Many people think that successful investment is about hot tips. If someone rings you with a hot tip, ask yourself, ‘Why is he calling me?’ and put down the phone. If you act on a hot tip from a friend, you may lose a friend and some money. If you act on a hot tip from a stranger, you will just lose some money.
Books tell you how to become rich from stocks. Software programs and training courses claim to help you trade successfully. Their authors assert that, with their assistance, you can make a comfortable living playing the market. Before you succumb, ask the following question: if I had a system that held the secret of lazy riches, would I publicise it in a book from which I will earn – at most – a few thousand pounds?
You may already have asked a similar question: why would anyone who could write like this one choose to do so? If you are hesitant about taking on that responsibility, you should, by the end of reading this, be able to ask penetrating questions of anyone who offers you financial advice. This post is not for people who want to become professional traders but for those who want to sleep securely, knowing that their portfolio is in the most trustworthy of hands – their own.
Is it possible to be your own investment manager? The financial services industry attracts many of the smartest people in the country, and certainly includes many of the best-paid people in the country. The City of London is made up of office blocks accommodating thousands of professionals. Traders in the City spend long days dealing in securities, with access to unlimited computing power and extensive data resources. How can you compete with them? You can’t, and you shouldn’t. But you can hold your own in their world.
There are reasons why DIY investing is possible, even necessary, unlike DIY law or DIY medicine. An obvious and depressing reason for relying on your own judgement is that most people who offer financial advice to small and medium-size investors aren’t much good. A doctor or lawyer may not always get it right, but you can be confident that their opinions are based on extensive knowledge derived from a rigorous training programme with demanding entry requirements. You can also expect that the doctor or lawyer will have real concern for your interests, not just his or her own.
Traditionally, financial advisers were neither expert nor disinterested. People who called themselves financial advisers were salesmen (overwhelmingly they were men) remunerated by commissions and selected for bonhomie and persuasiveness rather than financial acumen. They were financial advisers in the same sense that car dealers are transport consultants. Most of these financial advisers knew little that their customers did not know – except one piece of information which they did not share: how much the adviser would be paid to make a sale.
Things are getting better. Comprehensive regulation of the sale of retail financial services began in Britain only in 1987. As regulators investigated, they found instances of major abuse; the mis-selling of personal pensions and endowment mortgages was followed by the marketing of over-priced and often useless payment insurance (PPI) to millions of customers by salespeople motivated by commissions and targets. Some victims were scammed again by claims management companies which offered to assist in recovering the compensation banks were obliged to pay. The Retail Distribution Review, implemented from 2013, attempted to clarify the distinction between the independent financial adviser and the sales force, and banned many commission payments, requiring advisers to seek remuneration through clearly disclosed fees. This sits on top of a requirement to ‘know your client’; advisers must obtain basic information about their client’s situation and needs, and understand key features of the products they sell.
Training obligations are more demanding, although there are still many financial advisers whose expertise has been acquired in the school of life, over a drink, or several. There is still a long way to go. A ‘bias to activity’ is intrinsic to the processes of financial advice; few people will pay much to be told to do nothing, even though that is often wise counsel. Training is largely concerned with the process of selling and the mechanics of regulation rather than financial economics. You will understand the principles of investment better than most people who offer financial advice to retail investors. You do not have to worry about ‘knowing your customer’ if you are your own customer. You need not fear that the advice you give yourself will be biased by the prospect of a fat commission. You can also benefit from the wider set of opportunities that the internet gives the individual investor.
Financial services cannot only be bought and sold electronically, but can also be delivered electronically. From home or office you can now obtain a wide range of information, buy and sell securities very cheaply and access many investment products that did not exist two decades ago. Comparison sites enable you to scan a range of providers. The internet will never replace the truly skilled intermediary, just as it will never replace the doctor or lawyer, though it may change the roles of these intermediaries. But the search engine and the comparison site can now do much of what intermediaries would once have done. Unfortunately, the search engine and the comparison site are also corruptible. Like the salespeople, they are paid by product providers. What these sites display may not be comprehensive; what they highlight is not necessarily what is best for you.
The divergence between your interests and the interests of those who would sell you financial products is pervasive. One of the oldest anecdotes in the financial world tells of a visitor to Newport, Rhode Island, weekend home of American plutocrats, who is shown the symbols of the wealth of financial titans. There is Mr Morgan’s yacht, and there is Mr Mellon’s yacht. But, he asks, where are the customers’ yachts? That question is as pertinent today. For a time I served on the board of the statutory body that paid compensation to retail investors who had lost money through fraudulent or incompetent financial advisers. One such business was run by a flamboyant and persuasive individual who drove a Rolls-Royce and entertained his customers at lavish parties. In the small town in the north of England where he had lived all his life, his extravagant lifestyle was interpreted as evidence of his financial acumen. In a sense, it was: the money received from customers went directly into his pocket and paid for the chauffeur and champagne. Crude theft is, fortunately, rare in the financial services industry, although some practices came close to what an ordinary person would describe as robbery. But the lawful earnings of many people in the industry seem ludicrous to an ordinary person, and they are.
