How to Invest: a review
A new book in The Economist series offers a comprehensive guide to investment principles but is perhaps not for the complete beginner
A new book How to Invest in The Economist series published by Profile Books has some old lessons to impart about the perennial opportunities and hazards of investing in equities.
Though billed as an introduction for the private investor this is a rather demanding read, the argument dense and the prose spare, reflecting, perhaps, the authors’ — Peter Stanyer, Masood Javaid, Stephen Satchell — backgrounds in senior investment roles and academia. But through the complexity it is possible to discern a measured but definite preference for a simple investment strategy very much in sympathy with the sentiment of this blog. In brief, we simply don’t know what is going to happen in the future, so the wisest course for the long-term investor is to buy and — for the most part — simply hold a diversified portfolio weighted towards equities.
Despite its modest length the book is able to cover an array of fixed income and alternative assets in surprising detail, including bonds, private equity, gold, cryptocurrencies, property, and even the fine art market. A bias to fixed income and certain alternatives will be appropriate for investors with shorter time frames. But the clear evidence of modern financial markets is that those with longer horizons should favour equities. When decades rather than years are in play, a strategy oriented ‘towards equities and away from bonds is sensible, for cautious as well as aggressive investors’, especially given the possibility that higher inflation, so damaging to fixed income, may persist at higher levels than has been customary in recent decades.
The equity premium, then and now
Referring to The Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton’s epic review of the outsized returns 20th century investors enjoyed from equities, How to Invest suggests that today’s investors might continue to expect a significant equity premium relative to cash. But not, unfortunately, as significant as that earned by previous generations who invested through a period when shares were unusually high relative to other assets. Dimson, Marsh and Staunton’s forecast of around 3.5% is typical of most long range forecasts, which speculate that the 6–7% return earned by equities through the past century may prove unsustainable.
Of course the pessimists may be wrong: today’s optimists argue that the ease with which investors can now access the market though low cost passive funds and no cost trading apps will sustain high valuations. But the turbulent waters investors have had to navigate so far this century — there have already been three major downturns — indicate that a steady equity risk premium cannot simply be taken for granted. Indeed for Stanyer, Javaid and Satchell ‘the risk of equity strategies underperforming safe-harbour investment strategies over long periods needs to be taken seriously. These are not remote events to be dismissed as exceptional bad luck: these things happen.’
The sober prospect of more modest returns sharpens the ever-present temptation to beat the market. Frustrated investors might, for example, seek to take advantage of market cycles, dialling their equity exposure up or down in anticipation of bull and bear markets. But though indices clearly do move in cycles, the authors are sceptical that their turning can be predicted with any accuracy: the phenomenon of mean revision ‘is much more easily agreed than exploited.’
There is also something to be said for weighting portfolios towards small cap and value shares, which market history indicates are capable of outperformance over the long-term. Here too, however, the evidence is ambiguous. It applies only over very long horizons. And in both the US and the UK markets small caps have underperformed large cap stocks in more than one quarter of rolling ten-year periods since their respective indices started.
The value strategy, as Stanyer, Javaid and Satchell neatly put it, ‘assumes that market prices oscillate around their fair values and that the turning point, when valuations become extended, is unpredictable’. But by tending to focus on unglamorous stocks in established industries value investors can overlook the rapid economic changes occurring under their eyes, as vividly illustrated in recent years by the dramatic rise of the big tech stocks that have driven the market’s performance. It seems that ‘a failure to pre-empt transformative changes is an enduring weakness of value investing.’ But growth oriented strategies have their own issues. Though momentum stocks can surge spectacularly, the research — and guesswork — necessary to identify them in advance of the wider market ‘is notoriously difficult to undertake successfully and consistently’.
Summarising the debate with characteristic understatement, Stanyer, Javaid and Satchell conclude that ‘Agnosticism about competing styles of investing strengthens the case for simplicity in investment arrangements.’ They think that simplicity might well consist in resting content with a global equity tracker fund, which ‘can be a surprisingly sensible way to invest in equities’, ensuring exposure, diluted though it may be, to the handful of exceptional stocks that supercharge the capacity of equities to outperform other assets.
The authors certainly consider that to be a wiser course than attempting to pick winners, a temptation that proves ‘the undoing of many active investors’. The stark fact is that most US equities underperform US Treasury bills. ‘The tortoise of a broad market exposure (which is exciting enough for many investors) is a surer way to manage wealth than to try to pre-empt the latest new thing by buying before its stock price appreciates.’
Keeping classic investment principles in view
As well as ensuring their portfolio is appropriately diversified, investors should observe other well worn but proven investment principles, notably the management of costs and the payment of regular rather than erratic contributions. No matter how tough the environment, ‘the one thing any investor can do to raise their expected returns is to be vigilant about the fees that they pay’, which have a profound impact on wealth accumulation over extended periods of time. Steady, unspectacular direct debit style contributions are an effective discipline for guarding against the temptation of buying when the prices are rising, the steady drip-drip of payments ensuring shares are purchased when the market is cheap as well as when it is dear.
The book commends another venerable technique, the ‘model portfolio’, as an invaluable guide for the appropriate structuring of investments, a benchmark that can ‘anchor and monitor the management of investments’ and ‘express an attitude to risk-taking’. Again, the advice is to keep model portfolios simple: the authors see no reason to go beyond the principle first established by James Tobin in the 1950s that investors with different attitudes to risk should allocate financial investments in varying proportions between ‘cash’ and ‘volatile assets’, which today might translate simply to government bonds and low-cost global equities. In other words, ‘regardless of your degree of risk aversion and caution, you will only need two baskets for all your eggs’.
The simpler the model, the more readily investments can be adjusted in response to changing market conditions. For all their emphasis on stability, Stanyer, Javaid and Satchell think it important to pause from time to time to consider whether a portfolio properly reflects the market’s evolving composition. Consider: ‘At the start of the 20th century, railroad stocks represented 63% of US equity; 120 years later, that percentage was less than 1%. Japanese companies accounted for 45% of the global stock market in early 1989, but by 2020 this had diminished to 7%. In 1988, emerging markets represented 1% of global equity markets but 20% of world GNP; in 2021 emerging markets accounted for 11% of global equities and 44% of the global economy.’ Investors content to track the entire market might decide to do nothing, but those who have weighted their portfolio towards certain sectors might wish to rebalance from time-to-time.
A good introduction — for some
How to Invest offers a solid introduction to the investment options available to the private investor, written with the cool, considered authority one might expect of a publication associated with The Economist. I’m not sure if I would recommend it as an introduction for a complete newcomer: there are guides, both online and in book format, that explain the essentials more clearly. Here the reader is given rather a lot of information to disentangle.
But the book is bang up to date, providing substantial summaries of the very latest thinking regarding the merits of various securities. And I should note that I have only picked out the themes most relevant to this blog: the authors cover much more than I have discussed here. How to Invest is a useful guide, but expect to give it due time and attention!
How to Invest by Peter Stanyer, Masood Javaid, Stephen Satchell is published by Profile Books. Photo by Sigmund on Unsplash.
