Topic: Investment

UK General Elections and the Stock Market

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Last week’s election was the first vote in the UK since the EU referendum – aren’t we the lucky ones…. and who is to say how soon the next one will be?

In this blog, we explain why investors would be well served avoiding the temptation to make significant changes to a long term financial plans based upon predictions as to who may be in number 10. The data below has been provided by investment firm Dimensional Fund Advisers.

Exhibit 1: Growth of a Pound Invested in the Dimensional UK Market Index

January 1956–December 2016

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 For illustrative purposes only. Past performance is not a guarantee of future results. Index is not available for direct investment, therefore, their performance does not reflect the expenses associated with the management of an actual fund. Dimensional indices use CRSP and Compustat data. See “Index Descriptions” in the appendix for descriptions of index data.

 Trying to outguess the market is often a losing game. Current market prices offer an up-to-the-minute snapshot of the aggregate expectations of market participants— including expectations about the outcome and impact of elections. While unanticipated future events (genuine surprises) may trigger price changes in the future, the nature of these events cannot be known by investors today. As a result, it is difficult, if not impossible, to systematically benefit from trying to identify mispriced securities. So it is unlikely that investors can gain an edge by attempting to predict what will happen to the stock market after a general election.

 The focus of this election was Britain’s exit from the EU. But, as is often the case, predictions about the outcome and its effect on the stock market focus on which party will be “better for the market” over the long run. Exhibit 1 shows the growth of £ 1 invested in the UK market over more than 60 years and 12 prime ministers (from Anthony Eden to Theresa May).

 This exhibit does not suggest an obvious pattern of long-term stock market performance based upon which party has the majority in the Commons. What it shows is that over the long run, the market has provided substantial returns regardless of who lives at Number 10.

 Equity markets can help investors grow their assets, but investing is a long-term endeavour. Trying to make investment decisions based upon the outcome of elections is unlikely to result in reliable excess returns for investors. At best, any positive outcome based on such a strategy will likely result from random luck. At worst, such a strategy can lead to costly mistakes. Accordingly, there is a strong case for investors to rely on patience and portfolio structure, rather than trying to outguess the market, in order to pursue investment returns.

 I know I keep banging the drum as far as diversification and not timing or predicting markets is concerned but history has proven this to be the right strategy.

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Turn Down the Noise

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The Investment and Financial Services industry is noisy and is especially so in the middle of an election. Every day, thousands of articles, blogs, broadcasts, podcasts and webcasts are published, shouting for your attention and trying to make investment sexy.

It’s easy to fall into the trap of thinking that if you do not listen to the noise carefully and sift out the best ideas, i.e. the one’s that could help you find the highest returns—then you will not achieve your financial goals. Actually, we find the opposite to be true; trying to keep up with the latest investment fads can be detrimental to your long-term performance rather than beneficial to it. The noise can drown out the signal.

So what is the alternative?

We believe that it starts with having a strong evidence based investment philosophy that, over a long period of time, will prove to be rewarding for our clients. Our philosophy is based around some of the most enduring ideas in finance, these are ideas that help us achieve your financial goals by harnessing the power of capital markets in a systematic way. At the core, these fundamental concepts have remained the same for decades, but as research evolves into how markets work, our understanding improves and we develop our approach accordingly.

Added to this, we use investment managers that really take care over the details of implementation of the ideas. They understand that investment returns are precious and easy to lose in day-to-day management. They know it does not make sense to pay 5% in fees and costs to go after a 4% return.

This combination of a robust, enduring philosophy and a steady, disciplined application has helped us provide our clients with a way to turn down the noise.

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These foolish things

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I thought that this week I would share with you part of a document which was issued by Tim Hale of Albion Strategic Consulting who have recently helped us develop and refine our investment portfolios. It is a longer blog than usual but I think it is well worth the read.

We are all prone to making mistakes when investing, not because we are foolish, but because we are human. It does appear that a switch inside even the most sensible person seems to flick and rationality disappears in a cloud of emotion, when we begin to think about the markets.  This note highlights some of the dangers and provides some tips on how we can attempt to behave better.  In short, the answer lies in adopting a disciplined process.

