Unless you’re lucky enough to be able to buy a very expensive house, a pension is usually the biggest purchase any of us ever makes.
Yet it’s amazing how many people invest for their retirement without examining the evidence about how best to go about it.
There is, in fact, a wealth of independent, peer-reviewed, academic evidence about investing.
We asked Jens Hagendorff, Professor in Finance and Investment at the University of Edinburgh, to summarise the key takeaways.
Professor Hagendorff says: "I think there’s two main lessons from academia for investors. One is: it pays to be diversified, so it is very important that we diversify across asset classes, also about geography, so it’s important that we invest in stocks and bonds and properties and commodities across many different countries, and there’s a number of people who have done very good work on that. And the other very simple lesson for investors is that it is on average not possible to beat the market. Market returns are determined by risk, riskier stocks achieve higher returns, so the only way to achieve a high return is to load up on risk. It is not the stock-picking in terms of firm strategies or management that pays it is actually exposing oneself to more risk that gives higher returns. But the implication is very clear from that, it is a passive investment strategy is one that will outperform, stock-picking doesn’t work over the long run."
So, if you want to enjoy maximum benefit from diversification and avoid taking excessive risk, Professor Hagendorff says the answer is to invest passively.
In other words, you should use funds that simply track an index - capturing market returns at the lowest possible cost.
Professor Hagendorff says: "The active versus passive debate is really very simple. At the end of the day it’s the cost. It’s not some great theory of what markets are like. It’s a simple fact that if you go for an investment strategy that is more costly, but does not deliver additional returns, you are losing out, and it seems quite counter intuitive that not trying to beat the market leaves you better off than trying to beat the market, but that is the case because trying to beat the market costs you so much more money."
We’ve heard a great deal lately about so-called smart beta.
Smart beta funds are similar to index funds in that they include a very large number of different securities, but they’re specifically designed to capture a different risk factor.
So, are they a good idea?
Professor Hagendorff says: "They can make a lot of sense for some investors. However they are still a form of active management. They are active management in the cloak of a passive strategy. So we know and we have known for many years that for instance small firms outperform large firms, but the reason for that is that small firms tend to be riskier than large firms. So there’s nothing particularly smart about these smart beta funds, they make use of well-known risk factors if you like, we know that small firms for instance outperform big firms, so they are not particularly smart but they do something quite well and that is they can give investors that want to have exposure to certain risk factors exposure to those risk factors and they do it quite cheaply."