One of the most destructive forces in investing, and how you can escape it

Investing is risky by nature. But one of the biggest risks of all gets very little attention in the press. John Stepek explains what it is, and how to defend your wealth against it.

We all know that we should invest for the long term.

Making short-term punts, ducking in and out of stocks in reaction to headlines, and generally trading too much, is a recipe for losing money.

Yet it's very tempting. If you're remotely interested in the workings of the financial markets, then it's very hard not to pay attention to their ups and downs. And when you see hot' stocks doing well, or exciting new trends taking off, you naturally want to get on board.

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So you might be tempted to take the decision out of your own hands, and give all your money over to a fund manager to invest.

The trouble is, what few investors realise is that the professionals' are beset by exactly the same emotions. In fact, if anything, it's even harder for them to resist the urge to invest for the short term.

Here's why and what it means for your money...

Fund managers' incentives are all wrong

As Paul Woolley and Dimitri Vayanos point out in this morning's FT, the long-term' versus short-term' investing debate is a bit of a hot topic among governments just now.

The most recent paper on the topic has come from the G30 (a think tank comprised of various economists and former central bankers and regulators). According to Woolley and Vayanos, they argue that regulators should draw up "best-practice guidelines" for long-term investors such as pension funds or sovereign wealth funds.

The idea is that this code would help all investors to understand just how damaging the current approach can be to their money.

So what sort of thing would be in it? Interestingly enough, it's the sort of thing that we've been banging on about for a long time.

The distinction between short and long-term investing is not just about the length of time you hold an asset for. What really matters, say Woolley and Vayanos, is "the investor's choice between the two basic investment strategies of momentum trading and fundamental investing."

Momentum traders forget about trying to value stocks or any other asset. They just buy when prices are rising, and sell when they're falling. The tools of the trade will usually involve charts and technical analysis.

Fundamental investors try to work out the fair value' of an asset, based on things like cash flow, and profitability, and balance sheet strength. They'll look at the books and pore over ratios. If they find something that's sufficiently cheap, they buy, sit back, and wait for the price to recover.

Both approaches have their place. Dedicated momentum investors can do very well. And fundamental' investing has made the likes of Warren Buffett a lot of money over the years.

The trouble is, lots of fund managers who purport to be using fundamentals, are really just chasing performance. And this largely comes down to the way the finance industry is structured.

Fund managers are measured on short-term performance. If the FTSE 100 goes up by 10% over three months, and a UK equity manager's fund goes up by just' 5%, you can bet he's going to get some angry phone calls. If the FTSE 100 slides by 20% over three months, and the manager loses just' 10%, nobody will complain.

So why would you bother searching for value? Your best bet for a quiet life and some relatively easy money is to hug your benchmark as tightly as possible. If that involves over-trading and racking up lots of costs, so be it. As long as your performance is merely mediocre, and not downright catastrophic, your job will be safe.

It's called career risk'. We've discussed it many times in the past. It's probably one of the most destructive forces in the market.

The solution to career risk

Woolley and Vayanos come up with some good ideas for what should be in a long-term investing code'. For example, they suggest capping fund turnover at 30% a year, and scrapping performance fees based on short-term results.

Persuading investors to look at other measures of success when choosing funds, could help to push a change of attitude in the business. Particularly now that the consumer focus is falling so heavily on costs.

But you don't have to wait for this to happen. As an individual investor, you don't have to worry about justifying your performance to anyone else. So all the distortions caused by career risk' vanish when you take your investments into your own hands.

You don't have to worry about beating, or matching a specific benchmark. All you need to do is to keep your nerve. That's easier said than done. But right now, my colleague Phil Oakley is working on a newsletter that looks at how to build a simple, core portfolio that should help you to grow your money through thick and thin in the long run. It's still in development but I'll keep you up to date on it as we go along.

How to profit from short-term trading

This said, I wouldn't dismiss momentum investing out of hand. Momentum or trend-following can be a very successful strategy. But you need to know what you're doing.

You can of course try out spread betting (sign up for our free MoneyWeek Trader email if you're interested). But it's always worth remembering that most spread betters lose in the long run. It's not a route to easy riches.

So this is one area at least where I'd suggest it's a good idea for most investors to delegate the job to an expert. If you're interested in profiting from momentum, regular MoneyWeek contributor Tim Price has tipped a trend-following fund, the BlueCrest BlueTrend (LSE: BBTS) fund a few times in the past.

It's fair to say that the share price has done very little over the past year or so. But so far this year, it's looking as though markets may start to trend more strongly. We've seen big, dramatic moves in everything from stocks to currencies.

So the environment for trend followers may be improving. It was one of Tim's tips for 2013 in our New Year Roundtable. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.