Last week's final letter in your column, regarding investment advice and selection, reminded me of a quote in an investment textbook I studied recently, regarding the average return difference between qualified advisers and random selection by an untrained animal. I believe it was a chimpanzee.
Over a several-year period, it achieved returns in excess of the trained professional.
Stories about chimpanzees and monkeys outdoing professional stock pickers are not uncommon.
But they're not usually about financial advisers but the people who decide which shares a managed fund should buy and sell, or sharebrokers recommending "buys" and "sells" to their clients.
A recent example is the tale of Lusha, a Russian circus chimp who chose eight cubes representing eight companies out of 30 companies.
Her portfolio - which included banks and mining companies - outperformed 94 per cent of Russia's investment funds, growing three-fold in a year, according to Moscow TV.
Other stories tell of people throwing darts at newspaper stock price tables, buying whatever stocks the darts land on, and outperforming the experts.
These are colourful illustrations of what's called the efficient market.
In an efficient share market, the minute any news is released about a company its share price changes. If the news is good, lots of people will want to buy the share, pushing up demand and therefore pushing up the price. If the news is bad, people will want to sell, pushing down demand and hence the price.
Unless you are among the very first to know - and not even the professionals can always be first - you probably won't gain by buying a share after the company has announced some good news. Even if the news is about, for example, a contract that won't boost profits for another year or two, the share price will already have risen to take that into account. And you don't win by buying shares at high prices.
Ditto for selling on bad news. The news - which might not affect profits for quite some time - will lower the share price right away.
In other words, in an efficient market share prices at any time take into account all the information available about the companies. There's no point in trying to work out which shares are good or bad buys - they are all fair buys. So you might just as well pick any share as any other. Or let a chimpanzee or a dart do it for you.
But first, how efficient are sharemarkets? There's been heaps of research on this. Everyone agrees they are not fully efficient, but opinions vary on degree. It seems clear that the US and other big markets, with their thousands of professional investors watching every move of every listed company, are more efficient than smaller markets like New Zealand.
Some New Zealand fund managers and sharebrokers - and for that matter financial advisers - say our market is not very efficient at all. Therefore, they say, there's scope for picking which shares will do well or badly.
That's probably true to some extent. But I'm yet to be convinced that any New Zealand expert is good enough at choosing shares for me to invest with them. That's why I prefer index funds. Read on.
Index funds queried
I've read several of your books and appreciate all your advice in your articles in the NZ Herald. But ... I have to disagree with some of your advice. Mainly on the whole diversification and index funds you recommend.
Surely if I have the time and willingness to learn about shares and property investments and concentrate my investment money into opportunities that make financial sense, I'd be better off than buying index funds like FONZ or TENZ, for example.
It doesn't take an idiot to work out that most of the businesses on the New Zealand sharemarket are under-performers, which is what you would buy into with an index fund. If you know what you are doing with shares and property, you have a great opportunity to outperform the returns from a passive index fund.
Firstly, let's separate out property. Because every property is different, the property market can't be analysed in the same way as the sharemarket, in which every company has to publish audited reports on how they are doing.
The property market must, therefore, be fairly inefficient - in the sense described above. So those in the know probably can spot good buys and know when to sell. If you want to put the effort into acquiring that knowledge, go for it.
However, in the sharemarket, as Lusha the chimp shows, even highly paid full-time investment experts often pick shares poorly.
Want more proof? A while back Lipper Analytical Services looked at the 20 top-performing US share funds between 1988 and 1998. That's the best 20 out of 2322 funds.
How did those funds perform in the following decade? The best one came 208th , and the worst came 14th from last. The average ranking of the 20 funds was 1745th - which is within the bottom quarter. Overall, their performance was abysmal, which suggests it was more luck than skill that put them at the top the decade before.
As I said above, inefficiencies in the New Zealand market probably make share picking a bit easier here. But merely looking for companies that are run well isn't going to work. If you know that, all the professional investors do too, and their demand will have pushed up share prices to the point where those companies may not be good buys.
The important point is this: Shares that grow in value aren't necessarily in companies that perform well. They are in companies that perform better than the market expects, and so their good performance wasn't already reflected in a higher share price at the start of the period. They could well be companies that are doing terribly at the start - the very companies you would shun - but they experience a turnaround.
