As I have spoken about in previous articles, I believe that the vast majority of retail investors (e.g. you and I) do not possess an edge when it comes to investing (for a deeper dive into why I think this is the case, read my Three Golden Rules of Investing).
By an edge, I simply mean a technique, method or approach that gives you, as an investor, an advantage over other investors in the market.
In this article, I explain a stress-free method of investing for retail investors who do not possess an edge. I discuss the science behind the theory and elaborate on some of the key assumptions which underpin it.
As always, this article is a discussion on theory for educational purposes only and you must always seek your own professional advice before making any investment.
Now let’s get into it.
- Learning to trust the market
- The ‘invisible hand’ of the market
- How can you invest without an edge?
- Let the market do the maths
- Introducing Index Funds
- Should you just invest in the S&P 500?
- The strength of global equities
- What about actively managed funds?
- You need an edge to pick an actively managed fund
- Will you ever have an edge?
- The Bottom Line
Learning to trust the market
If you assume that you don’t have an edge when it comes to your investments, each pound you invest in the market is presumed to be equally intelligent. You are not claiming to know anything that the market does not already know. As such, you are trusting that the market already accurately reflects the correct value of each investment.
When you think about this, it makes sense. The price of a share on the market is determined by the supply and demand for that share. In turn, the supply and demand for the share are determined by a range of factors so wide that it is almost inconceivable to try and comprehend.
Instead of having to digest and process the information which affects the supply and demand for a share, the market does it for you. It looks at the volume and price of shares that are being sold and compares it with the volume and price of shares being bought. From these two data points, the market spits out a price which reflects the real value of the share.
The ‘invisible hand’ of the market
For the market, the rationale behind why a share is being bought or sold is irrelevant. All the market cares about is determining a fair value for the share.
This process is called the ‘invisible hand’ of the market. The invisible hand does all the hard work for us by determining the correct value of the share based on the total supply and demand for that share at any given time.
If we don’t have an edge, then our assumption must be that the market value is accurate. Why? Because if the market value wasn’t accurate, then either no one would buy the share or no one would sell it.
This would force the price of the share downwards or upwards until a value is reached which incentivises sellers to sell and buyers to buy again. The balance is thus restored at a new price which represents the new level of supply and demand.
As such, the invisible hand of the market moves the price of a share in accordance with the constant flow of information that it is receiving from buyers and sellers. The value of the share continually realigns itself in accordance with real time data.
How can you invest without an edge?
Admitting that you are an investor without an edge can be liberating. Because you trust the invisible hand of the market to determine a fair price for your investments, your equity holdings should reflect the fraction of those equities in the market’s overall value.
You trust that the fraction of that equity in the world market is correct because you trust that the market value is correct. In the absence of an edge, the market does all the heavy lifting for you.
For example, if the entire market consists of 50% of Company A’s shares and 50% of Company B’s shares, the investor without an edge would invest 50% in Company A and 50% in Company B. The market, with all its available information, is telling you that this is the correct investment ratio for these shares.
If the weighting changes such that the market value now consists of 80% of Company A’s shares and 20% of Company B’s shares, the investor without an edge would invest 80% of their portfolio in Company A and 20% in Company B.
Remember, we are not seeking to disagree with the market, because we don’t claim to have an edge.
Let the market do the maths
If you choose to invest in shares in proportions which do not reflect their fraction of the market’s overall value, then you would be claiming to know something the market does not. In other words, you would be claiming to have an edge.
An investor without an edge should trust the market by investing in shares based upon the fraction of those shares in the market’s overall value. The invisible hand of the market is analysing trillions of data points every second and using this information to determine the price of the share. Without an edge, it does not make sense for the investor to try to compete with this force.
Trusting the market to correctly allocate value in this manner is known as the “Efficient Markets Hypothesis”. In essence, you trust that the market can do a more efficient job than you can in analysing market data to establish a fair value for your investments.
The investor without an edge shouldn’t find it too difficult to subscribe to the Efficient Markets Hypothesis. Understanding that the market can do a better job than you of ascribing a fair value to an investment is almost self-evident, because it is impossible for a human brain to digest and analyse the gargantuan quantity of data that feeds into the markets every single day.
The market is therefore the most significant weapon in the armoury of an investor without an edge.
Introducing Index Funds
The power of the market to dictate a fair price for equities is why index funds (like an ETF or a mutual fund) are such a powerful tool. By reflecting the average price of a broad range of equities, the index automatically represents the fractions of those shares within that index.
It also does this at a sliver of the price of an actively managed fund (usually less than 0.25% fees per year).
For example, a S&P 500 index fund reflects the average value of the companies which make up the S&P 500 index. The value of the fund must therefore represent the value of those shares in the proportions in which they make up the S&P 500 index.
If Apple represents 5% of the overall value of the index, then holding the index fund is equivalent to holding 5% of Apple shares relative to the rest of the shares in the index.
If the entire world market consisted of just the S&P 500, 5% is the exact percentage of Apple shares we would want to own. This is because the percentage of Apple shares in our portfolio would be the same as Apple’s weighting in the overall market.
Should you just invest in the S&P 500?
The difficulty with investing in an index which only represents one specific region is that it does not reflect the entire market. Sure, the S&P 500 does a great job of representing the US market. But as of 2022, the proportion of all US equities as a percentage of total world equities is around 41%. This means that an individual who only invests in the S&P 500 is ignoring roughly 59% of the total world market.
