Stealing a living

Now I am retired, I can safely make a confession: for years, I was stealing a living.

I say so because the general financial advice any retail investor needs is actually very simple:

 - Minimize taxes and charges. Avoid expensive fund manager fees. Don’t trade very much. Make full use of Isa and Sipp allowances.

 - Make the power of compounding work for you, not against you. Start investing as early as you can. And remember that fund managers’ fees compound horribly over time; an extra half percentage point in annual fees can easily add up to over £2000 for every £10,000 invested over twenty years.

 - Diversify sensibly. Hold equities for growth, and non-equity assets (which might just be cash or your earning potential) to spread risk.

 - Invest regularly, via monthly direct debits. The habit of savings is important.

Granted, we can finesse this. History suggests we can use market timing; equity returns have been partly predictable by consumption-wealth ratios, the dividend yield, ten-month moving averages or simply the time of year. And two types of stock have beaten the market on average over the long-term: defensives and momentum: yes, most stock market anomalies are illusory (pdf) or short-lived, but not these two.

But retail investors don’t need these add-ons, not least because we’ve no guarantee that past relationships will continue to exist. Many people can safely invest in tracker funds and cash and get on with their lives. You needn’t bother with portfolio optimization. It can’t be done. Simple (pdf) diversification works. Satisficing is the best we can do.

Everything useful that needs saying about investing can thus be written in a few words. Beyond this, there are sharply diminishing returns and I suspect even negative ones. Which is why I say I was stealing a living.

And so too have been thousands of finance professionals:

 - Equity analysts. “corporate growth rates are random” concluded Paul Geroski in one study (pdf). “There is no persistence in long-term earnings growth beyond chance” found Chen Karceski and Lakonishok in another (pdf). “Firm growth is characterized by a predominant stochastic element, making it difficult to predict” concluded Alex Coad in another survey. All of which means that, insofar as equity analysts are paid to forecast earnings (and in fairness they do other things) they are getting money for nothing. The big price falls we’ve seen recently in Netflix and Peloton (along others) shows the dangers in relying upon forecasts for earnings growth.

 - Economic forecasters. Prakash Loungani has shown that these have consistently failed to predict recessions around the world: they are better at forecasting GDP growth in normal times, but that’s when we don’t really need forecasts. If you want to know the chances of recession, just look at the yield curve.

 - Fund managers. These, said the Financial Conduct Authority in a recent report, “did not outperform their own benchmarks after fees.” The “vast majority” of them, said David Blake and colleagues in another “were not simply unlucky, they were genuinely unskilled.” Such findings corroborate evidence which we’ve had for years (pdf) in the US (pdf). Granted, there’s some evidence fund managers can pick stocks, but the benefits of this are dissipated by their need to hold more shares to reduce liquidity risk, or by their poor selling strategies.

Many people in finance, then, are simply quacks, snake oil salesmen.

I use the analogy for a reason. Quacks and snake oil salesmen thrived for decades: the market does not always weed out charlatans. Our latter-day snake oil salesmen prosper because they use similar techniques to their 19^th century counterparts, described (pdf) brilliantly by Werner Troesken. They use product differentiation (such as the launch of new funds, be it small cap ones in the 80s, TMT ones in the 90s or ESG ones today); exploit wishful thinking and the public’s ignorance or distrust of experts; and they rely upon people not distinguishing between skill and luck.

The analogies between the finance and patent medicine industries aren’t perfect, however. One difference is that the finance industry is less competitive. Thomas Philippon (pdf) and Guillaume Bazot (pdf) have shown that the costs of financial intermediation (such as fund managers’ fees or spreads between borrowing and lending rates) haven’t changed for decades. The IT revolution has done nothing to lower costs for customers.

Huge swathes of the finance industry are therefore failing their customers. This is not because of mis-selling or crime. It happens in the legal everyday operation of the industry. Adair Turner was bang right to describe much of the finance industry as "socially useless".

Which is true in another way – the financing of business. For every £1 banks have lent to UK manufacturing companies they have lent £34 in personal mortgages. And in 2019 (the last normal year before the pandemic) banks’ net lending to non-financial companies was just £11.5bn compared to household savings of £72.2bn. The idea that banks use household savings to finance business isn’t just wrong in theory (savings don’t create loans): it is wrong as a matter of numbers. Banks are property lenders with a casino sideline, rather than financiers of industry.

The financial system, then, does not serve its customers well.

There’s another way in which this is true – financial innovation.

