Do you remember playing pretend when you were little? Maybe you were a superhero, a dinosaur or a princess. It’s normal when you’re little, and it’s usually harmless. Most children know the difference between pretending to be a superhero and jumping off the roof thinking they can fly.

But adults often forget.

For instance, we may stop pretending to be superheroes, but a lot of us seem convinced that we can pretend to be investors. That’s dangerous.

1. Pretend investors think that financial pornography is real, so the ticker tape scrolling across the television screen all day represents actionable information.Real investors know it might be entertaining, like going to the circus, but they would never make a decision because of it.

2. Pretend investors think it makes perfect sense to change their investments based on what they hear in the news: There’s a new president, so act! He doesn’t like the Federal Reserve, so trade! He criticized bankers, so buy bank stocks!Real investors know that they make changes to their investments based on what happens in their own lives. If their goals change or there is a fundamental change in their financial situation, then they consider an alteration. But they would never make a change based on someone yelling “buy” or “sell” on television.

3. Pretend investors think they need to monitor their investments all the time. The little supercomputer they carry around in their pockets makes it so easy.Real investors know that it takes a long time for a tree to grow, and it will not help to dig it up to see if the roots are still there. The same rule applies to investments. And because watching things get big slowly is not very exciting, real investors tend not to talk about that tree all that much.

4. Pretend investors talk about their investments — a lot. They say things like, “I’m long this, or short that.” They use jargon that often does not make sense, though it sounds kind of impressive if you don’t listen too closely. Sometimes they cheer for things like increased consumer spending, higher unemployment, or in some cases, war.Real investors understand the difference between the global economy and their personal economy and choose to focus on the latter.

5. Pretend investors will worry endlessly about the news in some far-off part of the world or the impact on their portfolio.Real investors focus on the things they can control, like saving a bit more next year, keeping their investment costs low, not paying fees unless it’s necessary and managing their behavior by not buying high and selling again when prices are low.

6. Pretend investors complain endlessly about volatility in the market and external actions that have short-term impact on the big bets they have made on individual stocks.Real investors have enjoyed the benefits of a market that is up more than 180 percent in the last 20 years.

So ask yourself this: Isn’t it finally time to stop pretending now?

SOURCE: BEHAVIOUR GAP

The ASX/200 has gone nowhere in ten years and nor have the associated ETF’s. “Most fund managers underperform the index’ Why?

This story as we all know is getting a good working over from the press. Investors are not only realising that the they are getting fleeced by index managers but in fact there are alternatives if they’re prepared to do the research. The distractive lure of ‘index performance’, diversification and purported low costs no longer resonates with the astute investor of today. Like the politicians of the world we are sick of the hypocrisy and simply no longer believe them. Why should our portfolio’s shrink in value? With correct risk management settings there is no reason.

The growth of passive investments here in recent years is more a symptom of crowd behavior and lack of alternatives. In the US these index funds are at a much lower cost and also tax deductible. That makes sense but you are still subject to down swings in the market. And as to the growth of the ETF alternative, I’ll come to that shortly. As with many shortsighted investment strategies they are fine when things are going well but when the fat lady sings, carnage sets in.

We need to be educated and as smart as possible, not accept average performance, and think about achieving real returns rather than the distraction of benchmarks and indices. The reality is that the index has gone nowhere for ten years and ETF investing is simply a reflection of an index only it is a listed entity. Just as the heavily laden leader based index has performed poorly so to has the midcap and smaller cap indices. BUT if you had selected your stocks right, like a good active manager should, you would grow your equity. By ignoring the ‘weak’ and focusing on the strong you can generate an absolute positive return year on year. Now that’s the benchmark we want.

Now to ETF’s. Yes they offer a spread of stocks based on a sector or country. It seems a godsend and the cheap ‘answer’. But Richard Montgomery highlighted the reality in this weekend’s Australian of the crime that is an ETF. Take the example of a large market capitalised stock in an index that is an ETF. The provider receives funds that must reflect movements in a basket of stocks. In spite of the fundamental performance of a stock, to reflect the movements in a basket of stocks it must blindly purchase or sell a stock to reflect the fund inflows. So their growth is a self-perpetuating phenomenon as it distorts the price of the underlying stock. Montgomery uses the example of Exxon, which since 2013 has had a revenue decline of 46%, EPS decline of 74%, a debt increase of 129% but as it is included in an S&P index and a variety of specialist ETF’s. It has had a share price increase of 4%. Despite the fundamental structural deterioration of the stock it is unrealistically being propped up because of a weight of money being thrown at an ETF with both good and bad stocks. When the outflow starts the reality will hit and dominos will start to fall. The reverse is also true in that the good will be dragged down by outflows. It will be dependent on the current market ‘whim’.

So ETF and Index investor’s face the risk of permanent capital decay, volatility, average performance and an unrealistic divergence between price and fundamental value giving active managers that play an ‘edge’ a big edge, so to speak. On any level large, midcap or small, accurate stock picking will easily seek out and find outperformance. Index investors will have to be exposed to rubbish stocks but if you exclude those stocks from your portfolio then will you easily outperform and are well on the way to generating positive returns. As Montgomery points out indices were originally designed as a measure of market activity not as investments.

Now just to be extra safe with our active management strategy based on an ‘edge’ and to be confident your capital is safe in times of crises, which at any stage we can be exposed to, a quality risk management process that doesn’t carry drawdowns past say 15% would seem a sensible safety net to include. Some upside may be forsaken to ensure the downside is protected but that’s smart investing.