Oxford Today editor Richard Lofthouse learns some vital secrets in a tête-à-tête with one of the great public intellectuals of our day.

How you can beat the bankers at their own game

By Richard Lofthouse

A fellow of St John’s College since 1970, when he was also a lecturer in economics, John Kay is one of those rare individuals who successfully balanced academia and education with boardroom positions at public companies and in finance. He was also the inaugural Dean of Oxford’s Saïd Business School when it opened its doors in 1997. His significant output of publications that are actually intelligible to a lay public has cemented his position as one of the great public intellectuals of our day.

We agree to meet at a modest brasserie in London’s Marylebone, far west of the Square Mile and pointing, one might say, towards Oxford. Although Kay’s most recent book is a second edition of The Long and Short of It, aimed at you and me as investors of our savings and pensions, he immediately hands me a paperback copy of Other People’s Money, first published in 2015 and subtitled Masters of the Universe or Servants of the People?

How you can beat the bankers at their own game

How you can beat the bankers at their own gameHe kindly signs and dates it, and we order from the prix fixe menu — I joke that I am insisting on a structured product because it is better value than a la carte. Thepoint made at some length in The Long and the Short of It, in respect of structured products aimed at individuals (such as protected equity, kick-out bonds and other sorts of ‘bundled’ products) is that the exact opposite applies: ‘the cost of the structured product is generally higher than the cost of the components and the premium is the source of the financial engineer’s profit.’To my relief, he agrees with a grin that we’re probably better off here with the menu of the day, and heads for sea bass atop chick peas.

Kay has insisted that both books are ideally read together, and well after our lunch has concluded, I realise why. Other People’s Money is in some ways Kay’s masterpiece, because it wields a razor over the whole world of finance and financial services, and serves up the best analysis I have read on what went wrong and why in 2008–9.

One of the summary arguments that threads through the book is that any society at any given moment has a particular stock of assets, ‘so trading in secondary claims in existing assets cannot be adding value’. If one group of people are making fabulous salaries and bonuses they are doing so at the expense of someone else, even if the ‘someone else’ is (for example) a regional German Bank tricked by an American investment bank into buying collateralised mortgage debt in 2006. Kay later notes in a further email exchange, ‘The way I often explain this is to say that if we lock the doors of a room and spend the evening trading bits of paper with each other, the value of the bits of paper we leave with will be the same as it was when we entered — just distributed differently.’

The trick of financiers for a long time was to persuade everyone — including even the highest levels of government — that this was not so, and that they were the engine of fantastic growth and even deserved very special treatment. Even after 2008–9 that trick has not lost its allure. We are still living with the aftermath — even as I wrote this piece, Deutsche Bank announced that it would seek to raise €8 billion, the third such fundraising since 2013. The money will come from somewhere, and at the expense of healthcare or motorways or education. Other people’s money, in other words.

How you can beat the bankers at their own gameEven after 2008–9, the financiers’ trick retains its allure

 

I feel a Warren Buffett phrase bubbling up in my head and think to mention it. He said of the financial services world, with its arcane language and self-referential culture, that ‘priests of any profession need complexity to keep the laity from performing their priestly magic’. Kay nods. So much of his work has been to cut through that complexity.

This is where a glass of wine emerges and we start to discuss The Long and Short of It. A sharply intelligent book throughout, it reflects Kay’s additional forte as an educator. He repeats himself from time to time to drum home the message that fund managers’ priorities are different from yours. For them, and for the Square Mile, it is ‘better to fail conventionally than to succeed unconventionally’. This, then, is the premise of the book: that you and I should take control of our own investments. Even if we only copy the professionals we’ll do better, because we won’t be paying their fees.

How you can beat the bankers at their own game

Kay says we should aim for a return of 8% per annum, but I query that; even the Telegraph’s Questor column only shoots for 5%. He says it might be a bit aggressive, yes; but the point he’s making is partly instructional. If you take the now-tarnished world of hedge funds, and their traditional ‘2 and 20’ model of charging annually 2% of monies under management and 20% of profits above a certain threshold, it’s quickly apparent that compounded returns are ravaged by fee deductions — and that’s assuming there is a return at all, which is not guaranteed in today’s environment. Yet build your own portfolio of stocks and you have become your own manager, with zero charges beyond stamp duty and commission. It is not inconceivable to achieve an 8% return, he says, but it is quite aggressive.

The Long and the Short of It roves around a lot and has much to recommend it for the curious and the academic-minded. Kay knows his economic theory and wants to share it. The book rewards patience. To some extent you have to do the work, and in lots of places it slides into what may feel to neophytes like a briefing note for professionals, not the ordinary (but intelligent) audience he has in mind.

Above all Kay returns time and again to this signal moment in his own investing history, when he bought a ‘risky’ share called Robb Caledon. It was the seventies, and the stock stood to do very well or very badly from an impending government decision. Kay bought the stock and it did very well. His point is not that he won a wager, but that conventional thinking suggested that you could not make this investment, because it was conventionally risky. But as part of a well-diversified portfolio it was not actually that risky. What might be more risky is to be thoroughly conventional, chasing blue chip stocks whose returns will be modest and not necessarily as reliable as they might appear.

