23 May 2012 with Appendix added 3 June 2012
I think I became aware of the book after seeing it mentioned in the “Financial Times” in April. I immediately went to the website and downloaded a free copy. Before I could get round to reading it the author emailed to tell me about version 1.1. I downloaded that and recently read it on my iPad.
Although the book is 255 pages, it is a very easy read and I finished it in a morning, finding it absolutely riveting.
For me personal finance has been a hobby for almost 40 years. Shortly after I started my first permanent job, I recall investing £50 in a unit trust and have been an investor of one kind or another ever since. As a chartered accountant and chartered tax adviser I find it straightforward to read company accounts and to understand how the tax system affects my investment returns. However I don't claim any special expertise as an investor!
Accordingly I always find it shocking how uninformed the average citizen is about financial matters. People take out borrowings paying no attention to the APR (annual percentage rate) that the borrowing will cost even though the law requires this to be disclosed. Similarly people are persuaded to buy investments which are wholly unsuitable for them and which involve very high charges which are used to pay generous commissions to the salesman selling the investment.
Page 3 of the book gives a short biography of the author. It begins:
“Pete is a private investor who has been trading shares for over a decade. He has a degree in psychology and he has worked for most of his career in market research.”
The book consists of the following sections:
The author explains how shocked he was to hear in a podcast that about 85% of fund managers underperform the market. This led him to start researching the issues in the latter part of 2011 while the book itself was written in just over a month during January and February 2012.
The title comes from an entrant into an annual share trading competition that a randomly selects its shares and in an average year manages to beat two thirds of the contestants.
Overall the book provides an excellent explanation of why most investors in the stock market achieve only disappointing returns. They overtrade; incur excessive costs and bid offer spread, pay excessive management charges and give insufficient attention to taxation costs. Furthermore despite the time-honoured saying "buy low, sell high" human psychology causes investors to end up doing the opposite in many cases.
The above chapters develop the author’s proposition with excellent supporting references and then go on to make recommendations about how investors should behave.
I have not attempted to check the author's calculations. However to the extent that I could validate them with some mental arithmetic, I find them very persuasive. What the author is saying is fully consistent with what I have learned from 40 years of reading books and magazines about investment as well as my knowledge of the tax system.
Everyone who cares about their personal finances should read this free book.
There is one area where I regard the book as being a little weak. On page 150 the author has the following section:
M&S share price unaffected by sales of underwear
Another aspect that came as a bit of a shock for most new investors was to discover that the price of a company’s share is affected not just by its profits and performance, but by overall market sentiment. Indeed, I think even old hands at trading might be surprised at how much of the variance of a share price is affected by overall market sentiment rather than fundamentals in profits. For example, I ran a simple regression analysis of Marks & Spencer’s (MKS.L) six-monthly share price and its profits over the last 10 years. The correlation with the change in profit level was 0.65.11. When I did the same correlation, ignoring any information about M&S, and correlated it with the FTSE as a whole, the correlation went up significantly to 0.85. In other words, if you knew nothing about the status of M&S at all, didn’t know who they were or what it did, had never looked at its accounts or profits, you could predict with 85% certainly its share price by just knowing what the level of the FTSE was.
M&S is not an isolated example picked out to make a point. According to the CBOE measure, the overall correlation of all shares with the US S&P 500 index12 reached over 80% in December 2011.
I have no doubt that the correlation quoted above is correct. However it misses a fundamental point made regularly by great investors such as Benjamin Graham and Warren Buffett. A share is a part of a business. Ultimately, as I believe Warren Buffett has said on many occasions, your economic return from owning that share can come from only two sources:
In my view the greatest mistake made by investors, particularly relatively new investors, is that they forget that when they are purchasing a share they're not buying a lottery ticket; they are buying a piece of a business. Accordingly they should attempt to decide for themselves what that business is worth and then decide whether the quoted market price is above or below their own valuation of that business.
The author Pete Comley has posted a comment using the Facebook comments facility below. While the comment displays fine on screen, I had trouble reading the full comment on my iPhone so for the convenience of readers I have copied the comment immediately below, before responding to the points Mr Comley raised.
“Thanks for writing the review.
One comment on the M&S bit and that the point you make about you buying a share in that business. The points you make about it are true ie you'll only benefit from their dividends and the future perceptions of those dividends.
