Vanguard Asset Management is one of the companies that’s helping to change the face of investing. Based in the US, it came to the UK in 2009, and last year it launched a direct-to-retail operation, allowing investors with as little as £100 to invest each month to access a range of low-cost funds.
In this interview, Vanguard’s Head of UK Retail Sales NEIL COWELL explains why the company places so much emphasis on the importance of controlling costs, and discusses whether or not investors should use a financial adviser.
Neil Cowell, as a company, Vanguard is always emphasising the importance of fees and charges. Why is controlling costs such a key component of successful investing?
That’s right, we talk a lot about cost at Vanguard, and the importance of cost in investor returns. I think in the world of investing it can be said that you get what you don’t pay for. And costs do create an inevitable gap between market performance and investor return. The evidence is very clear when you look at the data. There’s data from Morningstar, for example, that clearly show that low-cost funds outperform their high-cost counterparts, and that alone gives a real indicator of why we attach such importance to it. In fact, Morningstar actually uses cost as a major predictor of a fund’s future performance, so every which way you look at it, costs are extremely important to investor outcome.
It’s not an easy message to get across to investors though, is it? In almost every other area of our retail lives, the more you pay the more you get.
That’s absolutely right. It’s counterintuitive. Clients definitely associate higher cost with higher quality and, as I said at the start, in the world of investing you get what you don’t pay for. When people see a fund priced at 1% per annum and another fund alongside it priced at 50 or 60 basis points, it doesn’t seem a lot in terms of a differential. But when that is actually compounded over time, it plays a terrific part in the overall return and takes quite a significant chunk from the final value.
How important is it, would you say, for people to have a financial adviser?
We’re very clear at Vanguard that clients are better served by working with an adviser. We spend a lot of time promoting the value of advice. We have a framework here that we call Adviser’s Alpha, which talks specifically around the value that an advised relationship will deliver over and above what a client left to their own devices may achieve. For a great investing outcome clients are well served by working with an adviser. We don’t say that clients who have the time, willingness and ability to self-serve can’t achieve a great outcome too, because that’s certainly possible. We just say it’s hard, and our message around the value of advice and what that adds is really very clear.
From your point of view, then, what are the major ways in which a good adviser adds value?
I think that there are two major parts. The first part is around the investment expertise itself, so the importance of getting the asset allocation right, the importance of rebalancing, the importance of ensuring that cost plays a part in portfolio construction. That does add value — there is no doubt about that. We rarely see portfolios that are constructed by clients themselves with a balance of equities and bonds, for example. They tend to resemble a collection of funds rather than a specific asset allocation. So there’s a real value add in the investment expertise element.
But I think, going back to the Adviser’s Alpha framework, where an adviser can really add value is in their role as a behavioural coach or an emotional circuit breaker. We see time and time again that when clients are left to their own devices they can start to make some very costly mistakes.
What are the most common mistakes you see people making when they try to manage on their own?
We see for example investors typically chasing yesterday’s winners. They invest in what appear to be yesterday’s winning funds, expecting those funds to repeat the performance and to prevail for the next three, five, seven or nine years. There is a clear pattern. People also try to time markets, which is not an advisable thing to do. Typically we see investors get there too late, by which I mean there’s a big difference between the fund return and the actual return the investor experiences. So those are two examples, chasing yesterday’s winners and getting there too late, of behaviours that really do erode value.
Another problem, of course, is that, in the words of your founder Jack Bogle, investors don’t “stay the course”. They bail out when markets tumble. And again, unadvised clients are more likely to capitulate.
That’s right. At Vanguard we have what we call our investing principles. We believe that for a great investing outcome, investors should have a clear, articulated and definable goal. They need to understand why they’re investing in the first place. Alongside that we think it’s important to have an asset allocation that’s appropriate to their individual risk profile, and also to choose the component parts of that asset allocation at the lowest cost possible. But then comes the critical element. Having constructed the plan, having put the time and effort into getting that all right, you need to tune out the noise and keep your discipline. Markets will inevitably experience degrees of volatility. There is an inherent behavioural bias in all of us which is loss aversion, and it’s inevitable that clients will at least consider bailing out. That’s when the adviser really adds value. Jack Bogle also coined the phrase, “Don’t just do something, sit there”. In other words, expect the volatility, be confident in the plan, and ride it out, for great investing outcomes.
What would you say to investors who think they can trust their ability to manage their own emotions and don’t need an adviser to do it for them?
If that is the case, then maybe they are on of those investors who has the time, willingness and ability to self-serve. I think they’re rare, because most of us are subject to some of these behavioural biases. Carl Richards, who writes for the New York Times about behavioural biases, tells the story of when he was an adviser, the CEO of a Fortune 500 company came to him and asked him to run his personal affairs. He said to him, “Why are you asking me to do this? You know far more about investing than I do.” And the CEO said, “The reason I am asking you is because you’re not me.” It was the peace around that separation, that emotional circuit breaker, that he so valued.
Where do you see the financial advice profession going in the future?
I think at Vanguard we’re very clear that the need for advice is growing. We’ve seen data from the US and UK that shows the need is now greater than it’s ever been, and it's also very interesting that people are more prepared now than ever before, according to the data, to pay for advice. I suppose we shouldn’t be surprised about that given the dynamics. People are living longer, life is typically more complex, and people are now contemplating for the first time running their own retirement pots rather than being able to rely on an employment discretionary benefit scheme or final salary scheme. There are so many reasons why people see advice as more important now, and it’s encouraging to see that coming through in the data.
Do you think some UK advice firms might feel a little threatened by Vanguard’s direct-to-retail offering?