Trap 1: I know that I am smarter than the other fools out there

The human being is, by and large, overconfident in his or her abilities. For example, out of 600 professional fund managers asked in a study (Montier, 2010), almost three quarters said they were better than average (in the same way that 80% of us believe that we are better than average drivers). A number of studies have shown that overconfidence leads investors to overestimate their knowledge, underestimate the risks involved and increase their perception of their ability to control events.

Mitigation strategy: Have some humility – plenty of very clever people get beaten up by the markets.

Trap 2: There is a distinct pattern emerging here

An easy-to-understand example of this behaviour can be seen on the roulette tables of Las Vegas. A rational gambler knows that the chance of any number coming up has the same odds as any other number of coming up.  Yet, a sequence of three or four ‘red 9s’ in a row, or other similar pattern, can create quite a stir at the table.  In investing, we often mistake random noise for what appears to be a non-random sequence.

Mitigation strategy: If you detect a pattern in shorter-term data it is probably meaningless and that includes active fund performance data.

Trap 3: Problems with probability (and maths in general)

As humans, we seem to really struggle with probability calculations and outcomes. For example, many people are willing to pay more for something that improves the probability of a specific outcome from, say, 95% to 99% than from 45% to 49%, yet the two outcomes are financially equivalent.  We shy away from even the simplest

The Solution to Uncertainty (Part 2)

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Carrying on from last week’s blog, I did promise to let you have our solution to dealing with uncertainty. We believe the very best tool for dealing with this issue is diversification. We allocate part of your investment to conservative fixed income investments to provide stability when equity prices fall and to rebalance into when equity prices rise. In addition, we also diversify the equity portion of your portfolio across international markets and types of companies.

In some instances, the entire stock market can move in unison. However, that is not always the case and different asset classes often behave differently at different times, but all have strong long-term performance characteristics.

As a recent example of diversification in action, consider the following difference in returns that even a single quarter can make;

4th Quarter 2016                              UK                          Overseas

Large Company Stocks                   3.89%                    7.08%

Value Stocks                                    4.19%                    11.17%

Small Company Stocks                   1.48%                    8.01%

 

1st Quarter 2017

Large Company Stocks                   4.02%                    5.1%

Value Stocks                                    1.0%                      3.0%

Small Company Stocks                   5.1%                      4.0%

 

During the 4th Quarter of 2016 overseas stocks significantly outperformed UK Stocks and this was mainly because of strength of both US Companies and the Dollar. The very next quarter the returns are generally aligned with each other.

You might think that if we were clever, we would be able to predict which is likely to outperform from quarter to quarter, but nobody can do that despite what they may think.

Over the long-term the expected returns of UK and Overseas stocks are similar, but as demonstrated here there is a diversification benefit to holding both. The benefit of a diversified portfolio is a smoother ride and a reduction in the uncertainty that can and will happen.

In short, we will never own enough of one thing to make an absolute killing, but in so doing we won’t own enough of one thing to get killed! If you have a reliable financial plan in place, you don’t have to make a killing to accomplish your goals. We believe the market return, which is there for the taking, is often sufficient to achieve a positive outcome to a solid financial plan.

 

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The Illusions of Certainty and the Value of a Financial Coach

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I would like to start by saying that we do not take any credit for the governments U-turn over the increased probate fees which took place within 2 weeks of our last blog! (see it pays to live).

Since then, we have had Theresa May (or Mummy to her cabinet colleagues) call a snap election, the results of the first round of Presidential Elections in France and the unpredictable first 100 days of the Trump Administration. All of these events could give rise to an increase in investor uncertainty.  On the contrary, this might imply that there is such a thing as investor certainty.  We can assure you this is not the case!

Warren Buffett says low-cost funds founder is my hero

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I know I go on about the cost of active investment management, but I am sure you will agree that Warren Buffett has more clout than me.

In his latest annual letter to his investors he referred to Jack Bogle the founder of Vanguard, which transformed investing forever with the index fund, as a hero for protecting millions of investors from the high cost of active investment.

