Monthly Archives: May 2012

The “monkey strategy” explained – iii guest blog post

http://www.iii.co.uk/articles/36243/why-i%E2%80%99ll-buy-40-random-stocks-when-ftse-100-hits-4000

There is an old joke about how to make a small fortune on the stock market (by giving a large one to a stock broker). Having spent the best part of the last year researching and writing a book called Monkey with Pin, I think I might be able to rewrite this joke as:

How to make a small fortune on the stock market? Give it to a monkey to invest.

Let me tell you why. I am a private investor just like you. I have been trading for over a decade, with a reasonable degree of success. However it struck me I never made as much as I thought I would. Therefore when I heard someone saying that 85% of well-paid fund managers couldn’t even beat the market, it set me on a quest to find out what are the average real returns for private investors like us. The result is a 250 page book with the answers based on facts and evidence and not on some of the marketing myths from the finance industry.

The average investor is probably missing 6% a year from their returns by the time you factor in all the costs, expenses, hidden charges, survivorship bias and our average investing skill level (which is negative).

The book is in to two parts, the first examines the evidence and the second what you can do about it and how better understanding the system can help you lose a lot less than 6% a year. It’s free (and I really mean free) – just go to monkeywithapin.com to download or read it.

Examining all the facts caused me to change my investing approach, which I will share with you. One important thing first; you’ll read in the book my conclusion that no one single investing system works all the time (I evaluate all the key ones). Some systems are better than others some of the time. It also shows that the best system is one you devise yourself. The key elements are a risk management strategy and that you write down a set of rules and religiously follow them, irrespective of what your emotions tell you.

I’m going to follow the “monkey strategy“. It is premised on the evidence I found that the average chimp can normally beat even the best pros at stock picking. Unbelievable, but unfortunately true and backed up lots of evidence (see Chapter 3 of the book).

There at least two reasons.

By randomly throwing darts into stock listings in a newspaper, you are more likely to pick smaller companies than the average fund manager. These tend, over the long run, to have a better performance.

Secondly, the monkey is not influenced by media stories, charts, or PE ratios. It does not follow the herd and in consequence does not suffer the penalty for this. There is a nice bit of analysis that shows on average a stock a private investor buys increased by 25% in the previous year. In the year after, it goes down 3%. We are just not that clever, are we?

But before you all rush off to the garage to find your old dartboard, let me tell you how I’m going to implement the monkey strategy. Firstly, being a statistician, I know this is only going to work if I can pick stocks to get a good random sample. For risk management I also need to ensure that no stock ideally exceeds 2-3% of my portfolio, which means about 40 stocks.

The exact number will depend to some extent on how much I want to invest. In the book I suggest the costs of trading (not just commissions, but stamp duty and bid/offer spread) can become excessive if you trade in amounts of less than £1000.

The final thing I learnt in writing the book is how the price of an individual stock is determined by overall market sentiment. In fact, hardly any of the variance in the price of an average stock has anything to do with a company’s profits or performance. Therefore before you invest you need to first understand market sentiment and where it might be going. What surprised me is how those feelings follow long term cycles (as well as being affected by the 6-7 year normal business cycle).

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Source: Monkeywithapin.com/Barclays Equity Study 2011

The market has for the last century or so, followed a pattern of rising for around 16-18 years and then consolidating for 13-16 years. We are currently 13 years into a consolidation phase. It therefore strikes me there are two scenarios that could happen now. One is that the market puts in a new low at some point in the next three years (i.e. FTSE below 4000) and that ends the consolidation phase. The other (and in my view less likely scenario) is that we’re already in our next secular bull market, in which case the FTSE is headed out of its trading range of 3500-7000 to 10000+.

I am going to wait to try out my “monkey strategy” until I know which of these two scenarios is going to happen. If the FTSE drops below 4000, as I think it may do one day, I’m going to do a Buffett and ensure I buy my portfolio when shares are really cheap.