Still, if you want to put the time into picking shares, you'll probably do pretty well - as long as you buy a wide range to get diversification. You will avoid the fees of share funds. And many people are happy with how their chosen shares have performed.
They probably don't realise that almost any diversified portfolio will grow over the years, simply because the whole market grows. And some, by luck, will beat index funds - although others won't.
For the benefit of other readers, index funds - sometimes called passive funds - invest in the shares in a market index such as the NZX-50. They do as well as the sector of the market covered by the index. In our NZX-50 example, that's the biggest 50 shares.
Because index funds don't need highly paid research on which shares to buy and sell, they charge low fees, which is why I like them. I'm happy to settle for "market returns", knowing that the more expensive active share funds, which pick their shares, are not necessarily going to do any better.
I agree with your comments in the past few weeks of KiwiSaver still being a good option. I was wondering, though, do any of the KiwiSaver providers do an index-based fund? None that I have looked at seem to.
We got a fair way through the column without mentioning KiwiSaver, but it does have a way of popping up.
You must have been looking in the wrong places. It's true that most KiwiSaver funds use active management. But when I was researching my latest book, The Complete KiwiSaver, two years ago, the following largely used passive management:
* ASB Group Investments' default scheme.
* Civic Assurance - all shares except 10 per cent of international shares, which are invested ethically.
* Smartshares - built around the Stock Exchange's index funds, so all the shares in its funds are passive.
* SuperLife - all their funds are passive except Gemino and Ethica.
Also, the following used some passive management:
* Craigs Investment Partners' kiwiSTART Defined - about 50 per cent of international shares.
* ASB Group Investments' FirstChoice scheme - all funds with "Tracker" in their name.
* Fidelity - all international shares.
* Grosvenor - 60 per cent of international shares.
* KiwiSaver - all international shares.
* Mercer KiwiSaver - for 30 per cent of the international shares in the Mercer KiwiSaver Conservative, Active Balanced and High Growth Funds, the manager uses an "enhanced index" approach. See the provider's website.
* Mercer Super Trust - the Passive Balanced Portfolio and all of the funds that hold international shares have a 30 per cent "enhanced index" management component. See website.
Finally, with Craigs Investment Partners' kiwiSTART Personalised scheme you can go entirely into passive investments, entirely into active, or a mixture.
I feel pretty disillusioned with the decrease to KiwiSaver tax credits. After all, it disproportionately affects those on middle to low incomes.
Example: When a KiwiSaver on $60,000 loses $521, that's around 1 per cent of income, whereas a KiwiSaver on $200,000 loses only 0.25 per cent of their income.
And it's worse for those like my wife who earns about $27,000 a year. Her tax credit loss is almost 2 per cent of her income.
That's assuming she tops up her contribution to $1043 a year, so she receives the maximum tax credit. It's a good move, but many people on lower incomes don't do that. They contribute just 2 per cent - rising to 3 per cent from April 2013. And if we assume those contributions, higher earners seem to be hit harder. For example:
* An employee on $30,000 contributes $600 now, rising to $900 from April 2013. Their tax credit drops from $600 now to $450 then - a drop of 25 per cent.
* An employee on $70,000 contributes $1400 now, rising to $2100 from April 2013. Their tax credit drops from $1043 now to $521 then - a drop of 50 per cent.
Note, too, that the switch from tax-free to taxable employer contributions affects people on lower incomes less, as they are in lower tax brackets. For example:
* Our employee on $30,000 receives $600 from their employer now. From April 2013, they will receive $743 after tax. That's quite a jump.
* Our employee on $70,000 receives $1400 from their employer now. From April 2013 they will receive $1470 after tax - barely any more. For them, the new tax almost cancels out the jump to 3 per cent.
It's all in the way you look at it.
Mary Holm is a freelance journalist, part-time university lecturer, member of the Financial Markets Authority board, director of the Banking Ombudsman Scheme, seminar presenter and bestselling author on personal finance. Her website is www.maryholm.com. Her advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to email@example.com or Money Column, Business Herald, PO Box 32, Auckland. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.By Mary Holm Email Mary