Here we reach the defining thesis of the book: that risk is about lots of things including — if you think about it — the risk that conventional thinking leads to humdrum returns. If you follow the herd you will not do very well. The avoidance of loss is different, Kay argues, from achieving low risk.

How you can beat the bankers at their own gameBenjamin Graham and Warren Buffett are two of the heroes, in Kay’s book

Achieving low risk in the true sense means diversifying investments so that they are to all intents and purposes uncorrelated with each other. This is the ‘mind your portfolio’ principle and possibly the most important single idea in the book, for practical success as a private investor. Contrarian thinking is often rewarded. That means seeking out unfashionable sectors whose time will come again, but whose valuations are low. If in the short term the market is a voting machine, in the longer term it is a weighing machine, says Kay, citing mid-twentieth-century investment giant Ben Graham. Reversion to mean value will take place sooner or later, even if markets can be stubbornly ‘wrong’ for a long time and are less efficient than some theory insists. 

Benjamin Graham, Warren Buffett, Charlie Munger and George Soros are the heroes in this book, because they all had or have the measure of life, and of investing as part of it. Graham published a now-famous book in 1949 simply titled The Intelligent Investor. If Kay has sought to update it post-2008/9, then the appearance of a second edition late in 2016 suggests that he is on his way to succeeding.

How you can beat the bankers at their own gameThe sea bass has come and gone, and we’re onto the coffee. Kay is delightful company. He wears a very slightly sardonic grin that counts for worldiness tempered by the weight of knowing full well how badly the world of finance has served society in recent decades. In Other People’s Money he goes so far as to conclude that the apparent, enormous prosperity of the financial sector is largely if not wholly illusory — he uses the exact words ‘wholly illusory’ but within a fictional fable epilogue called ‘The emperor’s guard’s new clothes’. It’s meaning is plain enough and conjures up once more the imagined room with the doors locked, a long night’s trading ahead but zero value creation to the ‘real economy’. At the end of it all, the bits of paper are the same bits of paper, ‘just distributed differently’.

But the silver lining of all this lies in The Long and the Short of It, where in one definite sense Kay makes you realise that you can profit from the system, not by subverting it or cheating, but simply by becoming your own fund manager. He never lays down a blueprint, but sketches some starter ideas (they’re on pages 218–19). But what he really advocates is that we all go beyond dogma and dictums, to make intelligent investment decisions about actual companies, sectors and geographies, based on our actual needs, age and financial goals.

The experience of reading about it is bracing, if a bit nerve wracking. I can think of lots of people who will do nothing differently with their savings as a result of reading this book, through a combination of inertia and (one might argue) folly. But there may be others who enjoy the advice and act on it.

John Kay’s The Long and Short of It is published by Profile Books (2nd edition, December 2016).

John Kay photographed by Richard Lofthouse at dinner and by Ineta Lidace of Bella Studio Photography with books; stockmarket board by Blue Planet Studio, tablet by leungchopan, Warren Buffett by Krista Kennell, all via Shutterstock; Benjamin Graham image via Wikimedia Commons; book jackets by Profile Books.

Comments

By Chris Miller
on

Even for those with £100,000 of 'spare' cash to invest, an 8% return amounts to £8,000, on which tax must be paid. Whether this is worthwhile depends on how you value your time. In my opinion, managing your own portfolio is rather like growing your own fruit and veg - it may well offer an interesting and rewarding pastime, but don't try to convince yourself that you're saving money compared to buying from a greengrocer.

By Mr A
on

I've always enjoyed re-reading John Kay and Mervyn King's The British Tax System ---- the final revised edition published in the 1980s. The summary of UK tax law is of course out of date ----- but the authors' discussion of economics and policy as applied to that body of law is still illuminating. Also very funny.

By Robin Stainer
on

Why Active Investment Management?

Richard,
Warren Buffet offered a testing ten-year bet almost ten years ago. He reports the bets progress (http://www.berkshirehathaway.com/2016ar/2016ar.pdf pages 21 & 22) in Berkshire Hathaway's latest annual report::

"In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. (See pages 114 - 115 for a reprint of the argument as I originally stated it in the 2005 report.)
Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. [RS comment: he lost]

By Brian Hershman
on

John Kay's argument that "...the money will come from somewhere, and at the expense of healthcare or motorways or education. Other people’s money, in other words.", is far too sweeping.
Unless all investment is an allowable expense against, or deduction from, tax, how can it affect those items of public expenditure that are funded from tax?
If Deutsche Bank raises some vast sum of money from investors to put into secondary claims, it is more than unlikely to make any direct difference to public revenue and hence to what is available to be spent on governmental welfare expenditure!

This is not to challenge Kay's main argument. That is unquestionably true, as evidenced by what hs happened to the financial world since 2008

By chris
on

Now retired, I started on Graham's book in 1967 His fundamental analysis is far different than the latest mathematical mumbo jumbo which always fails when the economics behind the markets changes
Yes, I invest my own funds but don't use Buffett as he is very political, and had his huge failure being contrarian on Tesco- he invested without investigating how different the Uk retail shopping market is from the US

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