The Long and the Short of It: A Guide to Finance and Investment for Normally Intelligent People Who Aren’t in the Industry
By John Kay
Erasmus Press £11.99, 300 pages

John Kay thinks the modern financial world is greedy, cynical and self-interested, and that we should all shun the professionals and manage our investments for ourselves. Two years ago, the first part of that sentence would have been a tough sell. Now that everyone thinks City folks are crooks, Kay’s timing could not be better.

Most of us may take some convincing that now is the time to grab our battered portfolios and set out on our own. But if anyone can persuade us to do a little financial DIY, it’s Kay. Like his weekly FT columns, this book packs an extraordinary amount of insight into a deceptively small space.

As with the columns, The Long and the Short of It can be hard to absorb all at once. But that’s simply an argument to read it twice. And keep it on your desk as a talisman against the scourge of conventional thought.

One word of warning: if you have any investments managed by somebody else – and like it or not, almost anyone with a pension does – this is not going to be a comfortable read. Kay’s point is not that professional investment managers are naturally wicked or corrupt, although, of course, some are. It is that inevitably, by the nature of their business, these people will rarely have your best interests at heart.

For starters, in order to remain professionals, investment managers need to make money out of your investments, regardless of whether they go up or down. You do not. If you manage them yourself, “your bonus is already in your pocket”. The regular FT reader is probably already scandalised by the scale of commissions and management fees in the retail investment industry, never more than when these percentages come on top of the double-digit losses that most investors will have suffered in 2008. But you are probably still not scandalised enough.

Before the credit crunch, many will have been encouraged to invest in hedge funds or private equity funds because these were earning regular double-digit returns. Now very few are earning that kind of money. But the average retail investor will not even have gained much from these investments on the upside.

The standard “2 and 20” charged by the funds – a 2 per cent management fee per year and 20 per cent of the profits – reduces a 10 per cent underlying return to 6 per cent. And most retail investors will invest in these assets through a fund of funds or feeder fund, which in turn takes another 1.5 per cent of assets for management and another 10 per cent of the profit. Suddenly that 10 per cent return on the underlying investment turns into a paltry 3.5 per cent return to the individual punter. That’s before inflation and tax. And before the crunch.

To bring the point home even more forcefully, Kay takes the example of Warren Buffett and his company, Berkshire Hathaway, which has earned an average compound rate of return of 20 per cent per year over 42 years. He has never charged any commission for his investment smarts – he and his investors have simply got rich from the rise in the value of Berkshire Hathaway shares. But suppose that he had charged himself the private equity fund’s “2 and 20” from the returns to his share of the investments. The results are jaw-dropping: of Buffett’s personal wealth of $62bn, $57bn would now belong to Buffett the investment manager, and only $5bn to Buffett the individual investor.

Admittedly, most funds don’t charge as much as this. And even in the private equity world, the days of “2 and 20” may be numbered. But when it comes to investing for your retirement, every percentage point counts. If you can earn a 10 per cent annual return on your savings, you only need to save 8.5 per cent of your annual income to have the same spending power in retirement. A 6 per cent return means you have to save closer to 20 per cent. It’s easy to turn a 10 per cent into a 6 per cent return by paying unnecessary management charges, fees and taxes.

There are other reasons Kay thinks we will do a better job than the professionals. Unlike them, we can afford to think long-term. And we can afford to focus on absolute returns, not relative. “The major risk a financial adviser runs is not the risk that his clients do badly, but the risk that his clients do worse than other people.” That makes it difficult for them to be unconventional. That is a great shame, because in Kay’s view, “the best way to use the expertise of the financial services industry is to do the opposite of what they recommend”.

At this point, the average reader might conclude: “All very well for him to say.” John Kay is an extremely intelligent man, with the confidence to match. I learned this first-hand when I worked for him at London Business School in the early 1990s. In this book he is modest. He even claims to share many of the irrational instincts and desires that encourage us to make bad investment decisions. But as you turn the pages, it’s pretty clear that he is smarter than the average bear. Or bull. We also know from the dust jacket that he lives in “London, Oxfordshire and the south of France”. He may think nothing of diving into assets that no one else will touch. The rest of us probably need to think about it very hard indeed.

But he has an answer for the lily-livered. We can be as cautious as we wish. He even offers up a conventional investment strategy that roughly replicates the portfolio of the average local authority pension fund, achievable at minimum cost with a few clicks of a mouse on any online share dealing service. His point is not that we need to be “intelligent” – that’s covered in another chapter. Just that we shouldn’t make the mistake of thinking we are being clever, or cautious, when we pay someone to manage our money for us. Nine times out of 10 the decision will cost us money, not just in fees but by leaving our portfolio less diversified and more vulnerable than it could be, because our investment manager is even less willing to go it alone than we are.

Put that way, it sounds like a no-brainer. Now, if only we had any money left to invest.

Stephanie Flanders is the BBC’s economics editor