Warren Buffett has estimated that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade.

Buffett stated: “If a statue is ever erected to honour the person who has done the most for American Investors, the hands down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.”

Buffett saved his most brutal attack for the hedge fund industry, stating that a number of smart people are involved in running hedge funds, but to a great extent their efforts are self-neutralising and their IQ will not overcome the costs they impose on investors. He then went on to say the problem, simply, is that the majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.

He advised investors of all spectrums to make more use of index funds and went on to say: “The bottom line: when trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

Bearing in mind that investment management fees are generally higher in the UK than the US, UK investors are likely to be even better off long-term by following Warren Buffett’s advice. This is why we advocate the use of low-cost funds by using the likes of Vanguard and Dimensional, so that you, as our client, retain more of the investment performance than you would if you invested in actively managed funds.

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Keep your heart out of investing

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Hello and Happy Valentine’s Day to you all.   Tonight, I will be spending a lovely evening with Nicky, cooking and eating a great meal and employing the kids as waiters or minders to keep our two-year old son out of the way with his football – just long enough for us to have some quality time together.

The thought of the day ahead, as I planned the menu for the evening, got me thinking about whether there was a place for the heart in investment and financial planning. Oh dear, get a life I hear you say…maybe you are right, but here goes!

Emotion and money seldom make good bedfellows and I think we have empathised this many a time together with the view that investment should be boring.

Hot funds or stocks aren’t guaranteed to keep going up and those that have plummeted may not go lower, in fact the opposite is likely to be the case. We get overconfident in our investment ability and put too much into a certain share or our favourite sector, and fail to diversify. We also try to predict the markets, but do we really think that the Sunday paper columnist (if he could predict the future) would be telling everybody how it can be done or would they just keep it to themselves and make their own fortune?

So, unfortunately there should be no emotion in your financial plan. It is a long term document and there will be mishaps along the way, but if you stick to the plan they will iron themselves out.   Hey, wait a minute, isn’t that is a lot like relationships?  They aren’t all plain sailing either. Except that the plan is there to achieve your financial goals and, if they are achieved, then it makes your emotional life far less stressful, so you can both enjoy yourselves without having to think about the money.

If music is the food of love, feel free to play on, but if your heart rules your head in finance, don’t expect to play for too long!

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If I were a rich man…

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We tend to assume that wealth is accumulated over time, often growing fastest in the later working years. Yet, in a broader sense, we are all born with wealth in the form of human capital, which represents the value of the earning potential that we have over our working lifetime.  As younger people have a long time to go before they will need the money, the advice they receive is often that excess earnings should be invested predominantly in equities.  A subtler approach considers the attributes of each person’s human capital which ranges from bond-like to equity-like in nature.  How assets are invested should, ideally, take this into account.  Cash-flow modelling can help those in the accumulation phase of investing to understand the financial impact of changes to their human capital.  Owning sufficient life cover to protect the outstanding human capital should also be an important part of the discussion.

If I were a rich man…

‘No man is an island, Entire of itself, Every man is a piece of the continent, A part of the main.’ John Donne, 1624

We are all born rich

Most of us have held a newly born child – our own perhaps, or that of a relative or a close friend – and in its fragile, dependent state wondered what life has in store for him or her. We perhaps frame these thoughts in terms of the current state of the world and the tough climate for young people struggling to get onto the housing and jobs ladder.  According to the Resolution Foundation[1], the younger generation is the first in living memory to be worse off than their parents.  Yet perhaps we should frame our thoughts in a more positive manner, starting with how rich every child is at birth.

We tend to see wealth as accumulated financial assets, large houses, nice cars and the freedom and time to do the things that are important to us. Yet on the very day we are born we are wealthy in terms of our human capital, or in other words, the present value of all the future earnings that we can accumulate over our working lives.  Part of those future earnings are turned into financial assets, which ultimately deliver income in our retirement.