As an investor without an edge, this should make you squirm. Because you don’t possess an edge, how can you possibly say that 41% of the world equity market will outperform the remaining 59%? If you did that, you would be claiming to know something that the market doesn’t. You would be claiming to have an edge.1For a valid argument in favour of US equities over global equities, read this post by the Banker On Fire. Whilst the post is brilliantly written and raises many valid points in favour of the US market compared to other regions, overweighting your portfolio with US equities is akin to claiming that you have an edge, because you expect US equities’ performance to continue to outperform other regions. I therefore do not think it is wise for a retail investor without an edge to weight their portfolio in this way. As a cautionary tale, the main index for Japan, the Nikkei 225, is down roughly 32% from its peak in May 1990. In the late 1980s, Japan was heralded as an economic miracle and its spectacular economic performance was expected to continue forever. The downturn in Japan’s equity markets should serve as an example of why the investor without an edge should avoid concentrating their portfolio in one specific geographic region.
The solution is to broaden your investments and scoop up the remaining 59% of the market. Because the investor without an edge assumes that each pound they invest in the market is equally intelligent, it makes sense to diversify as widely as practicably possible in order to mitigate the riskiness of their investments.
Instead of just investing in the S&P 500, the FTSE 100, or the Dow Jones, the investor without an edge should be investing in as broad a range of shares as possible in according to their fraction of the overall market value.
The strength of global equities
The easiest way to implement this portfolio is to use an index fund which tracks a global index. Until recent times, global tracker indices were almost impossible to implement cheaply. However, the advancements in investing technologies and infrastructure now mean that you can buy a global index tracker for an ongoing fee of less than 0.25%.
Examples of global equities trackers include Vanguard’s FTSE Global All Cap Index Fund which is comprised of 7,198 equity holdings for an ongoing fee of just 0.23%. HSBC’s FTSE All-World Index Fund C tracks the FTSE All-World for even less, with an ongoing fee of 0.13%, although its number of holdings are slightly lower at 3,321, meaning it is slightly less diversified.
Of course, there is a limit to the equities that these index funds track. For instance, you won’t find any shares from North Korea in the funds because it simply isn’t feasible to reflect the market in countries which are politically isolated. Similarly, only the largest companies are included in the index because it wouldn’t be practical to invest in businesses with a much smaller market cap.
In other words, a global equities tracker does not give you 100% exposure to every equity in the world. But for the investor without an edge, it is the best solution available today to implement a cheap and diversified portfolio.
What about actively managed funds?
It may seem that a simple solution for the investor without an edge would be to purchase an actively managed fund which is run by someone who does have an edge. That way, the investor is effectively ‘outsourcing’ the job of having an edge to an industry professional.
However, our assumption is that, like most investors, the investor without an edge is seeking to maximise their returns. Unfortunately for active fund managers, the data demonstrates that passive investing overwhelmingly beats active investing in the long run in terms of expected profits.
This isn’t because active fund managers are bad at their jobs, or because they don’t have an edge (being industry professionals, many of them do). It’s because the fee that you are charged as the investor does not justify the benefit you receive by choosing an actively managed fund.
As previously stated, a broad-based global equity index fund can be bought for an ongoing charge of less than 0.25% per year. In contrast, an actively managed fund which promises higher returns can sometimes have fees as high as 1 – 2%. The active fund is charging you 4 – 8 times more than an index fund without providing the same uplift in returns.
Compounded over many years, the higher fees of active funds really start to add up. In fact, for investments held over 15 years, only 8% of actively managed funds are able to produce greater gains than the average market return for their investors. The longer you hold your investment, the more this percentage decreases, because the higher fees continue to eat away at your profits.
You need an edge to pick an actively managed fund
To be able to pick one of the minority of actively managed funds that will provide greater returns than the market, you need to have an edge in picking active funds. In other words, you need to be able to choose the 1 in 100 active funds that will give you greater returns in the long run.
The longer your investment horizon, the more of an edge you need to have, because the performance of the active fund needs to outstrip the higher fees which compound over time.
For most people, this is virtually impossible to do. Every actively managed fund will have glossy prospectuses that claim their fund is the 1 in 100. But without being able to peek into the future, how could you possibly tell which one is the winner?
All of the actively managed funds have a vested interest in making you choose them because they can charge you a higher ongoing fee and make more money from you.
Once again, the best option is to assume that you do not have an edge in picking winning active funds. In the vast majority of cases, you will be much better served in the long run if you stick with a passive index tracker with a low ongoing fee, which tracks as broad a base of global equities as possible.
Will you ever have an edge?
The theory of investing advocated in this post assumes that the person investing does not have an edge. I believe that the majority of retail investors fall into this camp.
However, there may be times in your life where by planning or by luck you come to acquire an edge. For example, after working in a specialised industry for many years, you may acquire a technical edge over other investors in the market due to your knowledge of that sector.
If this is the case, you should absolutely take advantage of your edge if possible. However, in my personal experience, these types of edge are infrequent and short-lived. Given that this blog focuses on long-term investment goals, I think it would be reckless to suggest that such an edge is capable of forming the basis of a long-term investment strategy.
A far better tactic is to start with the assumption that you do not posses an edge and work from there. That way, you will be more self-aware and able to exploit any short-term edge which you acquire in the future.
The Bottom Line
Being an investor without an edge is a stress-free and lucrative method of investing in the long run.
Unless you have an edge, investing in a broad-based global equity index fund with a low ongoing fee over a long period of time is often far more profitable than trying to pick winning stocks or choosing an active fund to trade for you.
If nothing else, I hope that this article can help you to understand one specific stress-free technique to long-term investing and provide you with a new perspective on investment theory.
Investing without an edge is not the only method of investing, and you must always seek your own professional advice before making any investment.
Please make sure to leave your thoughts and questions in the comments below. I will see you in the next one.