You Probably Can't Outperform the Market - Here Is How You Should Invest Once Accepting That

21/05/2014 13:31 BST | Updated 20/07/2014 10:59 BST

As investors we are bombarded with stock tips about the next Apple or Google, read articles on how India or biotech investing are the next hot thing, or are told how some star investment manager's outstanding performance is set to continue. The implicit message is that only the uninformed few fail to heed this advice and those that do end up poorer as a result. We wouldn't want that to be us!

What if we started with a very different premise? The premise that markets are actually quite efficient. Even if some people are able to outperform the markets, most people are not among them. In financial jargon, most people do not have edge over the financial markets; they can't consistently outperform the market by picking different securities / sectors / geographies from the market as a whole, especially after costs. Nor are they able to pick which of the thousands of fund managers have the ability to do it for them. Accepting, embracing, and acting on this absence of edge should in my view be a key moment in most investor's lives.

The absence of edge does not mean that you should avoid investing. Doing so would exclude you from potentially exciting long term returns in the equity markets, or benefitting from the security of highly rated government bonds. Also, what else were you going to do - leave your money under the mattress or in a bank at zero interest? Instead we should assume that the current market prices of securities capture all available information and analysis, and that the price reflect that security's future risk/return profile. In equities we should then pick the broadest possible selection of stocks because just like we don't know which one stock will outperform, we don't know which sector or geography will outperform.

And what is broader than an index that track equities from all over the world in the proportion of value that market forces have already put on them? With a world equity index tracker we maximize diversification and minimize exposure to any one geography, sector, or currency. And since we simply track an index (like the MSCI All Country World, etc.) it is very cheap to put together for a product provider like Vanguard, iShares, etc., and thus cheap to us. If an all equity exposure is too risky, you can combine this world equity portfolio with government bonds in the proportions that suit your risk profile. The lower the risk desired, the more bonds you want.

So my key takeaways to most investors can be summarized as follows:

1. You almost certainly do not have edge in the financial markets. That's ok. Most people don't, but you should plan and act accordingly.

2. There is an easy and cheaply constructed portfolio which is close to optimal. It combines the highest rated government bonds in your currency (so £ for British investors) with the most diversified possible world equity portfolio. Get close to that in the right proportions, which depend mainly on your risk tolerance, stick to it and in my view you are doing better than 95% of all investors. That's it - two securities: one being an index tracker of world equities and the other a security that represent government bonds of maturity and currency that match your need. Both equity and bond exposure perhaps via an ETF. Simple perhaps, but you capture an incredible diversification of exposures via the equities and the portfolio is at your risk appetite when you incorporate the bonds in a proportion that suit your risk. You can add other government and diversified corporate bonds if you have appetite for a bit more complexity in your portfolio, but the portfolio is very powerful even without those.

3. Your specific circumstances do matter a great deal. Think hard about your risk appetite and optimizing your tax situation. But also pay attention to your non-investment assets and liabilities - many people already have a disproportionate exposure to their domestic economy through their house and some sector via their jobs. Don't add to this concentration risk with your investment portfolio.

4. Be a huge stickler for costs, don't trade a lot, and keep your investments for the very long run. The portfolio above should only be implemented via extremely cheap index tracking products that charge 0.25% per year or less.

Follow these steps and I think you will have a personal portfolio strategy that lets you sleep well at night, knowing that you have created a powerful and diversified portfolio cheaply, tailored to your risk appetite. To emphasize the point of costs, suppose you are a frugal saver who diligently put aside 10% of £50,000 annual income from the age of 25 to 67 that you invest in world equities. Further assume markets return 5% real per year in line with historical returns (ignoring taxes). Considering a typically 2% annual cost difference between an index tracking product and an actively managed fund (potentially in addition to the cost of an advisor), as you get ready to retire at age 67 the difference in the savings pot is staggering. You are left better off by perhaps £250,000 in today's money simply by investing with an index fund as opposed to an active manager.

If you think you have great edge in the market and think you could easily make up this 2% annual cost difference then by all means pick an active manager or your own stocks. If not, then the sooner you shift out of the expensive investment products or active stock picking and into cheap index tracking products the better off you will be. To put things in perspective consider that these additional and unnecessary fees for just one saver over their investing lives could buy 6 Porsches. And paradoxically this is money paid to the finance industry from a saver who could typically not afford to drive a Porsche.