From a financial perspective, our lives can be divided into three distinct phases:

  • Phase 1 – growing up and getting educated: this phase is of enormous importance to our financial lives; there is plenty of evidence to show that investment in education at a tertiary level can have a big impact on future earnings. Investing in education may well have a far larger impact on wealth than the rate of return achieved if the money spent was invested instead.
  • Phase 2 – working: this phase presents investors with a range of choices, not least how to invest excess earnings and protect their human capital from sickness or even premature death.
  • Phase 3 – retirement: this phase possesses its own challenges, particularly how to invest assets to deliver stable retirement income, without running out of money.

Today, investors must take far more responsibility for their financial assets than ever before and maybe need to think a little more deeply and subtly about how to structure their investment assets.

Today is not like yesterday

Up until the mid-1980s the conversion of human capital into retirement income was far more straight forward and considerably less risky than it is now, as companies offered their employees generous defined benefit pensions, i.e. a percentage of final salary that would be paid monthly on retirement, usually with some form of inflation protection. This income, coupled with the state pension, provided a stable, inflation-proofed, risk-free income for life.  Excess earnings could be squirrelled away into extra savings, paying down debt quicker or the purchase of a second home.  Today, £50,000 of inflation-proofed income, purchased at age 65, would cost over £1.5 million via an annuity.  Rejoice if you have a defined benefit pension!

However, for those still working today – and some more recently retired – such income security does not exist. The demise of defined benefit pensions – a sad story of government and corporate mismanagement – is too long a subject to be explored in this short note.  However, the impact of these changes, including the transfer of income risk from corporations to the individual, combined with a more flexible, fluid and entrepreneurial work environment are worth noting.  These changes have a material impact on the process of turning human capital into financial capital.  How one invests these assets, protects the value of human capital and secures a stable retirement income matter.  These are not easy decisions to make without the help of a good financial planner.

Human capital slowly converts into financial capital across a working life

At the start of a person’s life, human capital represents the major part of his or her total wealth, when wealth is viewed in this broader context. As they progress through their working lives, some of their earnings will be converted into financial assets in the form of payments into defined contribution pensions (by employer and employee), other investments and a family home.  At retirement, human capital is exhausted, unless the retiree does some part time work.  Financial assets then take over the financial burden of delivering income, supplemented by other sources such as a state pension and rental income, if they exist.  The schematic below illustrates this relationship in a generic form.

Figure 1:  Human capital, financial capital and total wealth

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Source: Albion Strategic Consulting

It is interesting to note that in many instances, toward the end of a person’s life, residential property may well be the principle asset, as other financial assets have been depleted.

Careers can be bond or equity-like

When it comes to saving and investing for retirement, i.e. the accumulation phase as it is sometimes known, advice has often been quite generic suggesting that as the investor has a long time horizon, they should invest more in equities to obtain a higher rate of return than holding bonds or cash. In general that makes sense for many.  However, the risks associated with each person’s human capital will vary widely.  This is plain to see looking at three different career paths:

  • Low risk: A tenured professor at a university has great job security and a regular, inflation-linked income that will rise in a predictable manner. Her or his human capital acts like an index linked bond.
  • Higher risk: A salesperson, whose high remuneration is based on commission, and who faces the threat of being fired if targets are not met, has higher earnings risk. His or her human capital acts more like a high yield (lower quality) bond, delivering strong returns when times are good but doing poorly when times get tough.
  • High risk and correlated: An entrepreneur launching an online retail equity trading platform has even more earnings risk. His or her income and rewards are both variable and uncertain and, more importantly, income is likely to be correlated with equity markets. Human capital, in this instance, acts like an equity.

So, if they are all 40 years old and have the same level of financial capital, should they all invest in the same way? Intuitively, the answer is no.  As Burton Malkiel stated in his seminal book A Random Walk Down Wall Street:

‘The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income’

Those with more bond-like human capital could well take on more risk and those with more equity-like human capital should, perhaps, take on less risk with their financial capital. Ironically, it is also possible that those who choose steady, stable jobs may have lower tolerance to losses than the entrepreneur, and vice versa.  One can see the risk of this scenario.  Additionally, two partners may also have different levels of risk in their human capital. Imagine a professor married to an entrepreneur; together they form a balanced portfolio between bonds and equities and their investable portfolio of financial capital should reflect this.