As Robert Shiller has shown (pdf) – based on Arrow and Debreu’s work in the 50s - financial products could in theory protect individuals from big economic risks. If we could trade securities which were claims on GDP or occupational earnings, people worried about or exposed to downturns could protect themselves by going short. This is especially useful because, given the impossibility of predicting recessions, monetary and fiscal policies are not sufficient protection.

In fact, though, we don’t get such useful innovations – or at least not on the scale we need. Instead, we get scams and gimmicks such as ICOs or NFTs.

There’s a reason for this. The innovation we get depends upon whether innovators can capture a sufficient fraction of their benefits. They can do so for (say) NFTs, but not for Shiller-type products.

It’s tempting to infer from this that we have a financial system which is not fit for purpose. Such an inference is wrong. It is superbly well-equipped for purpose – if that purpose is to funnel wealth from clients (and wider society) to itself.

You might think this claim is a radical one. Maybe, maybe not. It is, however, one that is rooted in wholly conventional economics. You don’t need heterodox thinking to challenge the existing order.

Comments

[Kamil Sicinski]

Enjoy your retirement. I hope you keep writing in this blog!

[VoiceOfAuthority]

Financial independence

[George Brown]

“I was stealing for a living”. You and me both. After 35 years selling software that doesn’t work to people who didn’t need it, I too recently retired. I’ve really enjoyed your blog over the years and I rather selfishly hope you keep writing as you enter this new life stage. Enjoy your retirement.

[Scurra]

Isn't that conclusion (that the finance industry exists to channel wealth from clients to itself) just a generalised one for unregulated* capitalism in general?

I will note here that I'm not dissing capitalism as a system, but it does rather resemble democracy in Churchill's immortal words (the worst way to run something apart from all the others than have been tried from time to time.)

And financial investment seems like the ultimate endpoint of capitalism in that it doesn't even produce anything in and of itself but merely looks at the returns when choosing where to go.

*'unregulated' is probably the wrong word here because it's worse than that, in that there is regulation but it is only selectively applied (i.e. essentially corruption albeit not always overt.)

Enjoy your retirement.

[ltr]

Please, please continue this wonderful blog.

[Jim]

Congrats on making it to retirement. Hope this excellent blog can keep going.

I suppose the definition of 'stealing a living' is to give the impression of doing something useful but not really. On that basis I reckon a great many are stealing a living, indeed it seems to have become the default option for mid to upper earners.

Actually doing something useful seems left to a small cohort and seems rarely to be well paid. Seems to me this is a natural result of an advanced society. With good education commonly available most real needs are easily satisfied but that means poorly paid. Getting further up the ladder fulfils few real needs but a great many need to get up the ladder and few dare let on that it is doing little or no good.

The alternative is to have them sit at home writing poetry, smoking grass and drawing a citizens wage.

[rsm]

《two types of stock have beaten the market on average over the long-term: defensives and momentum: yes, most stock market anomalies are illusory (pdf) or short-lived, but not these two.》

So, is the efficient market hypothesis wrong?

《we don’t get such useful innovations – or at least not on the scale we need [...] The innovation we get depends upon whether innovators can capture a sufficient fraction of their benefits.》

Why can't central banks, motivated by the public good not profit, insure us each by, for example, providing individual CBDC accounts that pay the inflation rate as interest?

《The alternative is to have them sit at home writing poetry, smoking grass and drawing a citizens wage.》

Mind if I prefer to wander through forests and deserts, sleeping outside, learning more from nature than from humans?

[Chris Pepin]

The last paragraph says it all...Have a great retirement and keep writing!

[Blissex]

«fund managers’ fees compound horribly over time; an extra half percentage point in annual fees can easily add up to over £2000 for every £10,000 invested over twenty years.»

It is much worse than that: between 30%-40% and 60-70% of a pension is paid to the City:

* Suppose a pension that accumulates over 40 years and a retirements of 20 years.

* The withdrawal rate over those 20 year should be around 3-4%.

* City fees amount to 1-2%, and that would be 20-50%, but they apply not just over the last 20 years, but also over the 40 years of the accumulation phase, so the actual confiscation by the City of a pensioner's funds is way above 25-50%.

State and employment pensions are much cheaper (around 0.5-1% of payments, instead of 30-70%, and that's why Conservatives, New Labour, LibDems have been working hard to cut them down to size and push workers to pay 30-70% of their pensions to the City.

[Kevin Gardiner]

I would suggest that you have helped your readers from believing the overconfident nonsense in media/marketing/academia... Enjoy the well-earned (not stolen) retirement.