However I do wonder these days why we need to buy shares in companies. Originally it was for companies to raise capital. However now many companies just issue debt/bonds when they need cash or take out loans (if a bank will give them one now). Even in IPOs like the Facebook one, I doubt they really need the cash. IPOs appear mainly so the original share holders can take their cash out of the business.
When you buy a share now in a FTSE company. That company does not benefit from your cash. Instead that cash goes to someone who has a more pessimistic view on that company than you.
All of it slightly questions why we private investors own shares - especially given the large amount (6%) the finance industry skims off us for the privaledge of doing so. The 3.5% average dividend does not make up for that.
Anyway, just a thought for you to chew over.
PS There is now a v1.1 of the book available (for free) from http://monkeywithapin.com. You can also listen to a free audiobook version by going to itunes and downloading the "monkey with a pin" podcast.”
The author is of course completely correct that when you purchase listed shares on the stock exchange, your cash does not go to the company, it goes to the (more pessimistic) seller of the shares.
There are two logically distinct questions within the author’s coment:
The author is correct in his comments about the purpose of many IPOs. (Initial Public Offerings, which is an American term. The equivalent English term is flotation. Both can be used interchangeably.) In many cases, the main purpose is to enable the original promoters and those investors who bought shares while it was unlisted to sell.
However most IPOs also raise cash for the company, as stock market investors generally take a dim view of an IPO where no cash is being raised for the company. The company can use the new cash so raised to expand the business more rapidly than it could by relying solely on operational cash flow and borrowings.
The author is incorrect when he implies that companies can raise all of the cash (beyond operational cash flow) that they need by borrowing, either in the form of bank loans or by issuing bonds.
While that is usually true for small incremental borrowings, it is often not true for larger acquisitions since there are very real constraints in how heavily a company can gear itself up before it is over leveraged. Accordingly, many companies cannot make a large (compared with the existing size of the company) acquisition without issuing new equity, either to the vendors as consideration or to the existing / new shareholders for cash with the cash being used to buy the target.
As someone who has owned shares for many years, I have regularly subscribed for issues of additional shares by companies already in my portfolio, normally in the form of rights issues.
Chapter 2, “The Industry Evidence for Equity Returns” states that the Barclays Equity and Gilt Study 2012 covering the last 112 years found a real (i.e. post inflation) return on equities of 5% p.a. assuming that dividends are reinvested.
In most cases it is easier to do calculations and understand them if one uses nominal (i.e. not inflation adjusted) figures rather than real figures. Using 3% for inflation, which is a reasonably realistic number in today’s environment, a 5% real return on equities becomes an 8% nominal return.
The way the 8% is reconciled with the 3.5% current average dividend yield is that dividends are expected to grow, on average, by 4.5% p.a. So if you invest £100 in shares, the dividends you will receive are as follows:
All calculations have been rounded to the nearest penny. The table stops after 10 years, but of course should go on to infinity.
Assuming the market dividend yield remains at the current level of 3.5%, at the end of year 10 your shares, which cost you £100, will have a market value of £148.57. (£148.57 x 3.5% = £5.20)
It can be shown with a little arithmetic that a current 3.5% dividend yield which increases in perpetuity at 4.5% p.a. is equal to an 8% nominal return. In other words, the dividend series in the table above, if extended to infinity, has the same net present value when discounted at 8% as does an infinite series of £8 each year, also discounted at 8%. In each case, the net present value is £100, which is the amount of the original investment.
Accordingly, the correct comparison to make, using the author’s 6% costs, is to compare 6% costs with an 8% total nominal return. That still shows you making only 2% after costs, but it does not make the investor look as silly as incurring 6% charges to earn 3.5%.
It is worth looking more closely at the composition of the 6% costs. The author summarises these on page 102 of version 1.1 in a table showing the 6% in the case of an investor in shares directly and 5.8% in the case of an investor in funds. For simplicity, I will limit the discussion to investing in shares directly, where the 6% is built up as follows:
Factors reducing investors returns
Skill / alpha of the investor
Index error due to survivorship bias
Bid / offer spreads
In my opinion, simply adding these individual numbers together to make 6% p.a. is not appropriate.
Some of them are clearly proper annual rates; for example the effect of survivorship bias (if correctly calculated) is that the stock market published index overstates total returns by 1% p.a. See page 57 of version 1.1. In passing I am not convinced that one can extrapolate from calculations of survivorship bias in the case of funds to the return on the stock market index. The reason is that all underperformance of a particular share while that share is a member of the index is reflected in the index return figures. However what the index will not show is the further underperformance of a share once the share has dropped out of the index which is where survivorship bias does become an issue.
