Chris Pearce, Director. Chartered MCSI and Chartered Wealth Manager.
What do I mean by ‘our investment philosophy’? When I look at the different types of investments for clients I make my choices and give advice in part based on theory and in part based on my own practical experience.
Since I began in the City in derivatives in the late eighties, I learned very quickly the hard way that the traditional theory of how markets work underestimated the likelihood of extreme price movements – the way derivative contracts were then valued shared the same DNA as traditional economic theory and the crash of ’87 laid bare the limitations of that valuation model.
That practical experience was invaluable when I then had a front row seat at the latter stages of the Japanese real estate and equity bubble and subsequent collapse which still resonates today – I even worked in the Urbannet Otemachi Building, which came to be known as the bubble tower due to its original extreme valuation.
Of course, there have been other bubbles and corrections since and in the recent banking and debt crisis part of the problem has been the use of traditional theory in risk models, which when added to leverage became a recipe for extreme losses.
Some continue to suggest that all of the above was rational and consistent with the theory – known as the efficient market hypothesis and covered in the Burton Malkiel’s book, A Random Walk Down Wall St – but the actual data fits the theory like an ugly sister trying on Cinderella’s glass slipper – it is an awkward fit. A whole field of economic thought, which has been around for several decades, called ‘behavioural finance’ questions whether people and prices are always rational – my experience tells me given enough time they are, but in the meantime can be driven by wildly optimistic or pessimistic assumptions, hence the requirement to invest rather than speculate. It is also why good advice is so important.
However, the theory still has a lot of merit. It gives us several important insights that are important for investors, the most relevant of which are ‘diversification’ and ‘there are no free lunches’. In other words the broad market is hard to beat and this seems true whether prices are right as the theory suggests or not. Repeated studies show that professional funds where managers choose their investments fail to beat the relevant index of broad shares – in large part because of the additional costs they incur, but also because of the problems of prediction in an environment of random news and irrational investors.
The answer in terms of equities is to choose broad based low cost index funds as the core investment. And even though an index investment is termed passive, they do in fact change in their makeup over time – the S & P 500 is very different now from its’ inception. Components are added and removed according to set criteria, normally to do with the size of the company and in this way they represent the survival of the largest companies and leave the investor exposed to the natural growth and innovation in new or existing companies, even as others fall away – and the same can be said for indices based on smaller companies.
I do not rule out other products, I just set the bar reasonably high whether looking at an existing portfolio or considering a new one – and I have direct experience of dealing with the more esoteric investment classes such as derivatives, structured products and hedge funds. So if you have any specific concerns please contact me.