Anthony Hilton: Investing and the vital need to keep one’s cool

With stock markets hitting new highs here and in the US, it is a good time to ask how many investors are actually making the money they could be. Booming markets suggest profits should be easy to come by, but how much of that market gain actually ends up in people’s pockets?

Studies tend to show that in cycle after cycle the clients’ experience is significantly less exciting than the market performance would imply. Indeed, the point was made again this week by fund manager Simon Hallett at a conference organised by the London Business School, which again explored the merits of active versus passive investing.

Some of our leading academics and practitioners sought to bring their perspective to the debate about whether active fund management delivers anything worth paying for or whether investors would be better off simply buying products which track the market.

To sum up what was a day-long session, a key conclusion was that this was in fact the wrong question. All passive strategies need a surprising degree of activity to keep them on track, and how well this is executed can make a big difference. Although the laws of arithmetic dictate that all active managers aggregated together will deliver the market return (because they are the market), that does not mean that some active managers won’t do significantly better. The challenge is to find them, to work out how much they should be paid and, most tellingly, to have the nerve to stick with them through tough times.

This last point matters greatly. What is too often overlooked in the active versus passive debate is that investors and fund managers are people not machines, and as a result they behave emotionally as well as rationally. Some economists at Barclays recognised this a few years ago when they published an investment guide under the title Overcoming the Cost of Being Human.

This highlighted how investors found market volatility was much easier to cope with when they were already sitting on profits.

But the downside was that most of the severe stock-market losses were incurred by new investors in their first two years of ownership. If they were hit by a big fall in prices before they had built up a buffer, they were panicked into selling to avoid losing the lot, and would never go near the stock market again.

The pain from a loss is far greater than the joy derived from a profit — that is not rational but it is how people are wired.

Mark Northway has built a business, Sparrows Capital, on a similar insight. He is a supporter of passive management because he believes that stock picking and attempts to second-guess market timing are so hard they are likely to fail so it is better not to try. Instead he focuses on controlling behaviours.

The key to his approach is the time he spends in advance understanding exactly what it is his clients want and what they are prepared to put up with to achieve their objectives.