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Choose simple diversified funds for long-term investment success

In 2007, US billionaire Warren Buffett made a famous charitable wager that no investment professional would be able to choose a basket of high-fee, complex hedge funds that could outperform a simple broadly diversified equity index fund over a 10-year period. Only one person stepped up to the challenge. To cut a long story short, this person has already conceded defeat, even with around six months to go until the bet ends. Mr Buffett’s chosen index fund, the Vanguard S&P 500, is up over 80 per cent in returns compared to the basket of hedge funds – which is up around 20 per cent.

In 2007, US billionaire Warren Buffett made a famous charitable wager that no investment professional would be able to choose a basket of high-fee, complex hedge funds that could outperform a simple broadly diversified equity index fund over a 10-year period. Only one person stepped up to the challenge. To cut a long story short, this person has already conceded defeat, even with around six months to go until the bet ends. Mr Buffett’s chosen index fund, the Vanguard S&P 500, is up over 80 per cent in returns compared to the basket of hedge funds – which is up around 20 per cent.

Mr Buffett has long opposed hedge funds and other high fee investment businesses, arguing that they provide little or no value to investors. When asked for investment advice, he recommends that people buy and hold a low-cost diversified fund. Let’s not forget that Mr Buffett himself is an active manager who has beaten stock market indices for many years in a row, and has a good eye for value when he sees it. He admits that while it is possible to beat the index, only a handful of very good investment professionals are able to do so, whereas the ordinary investor does not possess the skill and behavioural capacity.

For 23 years, Dalbar, an independent research firm which evaluates financial services, has published an annual report – the Quantitative Analysis of Investor Behaviour (QAIB) – which looks at how ordinary investors fare when buying funds as compared to market returns. The report’s objective is to show how investment performance can be enhanced by simply managing some of our common behavioural biases.

Over the years, the findings have been fairly consistent. Whether you take recent one-year data or data from the past 30 years, average investors continue to underperform broadly diversified stock and bond indices by 4 to 6 per cent in annualised returns. This indicates that investment results depend on investor behaviour, and investors who had allocated to broadly diversified instruments and did not try to time the market were more successful. In contrast, trying to pick a handful of stocks out of thousands, guessing the outperforming asset class every year and short-term trading all led to poor outcomes.

In the study “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, Professors Barras, Scaillet and Wermers found that after looking through 32 years of fund manager performance, 99.4 per cent were not able to beat a diversified index, and of the remaining 0.6 per cent who did, it was statistically indistinguishable from zero, meaning they were just plain lucky.

This inability to outperform a diversified index was also of a bestselling book by Princeton University professor, Burton Malkiel in 1973. He famously claimed that a “blindfolded monkey throwing darts at a newspaper’s financial pages could select a stock portfolio that would do just as well as one carefully selected by experts”. Mr Buffett alludes to this difficulty in finding a manager who can consistently beat the market, and notes that investment professionals, just like amateurs, may hit a lucky streak over short periods.

The important lesson here is that investing need not be very complicated nor convoluted. Many people feel that investing is complex and requires the help of experts to guide them along. The truth is that investing can actually be quite simple. By understanding a few essential points, even the novice investor can strive for a better investment outcome:

1. Believe that markets work. There is a multitude of evidence pointing to the fact that it is very hard to consistently beat the market, whether through active trading and/or trying to forecast which stocks or economies are expected to do well. For investors to maximise their outcomes, it is better for them to allocate to a broadly diversified portfolio, such as a global equity fund with at least a few hundred stocks and just sit through it for 10 years or more.

2. Know that investing comes with the risk of losing money. Although the long-term average of a global stock index is about 7.5 per cent per annum, this doesn’t translate to you getting 7.5 per cent return every year. In fact, over the last 35 years, the highest annual return was 43 per cent (in 1986) and the lowest was minus 42 per cent (in 2008). Understanding that stock markets can plunge 50 per cent in bad times helps investors not to panic when it really does go down. The reason that seasoned investors don’t panic when that happens is because they know that historically, in every case when global stocks collapse, the markets recover their losses and eventually surpass previous highs. But one first has to fight the very strong natural instinct to follow the herd and “cut and run” when the news says it is the end of the world and markets start plummeting. For the investor who understands that this is just part of the market cycle, he or she can stand to gain when markets eventually rebound.

3. Be wary of complex investment products and fancy marketing which purportedly promise stellar returns. It is probably best to steer clear of products where you have difficulty understanding how they work without a lengthy explanation. The more technical jargon used, the more you should be wary. Do not be naive and buy blindly. Do your research on the product and always ask about the downside – how much could you lose? Be watchful of high and hidden fees - how else would the advertisements and free gifts be funded? Know what your exit options are, and whether there are any penalties involved.

Although investing is simple, the difficult part lies in being aware of your natural tendencies and biases, and how they can run counter to your long-term investment success. Investors who are disciplined and possess the know-how to construct their own portfolio can perhaps go it alone. Others may need the help of a fiduciary adviser to help them get started with selecting a diversified portfolio, taking into consideration their risk tolerance, and then holding their hands throughout the ebb and flow of investment cycles.

ABOUT THE AUTHOR: Aw Choon Hui is the deputy CEO of GYC Financial Advisory, a licensed financial adviser and registered fund management company.

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