Figure 2: How human capital attributes influence asset allocation

Lower equity content in portfolio Higher equity content in portfolio
Low job and earnings stability High job and earnings stability
Low earning flexibility High earning flexibility
High correlation of earnings to equities Low correlation of earnings to equities
Low earning capability High earning capability (replenish losses quickly)

Source: Albion Strategic Consulting

In effect, investors should invest their financial assets in a way that provides both balance to, and diversification of, their human capital during the accumulation phase. In some extreme circumstances, it might be necessary to adjust an investment portfolio to avoid the specific industry risks that relate to a client’s human capital.

Human capital should be treated like any other asset class; it has its own risk and return properties and its own correlation with other financial asset classes.

Ibbotson, Milevsky, Chen and Zhu (2007)[2]

As an example, one of the saddest outcomes of the Enron collapse in the US in 2001 was the fact that many Enron employees held Enron stock in their pension plans making their human and financial capital highly correlated with devastating consequences.

Protecting human capital risk

As part of a comprehensive financial planning process, two key forms of protection exist that will need to be discussed. The first is protecting human capital using income protection and life insurance.  The second is protecting retirement income through the purchase of annuity.  The astute reader will spot the fact that these are exact opposites; one is a bet on dying early and the other is a bet on living a very long time.

Purchasing life insurance, which is a perfect hedge for human capital risk, needs to be modelled based on the outstanding level of human capital, which reduces with time as human capital is converted into financial capital. Fortunately, when most life insurance is needed (young and with a family), it is relatively cheap to obtain.  In a simple sense, the life insurance cover needs to fill the gap between accumulated financial assets today and the target level of assets at retirement.

Conclusion

The true value of cash-flow modelling by a financial planner is the ability to take both human and financial capital into account and to run severalp scenarios for each. It is difficult to see how a stockbroker or investment manager can structure a portfolio sensibly, particularly where the investor still has substantial human capital, without the insight into, and modelling of, the client’s total asset picture.  No financial portfolio is an island.

so, The next time you hold a baby, remember just how valuable and unique he or she is in so many ways, not least in terms of human capital.

 

 

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]     Resolution Foundation (2016), Millennials facing ‘generational pay penalty’ as their earnings fall £8,000 behind during their 20s, www.resolutionfoundation.org

[2]    Ibbotson, Milevsky, Chen and Zhu (2007), Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, Research Foundation of CFA Institute publication.

Tax efficient saving – right place, right time and right order

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Tax-incentivised, tax-free, or potentially tax-free are some of the savings choices on offer. Failing to make the most of these will mean you may pay unnecessary tax on income and savings. However, saving into the right tax wrappers at the right time, and crucially in the right order, can limit the tax paid.

The introduction of new tax-free allowances means that there is now greater scope to save and pay little or no tax on those savings. The new £5,000 dividend allowance and £1,000 personal savings allowance bring the total tax free allowances available in 2016/17 to £33,100.

Tax-incentivised savings such as pensions, and tax-free wrappers such as ISAs, are clearly preferable to savings which are potentially taxable. Consequently, when deciding where to save these should always be the first choice.

But pensions and ISAs come with a savings cap. The tax relief on pensions funding is controlled by earnings, the annual allowance and lifetime allowance. There is also a maximum subscription limit of £15,240 (rising to £20,000 from 2017/18) on ISA saving.

Once these pots have been maximised it may still be possible to achieve similar tax efficient returns on other investments with a little bit of careful management of allowances of course.

Unit trusts and OEICs The new dividend allowance creates an opportunity for virtually tax-free saving by building up a collective portfolio where income tax and capital gains tax can be ‘managed out’ by using the respective allowances.

This can be achieved by keeping dividend income to below £5,000 a year, and realising capital gains annually from the portfolio within the annual CGT exemption (£11,100 for 2016/17).

