Thursday, 2 April 2009

Pay Less, Diversify More, Be Contrarian

Just finished John Kay's "The Long and the Short of It". Lots of decent, straightforward explanations as to why retail investors should "pay less, diversify more, and be contrarian," without pushing some kind of snake oil that allegedly delivers the same financial result.

In fact, he says, "You are on your own". That's not a great outcome after a decade of New Labour fiddling that was supposed to result in "treating customers fairly".

In essence, Mr Kay explains that financial markets have a mind of their own, unrelated to fundamental value. Financial models that purport to predict performance over time may be illuminating but they are not true... "frequent small gains [are] punctuated by occasional very large losses." He calls these occasional events "Taleb distributions," on the basis that Nassim Nicolas Taleb explained this problem fully in his book Fooled by Randomness (and again more recently in The Black Swan). Not only are faulty financial models accepted as being more than illuminating, but also the urge amongst financial services firms to compete on relative performance moves their markets "too far, too fast" for most of the participants to realise they should take the profits and check out. To call a halt puts one's job at risk. "It is better to be conventionally wrong, than to be unconventionally right." So, while it pays to understand the "mind of the market", your purpose in doing so as a retail investor is to do the opposite of what "the market" is suggesting.

Interestingly, Mr Kay's recommended regulatory response to the credit bubble is to "firewall the utility from the casino, by giving absolute priority to retail the event of the failure of a deposit-taking institution." He says:
"The additional rules which will be introduced as a consequence [of 'more effective' regulation] will be irrelevent to the next bubble, just as the Basle I and II capital requirements imposed on banks - the subject of so much regulatory and academic debate over the last two decades - were irrelevant to the credit bubble."
The more one is diversified, the less regulation should matter. Right? Well, that's easier said than achieved, given the marketing might devoted to cross-sell in retail financial services.

Maybe the financial regulators should simply dedicate themselves and their budgets to pushing the line:

"You are on your own. Pay less. Diversify More. Be Contrarian."

But there won't be very many international meetings or compliance jobs in that...

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