No complex analysis is required to see that every penny that people take home from the City is derived from fees, commissions and trading profits obtained from outside the City. This is a simple matter of accounting. You and I, and people like us around the world, pay the large salaries and bonuses of people who work in the financial sector. We do so in our various roles as investors, as prospective pensioners, as customers of financial institutions and as consumers of the products of businesses that use financial services. There may be consolation for British readers in the knowledge that the City of London is a very large exporter, so that much of what the City takes is paid by foreigners.
In Britain, even people who do not work in the City benefit from the foreign exchange earned and the tax paid by City individuals and City institutions, although they also have to compete with City folk to buy houses and hail taxis. This consolation may, however, turn to anger when it emerges that some of the best-rewarded City people pay little or no UK tax – the result of unwisely generous concessions on capital gains tax and liberal interpretation of rules governing residence and domicile. The massive rewards available in financial services are sometimes defended as the result of competition to attract talented people. The observation is true.
The City of London recruits many of the best minds in the country. In my experience, only a few top academics and lawyers rival the best minds in the City for raw intelligence. The mechanism that achieves this result is indirect. Massive rewards attract greedy people. If the number of greedy people is large, then financial services businesses can select the most talented among them. Within the City you find many who are greedy and talented, many who are greedy and untalented, but few who are talented but not greedy. Interest in ideas is generally secondary to interest in money. That is why these people are in the City.
So it is, unfortunately, necessary to be suspicious of the motives of everyone who offers you financial advice. There are people in the financial world whose concerns are primarily intellectual. You will find some in the finance departments of universities and business schools. Others are behind the scenes in banks and financial institutions, where they are described as ‘quants’ or ‘rocket scientists’. Modern financial markets are sufficiently complex, and the relevant analytic tools sufficiently sophisticated, for some people to find observation of these markets interesting for its own sake.
The good news is that the retail investor can take a free ride on all these skills and activities. You can be a beneficiary of the efficiency of financial markets. Efficiency has both a wide and a narrow interpretation. Financial markets, though costly and imperfect, have proved to be a more effective mechanism for promoting economic growth than central direction of production and investment. But in investment circles market efficiency has a specific technical meaning. That meaning relates to the ‘efficient market hypothesis’ (EMH), the bedrock of financial economics.
The professional expertise of everyone in financial markets is focused on the value of stocks and shares, bonds, currencies and properties, and on advising on when to buy and sell. These market prices reflect a consensus of informed opinions. The information that Vodafone is a successful company or that the economy of Venezuela is in a mess is known to everyone who trades Vodafone stock or Venezuelan bolivars. The efficient market hypothesis posits that all such information is absorbed in the market-place – it is ‘in the price’. The market is a voting machine in which the opinions of all participants about the prospects of companies, the value of currencies and the future of interest rates are registered, and the result is publicly announced. The corollary of the efficient market hypothesis is that the results of the painstaking research of everyone in the City are available to you for free.
If that conclusion seems startling, and it should, then imagine going to an auction – a fine-wine auction, for example – dominated by professionals. At first, you might be intimidated by the assembled expertise. But if you behave prudently, the dominance of professionals ensures you can’t go too far wrong, because their bids will be the main influence on the price you pay. You may not be convinced by this analogy. You may fear that there will be collusion amongst the dealers at the auction, that the market is rigged against the little guy. You may well be right.
Fifty years ago you would have been justified in having similar suspicions about securities markets. But, over recent decades, extensive public resources have been devoted to securing the integrity and transparency of financial transactions. This is partly because of popular revulsion at corrupt and fraudulent practice, and also because a reputation for honest dealing, or at least more honest dealing than is found elsewhere, is a real competitive advantage in international markets, in which the City trades so successfully. These regulatory provisions don’t work perfectly, and never will. When you trade, your broker must normally secure ‘best execution’, which means you get the best price available in the market. The reality is that a bank dealing on its own account will often do better. But not so much better. The edge that the skilled and experienced buyer may have can be more than offset by the advantages you have in trading for yourself. You have greater knowledge of your own needs, you know that you can trust yourself. Best of all, you don’t have to pay yourself. Your bonus is already in your pocket.