Flaws of averages

I had lunch the other day with a fellow independent financial adviser I've known for a few years now. He was interested in learning more about how we track economic and stockmarket factors, how we form an asset allocation, and how we select fund managers to manage our clients' investments.

Once I explained our process he asked why we bothered with all of this cost and trouble when it's well known only a handful of fund managers manage to beat an index (such as the FT100 Index in this country). Mmm! Let's start by putting averages in their place. As I pointed out seven years ago in a Daily Telegraph article, when you are evaluating averages, it's worth remembering the average human being has one shapely breast and one testicle!

The motto of the Royal Society - an academy of science founded in 1660 is - "Nullius in verba", rough translation "take no-one's word for it". In other words check for yourself, don't accept the majority view. For when it comes to economics, stock markets or investments, ideas and beliefs perpetuate and amplify without a solid foundation of fact.

On the face of it everyone agrees with Warren Buffett's long term thinking, which you probably know leads to performance, in his case, over 40 years which trounces any index you'll care to compare. And yet so many experts and investors submit to short termism on investments, funds and strategy. Let's look at the last 10 years' performance of UK equity and UK equity income funds versus the FT 100 Index Total Return (which includes reinvested dividends).

If you pick up the March edition of Money Management magazine which carries tables of fund performance of all Unit Trusts, OEICS and Investment Trusts you can purchase in the UK and study the 10 year performance, up to the beginning of February, you will find facts at odds with beliefs.

Almost 50% of all UK equity managers over that period beat the FT Total Return, and 82% of the UK equity income managers also outperformed the index total return. Some handful!!

And what is the FT100 Index? How reliable is it as a barometer? Well for a start the constituent parts of the FT Index 10 years ago is entirely different from those of today. The last time I looked approximately 60% of the members 10 years ago are not in the FT 100 Index today.

It's a capital weighted index which means the bigger the company the bigger its percentage of the index and the more influence it has on Index movement. The top 10 capital weighted shares in the index dominate its performance.

And yet the media continues to focus on this index. Fund managers who can't beat it just closet track it, presumably not to look stupid in comparative terms. But that means their investors are being overcharged and let down by them tracking mediocrity.

Having been in this industry for 37 years I've been lucky enough to have experienced various cycles, good and bad times, and a few occasions when the financial World was about to end (according to experts).

Why not just follow commonsense? Legendary investor Sir John Templeton said the only successful way to invest is concentrate on Maximum Total Real Returns after Tax. How do you achieve this? Copy what works for the best long term fund managers! Here's a 10 point success plan they all follow - bar none:-

1. Value matters. Buying cheap stuff, small or large cap, here or abroad, works.

2. Be contrarian. You have to stand out from the crowd to get different returns from them. But it isn't fun.

3. You need to be patient. Value doesn't always work all the time so stick with it.

4. Invest in an unconstrained way. Throw away benchmarks, remember the flaws of averages.

5. Don't follow economic forecasts - they're always wrong.

6. Cycles matter. Progress isn't linear, it goes round in circles.

7. History matters. Edgar Allan Poe said history may not repeat itself but it certainly rhymes.

8. Be sceptical - nullius in verba.

9. Concentrate on both the big and the small pictures - macro economics, and individual sector successes.

10. Invest with advisers who advise you to buy what they are buying, at a fair and decent price, and no hidden charges.

Alan Steel

Chairman

This letter is the personal view of Alan Steel. Please check the appropriateness to your individual position with your adviser before taking or refraining from any action.