, Financial Mail, January 28, 2007)

Burton Malkiel’s classic A Random Walk Down Wall Street describes academic analysis that says the same.

Of course there are star performers, but these may be explained by chance. Of all the gamblers playing the casino slots, some will (by chance) emerge as winners. It doesn’t mean they can repeat their success. That’s why funds carry the wealth warning that past performance is no guarantee of future results!

Best way to achieve the benefits of diversification is through low-cost tracker funds or Exchange-traded funds (ETFs).

There are two main ways of picking stocks (or any kind of investment).

Fundamental analysis is concerned with looking at the economic fundamentals affecting the particuar stock (etc) and covers everything from the economy it operates in (interest rates, unemployment, exchange rates etc), through sector prospects (is the sector growing or declining, the competition etc) down to the particular stock’s accounts, and management team.

On the surface it seems fundamental analysis provides a reasoned and rational basis for investment decisions. The problem is that the information you’ve based your analysis on (plus that you missed) is also available to everyone else – including the smartest pro traders and analysts, their super dooper computer models, and the inevitable snippets they’ll discover that you won’t. Result, by the time you’ve done your fundamental analysis your findings (plus the stuff you didn’t take account of) is already reflected in the price.

Technical analysis is concerned with (don’t laugh) trying to guess future price movements by looking at historic price charts. In theory this would seem about as useful as trying to guess price moves from studying tea leaves. Technical Analysis is dismissed as useless by academic, author, and succesful investor Burton Malkiel (A Random Walk Down Wall Street). And yet the fact that technical analysis is still widely used might just make it a proverbial self-fulfilling prophecy; ie a technical buy signal occurs, lots of people buy, the price goes up… Though I suspect such a thing – if it exists – works only in the very short term.

Ultimately, the safest bet is simply to buy an index via a low-cost tracker fund, and that’s where your core investments should be. Either in a managed fund, or (if you can afford it) in a broad spectrum of diversified stocks.

But if you want a bit of fun, with non-critical money, do your fundamental analysis, do your technical analysis, but leave the final choice to that little voice within – your intuition.

Two of the most common investment strategies are growth investing and value investing.

Value investing is concerned with trying to find good quality stocks (and other assets) that are at the time cheaply priced.

Some indications of value are a low price earnings ratio (relative to sector), a healthy interest cover (earnings before interest and tax divided by net interest payments), eg 3 or more, and a conservative dividend payout ratio (dividend per share divided by earnings per share), eg 70% or less, and a decent inventory of tangible assets.

Of course it is always necessary to examine WHY a stock should be trading apparently cheaply. Is it truly on the way down and out? Or has it just temporarily fallen out of favor with good prospects of a turnaround? It’s worth remembering that markets often overreact, especially to bad news, before rebounding. So just after there’s been a tumble can be a good time to buy.

Value investing inevitably means taking a contrarian approach, ie going in the opposite direction to the crowd, and as such requires a degree of nerve.

By contrast, growth investing is concerned with finding which of today’s acorns will become tomorrow’s oaks. These are small stocks that you believe will get big.

Typically growth stocks have  high price earnings ratio and a low (even zero) dividend yield. The classic example of modern times is the dotcom boom and bust, where people were throwing dollars at just about any Internet business idea, however vague. Good profits were made by those who got in and out quick, but once the market came to its senses and realised the degree to which many stocks were overvalued many more took big losses.

Academic research indicates value investing is preferable, eg Louis K. C. Chan and Josef Lakonishok concluded in Value and Growth Investing: A Review and Update (July 2002) that “the evidence suggests that, even after taking into account the experience of the late 1990s, value investing generates superior returns.” Warren Buffett, the world’s most succesful investor, is primarily a value investor.

More on Value Investing

Value Investing: From Graham to Buffett and Beyond Bruce Cwald, Judd Kahn,  Paul D. Sonkin, Michael van Biema

The Little Book of Value Investing Christopher H. Browne

The 5 Keys to Value Investing Dennis Jean-Jacques