In the Quarterly Commentary 3 of 2008, Richard Carter explained the difference between fund and investor returns. He outlined both our role at Allan Gray and your role as an investor in closing this gap and improving your investment outcome. Jonathan Brodie and Trevor Black of Orbis also recently wrote about the partnership required between the investor and the manager for success in investment management. This article considers the role of independent advice in this partnership. Jeanette Marais argues that competent, independent advisers have the ability and experience often needed by investors to make the right choices and to manage their choices over time.
For a unit trust investor, success can be as much about sticking with your choices as it is about making the right ones
Simplistically, market participants have one of two broad mindsets. Both are completely valid of course.
- Speculators hope to sell their stock on for a higher price, preferably as quickly as possible, in order to put their capital to use in the next trade. They are focused on the marketability of what they buy.
- Investors hope for long-term returns, in both income and price gains. They are focused on the risk of loss and return on capital of their underlying investments.
If you are an investor (not a speculator), once you have made a fund choice, your ability to make the most of it is dependent on whether you remain committed to the investment for long enough to benefit from the potential returns, smooth out the inevitable short-term ups and downs and let the power of compound interest increase the value of your money and compensate you for the costs of investing. These steps sound simple enough but the gap between fund returns and investor returns shows that most of us fail dismally at putting them into action.
The value-oriented investment manager's challenge is to educate clients to remain invested for long enough to generate real long-term wealth
When inevitable market corrections occur, many investors forget their commitment to their goals and the characteristics of their chosen investment. Unless investors remain invested for long enough to benefit from our approach, we cannot help them achieve their goals of long-term wealth creation.
Our contrarian investment philosophy has the potential to make this even harder. Allan Gray is a value-oriented investment house. This means that often we are invested in shares that are not fashionable. Frequently, our search for value has us sell stocks that keep going up, and buy stocks that keep going down, resulting in short-term underperformance. At extremes of these times we have lost the most investors, and yet these have also been the times after which those who stayed the course have outperformed by the greatest margin.
The role of financial advice in the partnership between investment manager and investor
Financial advisers are not all independent, ethical, wise or diligent. But then neither are lawyers, doctors or, sad to say, investment managers. A third of our individual investors do not have an adviser linked to their investment and our fee model means that they are not charged for the advice they do not receive. However, it is clear that a good and independent adviser can make a significant difference to most individuals' investment success.
1. Making sense of the wide range of products and underlying investments available
Most people do not make the time to research even the most well-known investment managers in their home countries. South Africa now has 39 distinct unit trust management companies offering 765 funds for individuals to choose from. Internationally, the numbers are much higher. Logically, the more of these funds and managers you know of and the better you understand their methods and track records, the better your chance of picking the best. But making sense of that much choice is hard. Using an independent (this is critical) adviser to research and propose funds is a good way for investors to access a broad range of possibilities while avoiding complexity. Maintaining a relationship with him or her over time should also help to make sure that your choices are reviewed appropriately.
2. Choosing the right investment vehicle
Over the years, successive governments have encouraged individual savings in South Africa by allowing investors who put money away for a long time to pay less tax on their savings. Investment 'products' like retirement annuities, preservation funds and endowment policies all have built-in tax breaks in return for a lock-in. These examples are easy to understand if you have the time, but some of the consequences of your choice of investment vehicle are not always obvious and with regular changes in legislation this is an area in which even the most sophisticated investors tend to seek professional advice. On top of fund choice, good advisers therefore add value for their clients in choosing the right product for a particular set of circumstances.
3. Resisting behavioural biases and emotional responses
Ben Graham wrote: 'The investor's chief problem - and even his worst enemy - is likely to be himself.' Although it may not sound like it, the academic understanding, expertise and experience investors need to make sound financial decisions is the easy part. It is the behavioural biases that we are all subject to that the majority of investors struggle to identify and manage.
In previous articles we showed that the average investor in each of the Allan Gray funds that include equities, has not achieved the return of the funds themselves; in other words they have bought and sold our funds at the wrong times. Some investors would have had logical reasons to disinvest, but these would not have explained the systemic underperformance of investors relative to the funds - the effect would have been mixed, with the average investor achieving the same return as that of the fund. The only explanation we can find for the underperformance of investors relative to our funds is that behavioural biases (e.g. favouring recent performance over long-term performance, or reacting fearfully after a big decline) persuade them to buy and sell at the wrong times.
An independent adviser is subject to the same biases as anyone else, but a good adviser is aware of his or her biases and is able to coach a client through dangerous times.
4. Applying a disciplined savings and investment process
In order to ensure the combination of action and rigour in decision-making, successful investment requires a process of some kind and for this process to be followed with discipline over time. This is true for large professional investment firms and for individual investors saving for retirement.
(FINANCIAL ADVISERS) HELP INVESTORS TO MANAGE THEMSELVES WITH DISCIPLINE, IDENTIFYING AND UNDERSTANDING HOW THEIR EMOTIONS CAN LEAD THEM ASTRAY IN THE INVESTING PROCESS
In truth, people should not need an adviser to consider returns, risk, time horizon and cost before making a decision. But many advisers will admit that they add a large part of their value in simply helping their clients to be disciplined about managing their finances and about making, and acting on, savings and investment decisions.
In summary: the characteristics of a good financial adviser
The best financial advisers are independent of any product provider. They have the objectivity and experience to help investors meet the full range of challenges they might face. They help investors make sense of complexity and products available and in so doing, better equip investors to match an investment to their needs and to react (or not) when things change. Most importantly, they help investors to manage themselves with discipline, identifying and understanding how their emotions can lead them astray in the investing process.