What do holiday souvenirs and stock markets have in common?

How do investment markets work?

In November 2016 I was in Goa on the west coast of India. After a few weeks of winter sun, I was browsing a local market, looking for some souvenirs to take home with me.

“300 rupees please.” I knew I didn’t need to pay more than 50 rupees (50p) for a few brightly coloured spices.

“I’ll give you 20,” I responded. After some brief bartering, we agreed on 45 rupees.

This is how markets work. Buyers and sellers come together and agree on a fair price.

Stock markets work in the same way. People come together to buy and sell investments and ultimately agree on a price. The difference with stock markets is that there are millions of transactions every single day. With so many transactions taking place, the current price of an investment represents the consensus view of all the buyers and sellers.

New information is processed in the blink of an eye and immediately incorporated into prices. For example, when Spain recently stated that it will allow tourists from 1^st July, the share price of travel firm Tui rose by a third within minutes.

What do active managers do?

Active managers try to predict what the world will look like in the future and invest in the companies they think will outperform, based on their prediction. Some of their predictions are right and some are wrong, but the cost of buying and selling frequently to reflect their ever-changing predictions usually outweighs any benefit to investors.

For active managers to be successful, they need to:

1. Have information that other investors don’t (with so many buyers and sellers, that’s implausible).
2. Be able to act on that ‘information advantage’ before the rest of the market catches up (remember that new information is priced in immediately).
3. Identify investments that they think the market has priced incorrectly. In other words, the ‘fair price’ that all the buyers and sellers have agreed on is wrong; the active manager thinks it should be higher so they buy, in the hope the price subsequently ‘corrects’. Sometimes, these calls can work. However, the likelihood of them consistently working is incredibly small.

Okay, but can you prove active management doesn’t work?

Yes. Investment decisions should be based on evidence. The latest Standard & Poors report* which covers the ten years to 31^st Dec 2019 shows that 68% to 95% (depending on which stock markets we look at) of active managers failed to beat the market. The longer the time-period analysed, the worse active managers do. Given that more than two-thirds of active managers failed over 10 years, how many will fail over your investment lifetime?

There is a common myth that active managers do well when markets are volatile. However, data from Dimensional Fund Advisors** shows that over the 20 years to 31^st Dec 2019, active fund managers in the US have actually performed worse in volatile markets than they have in ‘calm’ markets.

The world is an incredibly unpredictable place. It always has been and, unless someone invents a fully functioning crystal ball, it always will be. Therefore, an investment approach that relies on predicting what tomorrow will look like is very unlikely to work.

A second opinion?

Despite their failings, active managers do a great job of promoting their funds so they still make up the majority of most investment portfolios. Therefore, for everyone reading this, there is a good chance that you currently have expensive active funds in your investments or pensions. Most clients who come to us find this to be the case.

We offer a second opinion service on your portfolio, which is available free of charge until the end of 2020 and comes with no obligation. If you would like to take advantage of this, please get in touch so we can set up a video/phone call to discuss it further.

*SPIVA Europe Year-End Scorecard 2019 (https://us.spindices.com/documents/spiva/spiva-europe-year-end-2019.pdf)

**https://eu.dimensional.com/en/perspectives/sticking-to-principles

Matt Duncan is Associate Director at Carbon and can be contacted at matthew.duncan@carbonfinancial.co.uk

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The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

Tax and Estate Planning Services are not regulated by the Financial Conduct Authority.

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