If I’m wrong and we do break 7000 on the FTSE, I’m happy to buy then as I know that wall of cash out there (and money taken out of bonds) is going to pile in and drive my monkey shares even higher.

Conclusion: give your money to a monkey, not a fund manager, to invest.

Article also reproduced in the Money Observer.

Also published in Moneywise.

Fund management hidden charges – IMA report

A number of people have been asking me about my views on the report published last week by the IMA (Investment Management Association) about fund charges. Sorry for the delay in posting my comments but I have been awaiting to see if the authors reply to my clarifications. Unfortunately their reply was largely it was “not possible to answer without further work for which we do not currently have the time“.

I will therefore have to comment on what I see in their report and make the best of interpreting it. First I’d like to say that it is great step forward that the IMA is talking more openly about the hidden charges that affect investors. For so long, investors have been mislead into thinking that the TER included all fund costs, which course it does not.

In my book, I estimate that the hidden charges for an average fund are around 0.6%, (assuming a portfolio turnover rate of 60%) made up of:

Explicit costs:
  • 0.3% stamp duty
  • 0.1% commissions
Implicit costs:
  • 0.1% bid/offer spread
  • 0.1% price impact

It is encouraging that the IMA report does almost completely agree with my estimates on the explicits costs. Their estimates are:

  • 0.28% stamp duty/taxes
  • 0.12% commissions

In order to look at the implicit costs, instead of trying to work them out, their report decides to take a different tack and come about it in a completely different way. It looks at the “realised annual shortfall” of funds vs the market benchmark over the last 10 years.

To me, with my academic hat on, this just muddies the water and makes it very difficult to see again what is really going on. Having said that, if done correctly could provide some interesting statistics. The key problem with what they have done is that they have just looked at the performance of the 15 largest UK All Companies funds.

Why is this a problem? Well, firstly it excludes all those funds that are not doing very well and therefore are not attracting lots of money. Secondly, it ignores a substantial number of funds that got closed over the last decade. Note, the authors do try to take into account survivorship bias in some way, but to be honest that is not necessary as they actually have all the data to do it properly. Their response to my specific request for this data was: “we do not have the time to do this“.

To put it in perspective, below is (roughly) the performance of the funds (in green) they have looked at to deduce their conclusions. They’ve ignored the red and yellow funds and so statistically their findings are probably just not worth looking at as they are not representative of the fund population as a whole.

Another point about this report, is the revelation that the IMA appear now to be admitting publicly that their definition of Portfolio Turnover Rate that they’ve been supporting for years is the wrong one.  On page 10 of their report, they are seen to be using the correct SEC definition.

Can we have Portfolio Turnover Rate, defined this way, back in all fund reports please? If it is an useful enough number for your statistics department to want to look at in your own reports, don’t you think it might be interesting for punters buying the funds to know to also?

My final comment pertains to Table 8, which shows the shortfall of funds over time. Somewhat alarmingly the shortfall has increased quite markedly over the last 5 years. When asked if the IMA had an opinion on why this might be, the answer was: “No“. I suspect if most investors realised this increasing underperformance, they might be asking slightly more forcibly than me for an explanation.

Book read by 5000+ people

A reporter asked me yesterday how many people had read Monkey with a Pin now. The answer I gave him was that I just did not know for sure but I knew it was probably over 5000, as that was the number of unique visitors I’d had to this website – see screenshot below.

The reason I don’t know for sure, is that this figure excludes a number of other potential readers:

  • People finding the book listed in the top finance books at Smashwords and downloading it directly there.
  • People Googling and going direct to either Google Books to read/download or Amazon.
  • The number of people who have forwarded the book to friends. In my reader survey, 90% reckon they will tell friends to read it and most at least two people.
Having said that, I know that number of people who visit the site never get beyond the home page, so although they may have listened to the video, they have not read/downloaded the book itself. Therefore, all in all, the total readership is a number no one will ever know!