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Most people will benefit from equity investing, but only if they properly understand the basics.
Posted 29 April 2024
I recently decided to look at the choices available to equity investors who want to be Shariah compliant. However before looking at specific investments, I wanted to ensure that my readers had a common base of understanding.
I covered the basics in my December 2023 column for the magazine "Islamic Finance News." You can read it below.
I recommend also reading my page "Personal financial planning 101 - The basics." While that page is not aimed at readers seeking Shariah compliance, the financial issues are the same irrespective of one's religious beliefs.
This month, I decided to put myself into the shoes of someone starting out in equity investing, who wants to be Shariah compliant, and who wants to invest for the long term, which I regard as 20 – 30 years. (I have never been a day trader and have nothing to say to those who want to do it, apart from “Don’t!”)
Many investors forget the most basic fact. After you buy a share on the stock exchange, you own a (very small) part of the company’s business.
Accordingly, to decide if the share is worth buying, you need to be able to value the small fraction of the business you are about to buy and compare that with the quoted price of the share. Unless you think the value of that fraction of the business exceeds the share price by some reasonable margin (which the legendary investor Ben Graham called the “margin of safety”), buying the share is irrational.
If you feel unable to value businesses, you are not competent to buy individual shares.
The alternative is to invest in collective investment schemes, usually known as “funds.”
You buy a small fraction of the fund, while the fund buys individual shares, either chosen by the judgement of the fund manager or chosen by a computer algorithm. Investing via a fund involves charges, possibly an initial charge when you invest, and certainly an annual charge computed as a percentage of the fund’s value.
If you invest $1,000 into a fund today, and hold it for 30 years, the final value of your investment will be represented by the investment returns earned by the fund, less the charges you have suffered. However, in practice very few people invest this way.
Since 1984, the independent investment research firm Dalbar Inc. of the USA has published a report annually, which it calls the “Quantitative Analysis of Investor Behavior.” The report finds consistently that the actual returns earned by fund investors are less, often by around 3% per year, than the investment return of the fund after charges.
The reason is that individuals typically put more money into funds when feeling optimistic because share prices are “high” and sell when feeling pessimistic because share prices are “low.”
While everyone will tell you that they would never be so stupid, very many investors do panic when the stock market plunges and sell. Accordingly, once you invest in a fund, think of yourself as being stuck with it for the next 20+ years, and never sell just because stock markets are down.
The next step in the decision tree is the choice between “active funds” where the investment manager selects individual shares based on the manager’s assessment of the value of the company’s business (just as you would do if buying an individual share) and “passive funds” where the fund uses an algorithm to create a portfolio that will match some externally defined index, most commonly a market capitalisation weighted index seeking to replicate the entire stock market concerned.
Index funds were only invented in the 1970’s, while active funds go back for about 150 years. Despite that, index funds now represent a very large part of the funds universe.
In my next column I will look at the choices available to a UK Shariah compliant investor but wanted to start by ensuring a common understanding with readers.
Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.