The portfolio value at which no tax will be due will, of course, depend on investment returns, but they could look something like this if allowances are fully used:

Portfolio size Dividend Yield Tax free income Cap. growth rate Tax free growth
£200,000 2.5% £5,000 5.5% £11,100
£400,000 1.25% £5,000 2.75% £11,100
£500,000 1% £5,000 2.22% £11,100

The order of saving For those who use their tax incentives and allowances efficiently, the order in which they are most likely to fill their savings pots is:

  1. Pensions The combination of tax relief on contributions, no tax on income/gains within the pension fund and 25 per cent tax-free cash make pensions difficult to beat as a means of long-term saving.
  2. ISAs Similarly, investments within an ISA do not suffer tax on income and gains. In addition, the ISA can be accessed at any time without giving rise to a tax charge.
  3. Unit trust/OEICs Building up a portfolio so that dividends and gains can be kept within the available allowances can create a fund which is potentially tax free.
  4. Offshore Bonds Income and gains within an offshore bond enjoy gross roll up and are tax-deferred rather than tax free. But there is the potential for them to be tax free if gains can be taken when clients’ or their intended beneficiaries are non-taxpayers.

The tax saved helps to optimise returns and this, combined with reducing the management charges for investment, means that you keep more of what you’ve saved to spend or pass on to your families.

 

Why sissies make great investors

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I was recently forwarded this article by Robin Powell of Regis Media and thought it was worth sharing the contents.

A funny thing happened the day after Christmas.  An unknown rookie basketball player by the name of Chinanu Onuaku stepped up to the free throw line and threw the ball underarm, or “granny style”, towards the hoop. The crowd gasped and then erupted as he scored the point.

Now, I’m less than six foot with a very rudimentary knowledge of basketball. But I’m reliably informed there is academic evidence that throwing the ball underarm gives the thrower the best possible chance of making a free throw. Until now, though, it hasn’t been seen in an NBA game since retirement of granny-style pioneer Rick Barry in 1980.

So, why did no professional basketball player until now try to replicate Barry’s success by perfecting the technique that is proven to deliver the best results?  According to Adam Kilgore in the Washington Post, “players uniformly resisted it, afraid of looking foolish, standing out as childish or unmanly”. Wilt Chamberlin, who briefly flirted with underarm free throws in the early 1960s, apparently reverted to the conventional style because he “felt like a sissy”.

There’s a very similar phenomenon to this in football. Ten years ago, Ofer H. Azar, an economist at Ben-Gurion University of Negev in Israel, conducted an experiment involving professional goalkeepers. What he wanted to find out was how they dealt with a high-stakes decision, namely what to do at a penalty kick, and whether it helped to explain the behaviour of investors faced with making similarly big decisions under pressure.

Azar’s research team analysed more than 300 kicks and concluded that the action that was most likely to prevent a goal being scored was, perhaps surprisingly, to stand in the middle of the goal and do nothing until the trajectory of the ball can be seen. This resulted in a success rate of one in three — far higher than the average.

But goalkeepers very rarely do that. Instead, they typically try to guess which way the ball is going to go before the player’s foot has actually made contact with it, diving left or right, to try to be in the right spot when the ball arrives. The researchers found that diving left resulted in success 14 per cent of the time, and diving right only 12.6 per cent.

Crucially, when they asked why the goalkeepers who took part in the experiment why they didn’t just stand and wait more often, it emerged that the overriding reason was the fear of what others would think of them. In particular, they didn’t want to give the impression to the crowd or their teammates that they weren’t trying or taking the situation sufficiently seriously.

What fascinates me is how analogous these two examples from the sporting world are to the response that many people have to evidence-based investing. It doesn’t matter how many times you tell them that this is a good way to invest or that is a bad way; some people will always act irrationally.

Humans are very much social animals. We pay huge attention to what others are doing, and to how other people perceive us. As a result, we’re often scared to do the opposite, even though we know, on a rational level, that’s just what we should be doing.

No, buy-and-hold indexing isn’t cool, it isn’t macho and it won’t make you the most interesting guest at a dinner party. But the evidence overwhelmingly tells us it’s the best way to invest.

Go on, be a sissy. And, as William Bernstein would say, “Let them laugh. The joke’s on them.”