Financial Advice and Risk Taking in the Stock Market: Part 2

1. Value of Financial Advice - author Jim Parker

2. Risk Taking - Active v. Index Management - author Amy Horan

Almost all investors are familiar with the concept of active management and understand the concept of trying to pick the right stock at the right time in order to benefit from its price appreciation. Opposed to this approach is the concept of passive, or index management, which simply tries to replicate the return of 'the market' at minimal cost to an investor. In both cases a return will be generated that will be either lower than the overall market (the index fund due to fees or the active manager who makes the wrong bet) or above the market (the active manager that makes the right bet).

There is however a third approach that combines both of these models and can deliver expected returns above the market consistently over time, which when coupled with diversification and staying in the market, will help investors achieve their long term objectives. Importantly this approach focuses on the risks and returns of investing and establishes a portfolio that matches these with those of the investor.

Active management

Active management attempts to beat the market by forecasting and picking specific investments and through market timing. Active managers assume that markets are inefficient and that they can accurately identify these inefficiencies to deliver above market returns to their investors. This type of approach can come in two forms, one being where they purchase securities that they believe are 'undervalued'and hence will profit as their price rises, the other being to short-sell securities that are 'overvalued' and profit when they fall in price.

Active managers come in all shapes, sizes and forms from large billion dollar funds to small boutique specialist managers. They have many different styles from Value, to Growth to GARP (Growth at a Reasonable Price) to Small Cap, Mid Cap, Large Cap, Distressed, Arbitrage... this list is almost endless. These approaches can then vary in terms of whether they adopt a 'qualitative' or 'quantitative' assessment of companies, as well as whether they take a 'top down' or 'bottom up' approach. In the end it all boils down to a fund manager making an assessment based on their 'opinion' of a stock. Unfortunately however, it is incredible difficult for the investor to try to pick the right manager with a recent survey by S&P showing that in the 5 years to 30 June 2009 only 33% of active managers beat the index. This makes it very difficult for the average investor to determine who will be the 'best' manager, with a further drawback often being higher costs caused by turnover and the resultant higher transaction costs and taxes.

Index management

Index management, also known as 'passive' management, refers to a buy and hold approach to money management. A passive manager assumes markets work, they make as few trades as possible in order to reduce transaction costs and they will directly track a specific benchmark, or index, in order to replicate its returns. Passive management is most common on the equity market where the manager will track a stock market index with the aim of matching the return (income and capital appreciation) before taking into account fees and expenses. The investor will therefore end up with the 'market' return less the cost of management, which in most cases is very low.

Passive managers provide research and evidence that shows us markets work. They believe it is difficult to outperform markets and the best approach is to accept market returns.

Can these two styles co exist?

The answer is yes. The concept of 'asset class investing' takes both the active and index approach and merges them into a model that assumes markets do work and through extensive academic research it has been identified that particular asset classes produce higher returns over the long term. At the same time, trading is kept to a minimum and therefore the consequent transaction costs are also kept to minimum.

When speaking of this concept and the idea of asset classes, we are looking beyond the main asset classes of Australian shares, International shares, Property, Fixed Interest and Cash. Within these asset classes, there are, if you like, 'sub' asset classes or 'factors' which research has shown over the long term tilting your portfolio towards will provide you with a higher expected return, not withstanding that you are taking on more risk. The most common of these asset classes are growth, value, small cap and large cap stocks, with research identifying that small and value stocks have higher associated risk and therefore higher expected return. This concept has been seen in all stock markets throughout the world and has done so consistently over a long period of time.

By actively allocating to these asset classes and then investing within them based on market capitalisation, you can achieve a portfolio that blends both the active and passive styles and which helps remove some of their worst features, being forecasting (Active Management) and higher transaction/trading costs (Active and Index). The diagram below shows how the constructing of this portfolio can help increase expected return.

Diversification and Staying in the Market

The underlying principal of diversification continues to apply and is very important to this concept, as it eliminates the random fortunes of individual stocks and structures your portfolio to secure the returns of broad economic forces.

It will also allow for you to adhere to another fundamental principal of 'time in the market,' rather than 'timing the market'. The table below illustrates the folly of trying to time the market (a trait of active management) and shows that over the recent crisis staying fully invested through the downturn made sure that you were there for the turnaround and thus, the consequent upturn, and how even missing just a small fraction of time can significantly impact returns. It all sounds simple in principal but so often many stray from the basics. As advisers it is our job to make sure clients stay the course, focus on their long term strategy and capture the risks worth taking.

The above is only a brief explanation of the various investment concepts. If you would like more details on how we can help with your investment strategy please contact one of our advisers.

This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2009 Moore Stephens Australia Pty Limited. All rights reserved.