Blogs | October 28, 2014

“Unavoidable ignorance shouldn’t stop us investing” – three rules of thumb for complex money choices

Investing looks horribly complicated. There are thousands of shares and funds to choose from, and it’s impossible to say which are the best given that returns are so unpredictable. Ordinary people can’t possibly understand finance. This is true. It is also irrelevant.


We can’t know the future
It’s true because, as the late economist G.L.S Shackle said, “knowledge of the future is a contradiction in terms.”
In truth, investing is too complicated even for the so-called experts to always get it right. Andriy Bodnaruk of the University of Notre Dame and Andrei Simonov at Michigan State University have shown that the personal investments of fund managers perform no better than those of non-professional investors. And Rene Stulz at Ohio State University has shown that banks in which chief executives owned large stakes did as badly in the financial crisis as those in which they owned smaller stakes. All this suggests that even professionals aren’t good at managing their own money. What William Goldman said of Hollywood applies equally well to finance: “nobody knows anything.”
But our unavoidable ignorance should not stop us investing.

Keep your eye on the ball
Put it this way. The motion of a cricket ball can be accurately described by the equations of classical mechanics. But we cannot solve these in our heads. Does this stop us playing cricket? Of course not. When we are trying to catch a ball, we don’t try to solve any equation. Instead, we rely upon simple rules: keep your eye on the ball; soft hands.
The same is true for investing. In a complex environment, rules of thumb can work pretty well. Here are three.

First rule of thumb “Invest regularly and start soon”
First, invest regularly and start soon. Doing so has three virtues. One is that it gets you into the habit of saving. Another is that you will automatically buy more shares when prices are low. If you’re saving £100 per month, your £100 will buy you more shares, the lower prices are. This allows you to buy when shares are cheap without thinking.
There is, though, a bigger merit. Starting early earns you big returns. Imagine you can earn three per cent per year – which would be a reasonable return on a mixture of cash and shares. If you invest £1000 a year for 25 years, you’ll end up with £36,459. But if you invest for 30 years’ you’ll have £47,575. A £5,000 investment has therefore made you £11,000 better off – a return of over 100 per cent. This happens because of the power of compounding. Three per cent might not seem much, but it compounds nicely over 30 years.
In this sense, the belief that markets are complicated is a very expensive one. If you think you don’t understand investing, you won’t start to do so – which means you’ll miss out on that 100 per cent return. Doing nothing can be expensive.

Second rule of thumb “Diversify simply”
Secondly, diversify simply. Split your investments between shares and cash; the more willing you are to take risk, the more shares you should hold. Don’t worry too much about the precise split and don’t try to be too fancy. As Jose Vincente Martinez at the University of Connecticut has shown, simple diversification works pretty well.

Third rule of thumb “Minimise fees and taxes”
Thirdly, minimise fees and taxes. This doesn’t mean seeking out fancy tax shelters, but simply taking advantage of the tax reliefs available to pension savers. It also means investing in simple equity tracker funds. The higher fees which fund managers charge mount up over time – the law of compounding again – and these are not, on average, offset by higher returns.

It is better to be roughly right than precisely wrong
Now, if you follow these three rules, you will make mistakes.
Some shares and funds will out-perform trackers.
And maybe shares will out-perform cash and so you’ll lose out by holding the latter. However, mistakes are an inevitable part of life.
The question is not how to avoid them, but rather: which are the better ones to make?
If you follow these rules, your mistakes will consist of missing out on some spectacular returns. But if you don’t follow them, your errors will be saving too little, dissipating your wealth in fees and taxes, and trading too much.
And these errors can be much more expensive.
Famous economist Maynard Keynes was correct to say that it is better to be roughly right than precisely wrong.
But he should have added that being roughly right is the best we can possibly do.

InvestingSavingMistakes

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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