November 22nd, 2018

Sell the hare, buy the tortoise?

By Andrew Craig

Reading time: ~ 11 minutes

Our fund – the investment tortoise…

Long-time readers will hopefully be aware by now that we have our own investment fund – the snappily named VT PEF Global Multi Asset Fund (don’t get me started on the name – there is an immensely boring story behind why it is such a mouthful. Suffice to say that it isn’t our fault!).

…anyway. I digress. What I hope is a vaguely interesting point is that our fund only exists because people asked for it. To back-track a little: Not long after I published the first edition of my book several years ago (late 2012), people started getting in touch to ask if I might consider investing their money for them “as in your book”. At the simplest level, people wanted a way of investing in all main asset classes and all main geographical regions – as per the “own the world” message in the book – but in one place, as efficiently as possible.

Regular readers will know that there are numerous ways to “own the world” – various of which I have explained over the years – but many of which have drawbacks that I wanted to get around (primarily the heavy admin of having to own lots of funds to implement the strategy and having to follow those funds proactively to mitigate the risk of heavy losses in crash years like 2000 or 2007/8).

When I first started fielding enquiries from folk who wanted me to invest for them back in 2012, the notion of having our own fund seemed too wild and fundamentally impossible an idea for us to actually achieve – for many years at least. There are huge barriers to launching an investment fund. It is very expensive and there is an immensely heavy regulatory burden of business plans and capital adequacy requirements and lots else besides that I suspect no-one reading this wants to know more about in any detail!

When launching a fund, there is also a significant ‘chicken and egg’ problem in that few people will invest in a fund before it has a track record and you obviously can’t get a track record until sometime after you’ve launched (at least one year as you will see). This is why most new investment funds are launched by giant fund management companies, usually to capitalise on a new and ‘hot’ theme that will make them as much money as possible.

(As an example of how hard this is, none other than the ex-head of the UK Investment Management Association, Daniel Godfrey, failed to launch his “People’s Trust” fund at roughly the same time we managed to launch our fund, despite getting £39 million of interest. Even with £39 million committed, he couldn’t make the economics work).

Back in 2012, I thought that ‘one day’, if we were incredibly lucky, Plain English Finance might be able to raise millions of pounds and have a fund but ‘one day’ would probably be many years in the future.

Through a happy series of events "…many years in the future" happened a great deal more quickly than I ever thought possible and I’m amazed to find myself writing this email today with the main purpose being to highlight that we have just updated our Fund Overview document to incorporate the first full year of live investment performance of our fund.

You may or may not know that investment firms such as ours are prohibited from talking about the actual performance of their funds until a full year after they have launched. Happily we hit the one-year anniversary of the existence of our fund at the end of September and are now, therefore, permitted (by the FCA – the UK financial regulator) to update our Fund Overview document with real performance numbers for our first year.

The purpose of this email, then, is to share this document with you. It is similar to the original document from just over a year ago but now incorporates the details of our first full year of live trading and, crucially, the impact that our real world experience has had on our simulated numbers all the way back to January 2001.

Many (I would hope most) of our investors understand that our fund is absolutely an “investment tortoise”. As per our prospectus and Key Investor Document and the other formal documents we have produced - the aim of the fund is to achieve “capital growth over the medium to long term”.

Our number one goal to achieve this is to do our very best to protect the downside. As Warren Buffet has said:

Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1.

Why is this so important?

Well - There are three very important investing realities that anyone who chooses to invest in our fund usually understand (we hope - the various professional investors who have trusted us with six or seven figures in the last year certainly do).

1) The break-even fallacy

The first is the fact (evidenced in our Fund Overview document by work that goes back as far as 1872!) – that growing money slowly over time and protecting the downside will very likely achieve a better long run investment return for most folk than owning things that might go up a lot when markets are running but will then crush you with a 30, 40 or even >50% fall when markets crash.

This is largely to do with a mathematical reality called “the break-even fallacy”. This is the fact that, for example, a 100% return is required to recover a 50% loss (a 33% return is needed to recover a 25% loss and a 300% return needed to recover a 75% loss).

Too few people understand this maths: If you ask the average person in the street what percentage return they will have to make to recover – e.g. – losing 50% on their investments - many people’s answer will be “50%”. It seems entirely logical that if you lose 50% (let’s say £10,000 to £5,000, £100,000 to £50,000 – or, for those at or near retirement £1,000,000 to £500,000) – you will then need to make “50%” to get back to square one.

Sadly – this is not how the maths work and it is a genuine tragedy how few people get this because it is yet another reason that so many people do badly in investment. If we take a moment to consider this statement and use those numbers as an example, you will realise that if you go from £100,000 to £50,000 and then make a 50% return when markets (hopefully) bounce, you will only get back to £75,000 (50% of £50,000 is £25,000).

To get back to £100,000, you will need to make £50,000 on £50,000 – again - a 100% return. As I say - this is one of the very most prevalent blind spots that most people have when they invest and one of the reasons we invest the way we do.