That’s a good question. I don’t think it was a particular secret that Vanguard would at some point introduce a direct offering. The reaction from our adviser community has been very positive. A lot of them are interested in the extent to which there may be access for advisers at some point. We’re nowhere near that, and it may never happen, but nonetheless the interest is there. So I don’t think there has been a bad reaction to it.
I’ve been very encouraged over the last two or three years to see advice firms getting better and better at articulating their overall proposition. And I think that’s the key. Advisers these days are building more and more of their value proposition around their role as that financial coach, that behavioural coach, and no direct offering in the world can be a substitute for that.
A big problem for many investors is their overconfidence. They have unrealistic expectations about their own abilities at picking stocks and timing the market, and about the results they’re likely to achieve.
Bent Flyvbjerg is a professor at the Saïd Business School University of Oxford. An economic geographer, he’s an expert on behavioural economics and so-called optimism bias. His particular specialism is the planning fallacy — the tendency to underestimate the length of time and the expense involved in completing major tasks. But he also has a strong interest in how overconfidence impacts on investors.
Although Professor Flyvbjerg admits to making small, and very occasional investments in individual stocks, he mainly uses index funds, and recommends that most investors do the same. He says it’s a lesson that he’s learned from being too optimistic about his own investments in the past.
Thank you for your time, Professor Flybjerg. What exactly is optimism bias?
Optimism bias is a propensity that humans have to look at the future through rose-tinted glasses, so to look at it in a more positive light than is actually warranted by what happens when the future gets here. That’s it in a nutshell.
Why, then, are humans prone to optimism bias?
There are a lot of theories about that, but the constant is that this is probably something evolutionary, that we need optimism to do what we do in life and to get up in the morning, to get married, to have children and go to work. This is something we assume that has been with humans for a very long time, that this is something we need to survive. It’s Darwinistic in that sense.
It’s often very useful to be optimistic. You wouldn’t want a team of pessimists if you wanted to accomplish something. But optimism may also trip us up, so we might actually miscalculate risks regarding things that are very important. So you don’t want to get on a plane, for instance, when the pilot says he’s optimistic about the fuel situation. That’s not the kind of optimism that you want. But you do want to get on a plane where the flight attendant says that he’s going to give you a great trip, and they’re going to serve you great food and drinks and so on.
How rife is optimism in the financial industry, in your view?
It’s not just what I think. We know from solid research that it is very rife, it’s widespread, and it’s one of the things that you really need to guard yourself against as an investor — both your own optimism, and other people being optimistic with your money. That can lose you a lot of money.
Give me a specific example, then, of how optimism bias can trip investors up, as you put it.
Everybody hopes to have a windfall in the financial markets, and especially inexperienced beginners, who will think they’re going to be better than the average investor. People go into casinos and have this optimism where they’re going to beat the odds of the casino. The hardest thing to learn is not to be too optimistic. It’s really difficult. It takes a lot of time, and a lot of experience, and there are very few investors out there who have this cool realism that will make you successful as an investor.
But it’s very tempting, isn’t it, not to act when we keep hearing in the media plausible arguments for buying this or that?
Yes, it’s difficult not to get caught up in that, but it’s well documented that you shouldn’t listen to that kind of stuff. Day-to-day news on financial affairs is mostly noise. You need to look at much longer trends to get anything like useful information. You can always build a story around some random variation that sounds meaningful, and then you act on the basis of that and find that it’s not meaningful at all.
It’s sometimes assumed that financial professionals are above these sorts of biases. What do you say to that?
It’s not true. With professionals, there’s actually an additional bias — in addition to optimism bias — because they have a deliberate interest in making people believe they can do better. It’s what we call a strategic bias. Professional investment managers will try to make their clients believe that they’re better than the markets, and again it’s been shown that on average you’re better off without a professional investor than with one.
You said it’s very difficult to combat optimism bias. But how can you make a start?
The first thing to do is to realise that you have optimism bias. And of course, if you’re biased, you need to be de-biased. Experiments have been made on people who make decisions about things. One group is not told what the usual outcomes are, and the other group is told. So the second group will get a realistic image. They will think about that when they make their decision and will not be as biased as the first group. So just telling people what the empirical data are will make them less biased.
But the real secret to getting bias out is not to make subjective decisions. You basically want to make decisions that are more or less automatic. So instead of trying to time the market you would say like, if you are investing, that I’m going to invest every three months on a specific date; I’m going to invest whatever I have at that moment. You’ll do better than if you try to save up your funds and figure out where the market is going and try to time the market.
Optimism bias has to have an opportunity to kick in, right, and it’s only when we make subjective decisions that it kicks in. So the more you can eliminate those and go on autopilot, so to speak, the better off you will be in making investment decisions.
But again, its hard to temper your optimism when you read about professional investors who’ve made successful call, isn’t it?
There are so many things happening in the financial markets that there will always be stories like that, and that’s exactly what you have to disregard. Only if you see something that you really believe in and you were dead certain that it’s going to outperform the market would you be justified in doing something apart from just investing in something like the S&P 500.
How has your research impacted on your own investment decisions?
I actually try to use these ideas about optimism bias in my own investments. So I’m very conservative in that sense. (If you’re going to speculate) you should only put a little money on it — very small investments on things that have an enormous upside. By making a small investment you create a small downside. So you play on the large upside with a small downside, and the rest of your investments you just keep in the index.
You invest in index funds yourself. Why did you decide to go down that route?
Like many investors, I took a lot of time to learn this, and it cost me a lot of money. I did it because I saw that it was bulls**t (to suggest) that professional investment managers are performing better than the index. At the same time as I was developing my own experience as an investor this type of research became very well known in the early 2000s. Daniel Kahneman won the Nobel Prize in Economics for his research on optimism bias and the planning fallacy. That just showed me that you’re just giving money to other people instead of actually investing it and making money for yourself.