However other numbers in the table are not annual rates at all. For example stamp duty of 0.5% is paid only when you buy a share. Accordingly the impact on your return depends on how frequently you turn over your portfolio:
The same point applies to trading commissions and the bid / offer spread. In passing, I think 2.5% trading commission is too high for most investors. The rate only gets so high when the investor is buying shares in small parcels. For example if you put £500 into a share, the brokerage charge (say £12.50) costs you 2.5% (£12.50 / £500). If you invested £10,000, the brokerage may still be £15 but it would now only cost you 0.125% of your investment instead of 2.5%.
The skill / alpha of the investor is an interesting question. Many investors make mistakes, are subject to panics etc., as the author dicusses in chapter 4, “Skill – The Real Numbers.” However there is a simple remedy, even for investors who cannot become investors with superior skills. That is to become a monkey with a pin! Investing randomly stops you being your own worst enemy. See the discussion on pages 26-29 of the book version 1.1.
Using the author’s own figures, a buy and hold monkey with a pin, even one who invests in small £500 shareholdings as in the example above, should achieve the following return.
The monkey invests £500 and suffer up-front costs of stamp duty 0.5%, trading commission of 2.5% and a bid / offer spread of 0.7%, totalling. These take a bite of £18.50 out of the £500 investment leaving £481.50.
On this, the monkey earns 7%, not 8%, because we assume that the overstatement of index returns due to survivorship bias is accurate. Accordingly the monkey’s return on £481.50 at 7% is £33.70. (This is expressed for simplicity as a perpetuity. In practice it would be a mix of some level of dividend return and dividend growth adding up to a 7% rate.) £33.70 each year on £500 represents 6.74%.
Accordingly our buy and hold monkey with a pin achieves a nominal return on his investment of 6.74%, or subtracting the assumed 3% inflation rate the monkey achieves a real return of 3.74%.
In my view (and this definitely does not constitute investment advice; readers should see the disclaimer at the foot of every page on this website) the above return is attractive enough to persuade investors who can accept the risks involved to buy shares.
I recommend reading his comments in the section “The Basic Choices for Investors and the One We Strongly Prefer” which is on pages 17-19 of the Berkshire Hathaway 2011 annual report. (I am a small shareholder in this company.) I have copied some extracts below, but recommend reading the full text.
“The Basic Choices for Investors and the One We Strongly Prefer
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.
Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.
• Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.
• The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.
Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”
Pete Comley has sent the comment below in response to my text above.
Many thanks for adding this Appendix and your further thoughts.
It was a slightly "off the cuff" comment about why we own shares. I agree there is a logic for doing so as Buffett illustrates. However, baring some acquisitions, many companies have just borrowed and leveraged themselves when I think it might have been better had they actually done rights issues. Had they done that many would not have gone into liquidation recently. But that is another longer discussion...
I have to pick up a couple of points you made on my analysis. You say that some of the key figures in my table like Stamp duty, trading commissions, spreads are not annual figures. They are. In the book I make it clear that these totally depend on your portfolio turnover rate. What I use in that table are those numbers multiplied by the average UK portfolio turnover rate for an average investor. This just so happens to be about 100%, so it looks like they are no adjusted, but they are.
I'm not saying that you can't reduce, and even eliminate them, by buy and hold. Indeed that is one of the points of the book to get that principle over to readers.
Over determining the size of the survivorship bias effect on buying individual shares, I did make it clear in the book, that I just could not find any published stats on the number. 1% is just my best guess. I agree it does not depend on the fund one. I have a sneaking suspicion the number is higher than 1% though given the results of some of academic modelling I looked at. I just did not think it credible to put in a higher number.
A small picky point in your example of the £500 investment. You need to factor in the both the buy and sell commissions to evaluate your return, ie include another £12.50. However over a long period of time, I agree this becomes a bit irrelevant in comparison to the amount of dividend and capital growth.
Finally, another minor amend to your calculations. The average dividend yield on the FTSE has increased 3.6% a year over the last 112 years according to the Barclays Equity Gilt study, not 4.5%. Not sure, it really affects your argument, just a correction as it is a figure I happen to know having spent too long reading the appendix of their report ;-).
Thanks again for posting this and encouraging people to think more about how they invest their money. As you said in your original introduction, people are just not spending enough time thinking about their financial decisions. That is resulting in errors over where they save/invest and unnecessary loss of money to the "banksters".