The Hare

At the moment, (happily) lots of people have made incredibly good money from owning things like the S&P 500 (see my article S&P at 3,000? or some of the funds I’m lucky enough to have recommended in the last few years such as Fundsmith (>+18% a year for 6 years) or the Scottish Mortgage Investment Fund (+200% in the last 5 years, +590% in the last 10) and lots of other equity-based investment products that have had a great decade.

(For what it is worth, I continue to be a believer in these sorts of investments if you’re investing in them regularly, if you have a multi-year time horizon and, arguably of most importance, if you have the mental fortitude to ride out the next 50% or more correction that is almost certainly coming).

That said, anyone owning these funds must be self-aware enough to understand that, if there is a big stock market crash – something that seems more likely every month – they will have to endure several years of being down quite heavily. If, for example, US stock markets fall 56% from peak to trough as they did from 2007 to 2009, investors will have to make 117% to get back to square one – and this will likely take some time….

2) Human Psychology

This brings in the second of my three investing realities: Human psychology. There is a good deal of evidence from psychologists over many decades that most of us are hard wired to fear a loss more than we get excited about a gain. Psychologists call this a “cognitive bias”, specifically, this one is called ‘loss aversion”.

As a pretty hard core real world example:

  • If a doctor says to someone with a serious medical condition: “I would like to perform an operation on you where you have a 90% chance of surviving.”
  • The rate at which those patients will agree to the procedure is entirely different to if the doctor says: “I would like to perform an operation on you where you have a 10% chance of dying…”

The probability outcomes are 100% the same but we are all hard-wired psychologically to fail to see it that way.

How is this relevant to investing? The answer is that most of us are the same with our money. If you see your investments fall by 20, 30, 40 or 50% in the space of a year or two, which happens to stock market investors every decade or so (and has happened to crypto investors in a big way this year), many people can’t handle it psychologically.

Many people’s loss aversion cognitive bias kicks in, significantly increasing the risk that they sell and crystallise a loss. Many of us just can’t handle seeing our funds or other investments in the red.

This is why smart hedge fund managers focus on a thing called “risk adjusted return” and know that making e.g. 8% a year, every year, year after year with a maximum “draw down” of, say, 10% in the trickiest of times, is inherently more valuable than making, say 30% one year and minus 20% the next – even if the outcome after 5 or 10 years is the same. The year they lose 20 or 30% is quite often terminal for their fund and for their career.

As a result: Our number one focus in designing our fund is to do our utmost to ensure that, even in the worst of times (Brexit, Trump and so forth) our product shouldn’t fall anywhere as much as “financial markets” more generally. The way we do this is by employing two investment techniques that we explain in the Fund Overview document: Owning the world (global, multi-asset diversification) and basic trend following – such that when the markets we own start falling (no matter what they are or where they are) – we switch out of those markets and into cash or a cash equivalent (short bond funds for what it is worth). You can see how this works on page 14 of the document.

If, when the worst of the worst happens every ten years or so, we fall 10% or so versus markets that fall 50% or so, the balance of probability is that our fund will win over time (over a life time of investment) and by some margin. The price we pay for this is that our fund can be rather ‘boring’ for relatively long periods of time as the tortoise shuffles along (as it has been since we launched).

But the evidence is that for most people, boring is good. If you have been investing in a fund for one year, three years or ten years or even more and you see it fall 5-10% in a massive market crash, you are more than likely to continue to own it and continue to invest in it. If you are in a fund that went up 100% over a few years but then crashes 30%, you are more likely to sell out and crystallise a loss.

3) Sequencing Risk

This is the third of the investing realities I mentioned above. We are incredibly lucky with our fund product to count Professors Andrew Clare and Steve Thomas and their colleague Dr. James Seaton as our collaborators on the strategy behind our fund.

Over the last few years, they have written about something they call “sequencing risk”. This is very simply the idea that not losing money becomes increasingly important as we get older.

If you are 30 and are lucky enough to have built an investment pot of, say, £10,000, you get hit by a stock market (or bitcoin) crash – and your pot falls to £5,000 – this is clearly a good deal less problematic and stressful than if you are 60 years old and the £1 million you have spent a life-time building falls to £500,000 – (particularly if you are wanting to use some of that money every year to fund you and your family as is often the case for retirees).

Sadly, this is what happened to so many people at or near retirement in 2000 and 2007/8. It is also what has happened to large numbers of wealthy people throughout history. JP Morgan Private Bank published a study some years ago that has become quite famous. The study looked at wealthy families going back to the early 1980s and showed, rather shockingly, that wealthy folk had an 85% chance of losing that wealth over one generation.

Wealth preservation is hard... for all the reasons I mention above and many more besides.

The investment “hare” has been running particularly fast in the last few years and lots of people have made great returns as a result. I think there is a chance that this will not be the case in the years ahead and our fund aims to be calibrated to deal with this reality.

For anyone who has made a good return so far and who is worried about protecting that return in the months and years ahead… It may well be a good time to think about whether you might prefer to join the tortoise…

To find out more, please do have a look at our Fund Overview document.