Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Wednesday, 30 January 2013

Dumb money: in praise of the index

I get a lot of emails on a daily basis. I reckon about 80% of them fall into just three categories. Firstly, there are those which say “congratulations you have won one million dollars” or similar (I must be the luckiest person in Australia, though funnily enough I never seem to be paid any of my winnings).

Secondly, emails that say “properties in Australian capital cities are expensive” (I know - that’s what happens in all capitalist countries: where most people want to live, self-interested people buy them and the prices tend to go up).  And thirdly emails that ask: “How do I/why should I invest in index funds?”

Outsmarting the market?

We as humans are a peculiar bunch. One of the stocks I hold has doubled in value over the past 6 months, so of course I’m currently feeling very clever. If you ever start to feel clever in investing, it is time to check yourself.

Yet, if you’d seen me six months ago I was absolutely livid and cursing everything from insider trading and the irrational market to incompetent company management or the tides of the moon.

I was utterly fuming about the stock’s performance and berating myself for trying to be too clever and beat the market. “Why didn’t I just buy into a fund?” I was asking myself. I averaged down so hard into the stock that I feared at one point that I might end up owning the wretched company.

I got out of jail on this occasion with the stock market flying over the past six months, yet if you follow such an approach sooner or later you are likely to end up with a trading account disaster.

Investors do this sort of thing all the time: assets that move down in value are dismissed as a result of bad luck and ill fortune; those which appreciate in value are treated as “intelligent” investment decisions.

A cautionary tale

Plenty of investors, including some that I know personally, averaged down into Gunns Limited (GNS), partly on the basis that it has been one of Australia’s most enduring companies.

Yet, as the tide turned against the woodchip industry and the exporting company was crippled by the strong Aussie dollar, the company eventually became insolvent and went into receivership.

This is a cautionary tale about putting too many of your eggs into one basket and precisely why I recommend holding a portfolio across different asset classes: including property, stocks, diversified index funds, fixed interest investments, art and cash.

Some also elect to hold commodities such as gold, though personally I favour gold-mining companies due to them being income-generating (mind you, I do own paintings that haven’t paid me any dividends of late).


The benefits of an index fund

I’ve written many times about why index funds are so effective.

Firstly, the management costs are very low – you do not have to pay a fund manager to try to outsmart the market for you, you simply hold a share in every stock in the index (be it the All Ordinaries, the ASX 200 or, my favoured index, the All Industrials). Instant diversification.

I choose to self-manage my super because research has shown that over time, managed funds cannot or do not beat the market, so the management fees add no value.

Why managed funds can’t win over time

In individual years a managed fund may beat the market, but cumulatively the fund has to beat the market by several percentage points each year in order to stay ahead – to cover transaction costs, fund management fees, insurance and taxes. It can happen in some years, but over time, funds will not succeed in beating this hurdle consistently.

To some extent we are a little harsh on the fund industry. Institutions holds such a large percentage of the market that by definition aggregated fund returns must to some extent reflect the return of the market: for they essentially are the market.

As a fund grows larger, asset elephantiasis limits the choices of stocks in can hold. Investors swarm towards funds which have experienced successful years thereby virtually ensuring that future returns cannot be as great.

As fund transactions grow in size funds suffer from market impact: large parcels of shares which are bought by the funds themselves impact the market (and they already are struggling to beat the bid-ask spread).

Dumb money

Perhaps the biggest disadvantage of an index fund is that they are boring! You can never outperform the market and brag to people at parties, you can only match the index which you invest in. Yet perversely, the boring nature of index funds is also their greatest advantage.

But by using an averaging strategy, you can achieve tremendous returns over time by simply continuing to contribute each month. I have a UK index fund which has been contributed to for 16 years consecutively now: very boring and very effective.

Buffett said that: “Once dumb money recognises its limitations, paradoxically it ceases to be dumb”.

What Buffett correctly implies is that in acknowledging that most average investors fail to beat the market, by reducing management costs and adhering to a sensible strategy of continuing to contribute each month, investors spread their risk and achieve a fine result.

Time is the friend of quality; and the enemy of mediocrity

To some extent the same is true no matter whether you are investing in silver, modern art, diversified funds, property or blue chip shares. The cleverer average investors try to be, the more likely they are to come unstuck.

While investors should always look to find value in their investments and buy high quality assets in a downturn, some level of diversification is important and acquiring assets over time has the effect of averaging the entry cost.

In the case of property we are continually being reminded that property markets can fall in value (stock investors don't need so much reminding as the most recent material downturn is still fresh in the memory). Investors should well know this. If you don’t know that stock, commodity, bond or property markets can go down as well as up, do yourself a huge favour and adhere strictly to an index fund averaging strategy.

In all asset classes the longer your time horizon – both for spreading your entry cost and for length of ownership – the lower the risk.

Over the duration of a typical mortgage term – 25 years – well-located property and a well-diversified fund of profit-making, dividend-paying industrial shares are a fair bet to generate worthwhile income and appreciate in capital value too.

The shorter your time horizon and the more you place big bets on uncertain shorter-term outcomes - my Rolf Harris painting immediately springs to mind! - the greater the risk of capital loss.