Overheard in the pub (part 1)
Person A. “Psst. I’ve got a top tip for the Epsom Derby on 3 June.”
Person B. “Brilliant! Which horse do you think will win?”
Person A. “Wings of Eagles.”
Person B. “But it’s is a rank outsider!”
Person A. “Which means you’ll get great odds…”
Looking back, I rather wish I’d actually had that conversation and acted on that tip. But – as you’ll know if you read my articles regularly – I’m no gambler when it comes to investing anyone’s hard-earned cash.
On that subject, let’s eavesdrop on a couple of other pub conversations…
Overheard in the pub (part 2)
Person C: “My adviser is brilliant at identifying top-performing funds! He’s put my investments into them and now I have an excellent portfolio.”
Me (thinking that’s not very scientific): “But no one individual has more chance of picking winning funds than anyone else does!”
Overheard in the pub (part 3)
Person D: “I’m old-school. I’ve always preferred to buy and sell my own individual stocks and shares.”
Me (thinking that’s a bit silly): “But if you buy individual stocks, you’re at risk because your investments are not diversified!”
So how do you increase the odds of winning?
Here are our four top tips.
If your portfolio consists of 10 randomly selected stocks, you’d have a certain expected return. If it consisted of 50 randomly selected stocks, you’d have the same expected return but with lower risk. And, if it consisted of 1,000,000 randomly selected stocks, you’d still have the same expected return but with even lower risk.
Diversification (usually) costs nothing extra. All it does is reduce your risk.
2. Lower costs
Mutual funds (unit trusts or OEICs) with lower expense ratios tend to outperform funds with higher expense ratios. By using funds with lower expense ratios, you increase your expected return, without any downside. This is the best barometer of success!
You can make dramatic savings when you reduce the cost of your portfolio from, say, 1% pa to 0.2% pa, when compounded over the years. On the other hand, it’s fairly pointless to worry about the difference between an expense ratio of 0.06% and 0.05%.
We’re not the only advisers who have noticed this. Academics, fund companies, and Jack Bogle (our investment hero) say the same. And Morningstar proved it in this analysis:
Morningstar says: “The expense ratio is the most proven predictor of future fund returns…Over many years and many fund types, expense ratios consistently show predictive power.”
Is the answer in the stars?
Morningstar also compared star ratings with expense ratio. With some exceptions, 5-star mutual funds beat 1-star funds on the three measures they tested. All told, stars guided investors to better results in 84% of their observations.
Russell Kinnel, director of manager research for Morningstar, said: “Perhaps the most compelling argument for expenses is that they worked every time – because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent. When the market swings dramatically, the star rating is going to be less effective.”
3. Ignore the news
Unless you’re illegally insider trading, you won’t hear any tips before the rest of the market does, and so the impact of any changes will already be priced in.
The price of any individual stock reflects the market’s consensus at any given time about the company’s expected future earnings. You will only get above-average returns if the company’s earnings grow faster than expected.
The same applies to mutual funds covering a whole industry or country. The price reflects the market’s consensus about expectations, and you will only get above-average returns if earnings grow faster than expected.
4. There’s no crystal ball
Looking at past performance is no guarantee of future performance.
Now we’ve cleared that up, I’m off down the pub. I’ll be happy to discuss these tips further there, if that helps.