Should the retail investor be allowed to invest directly in shares?

Stocks versus funds, which is best for the retail investor? A question of the same ilk as: "how long is a piece of string?" , insight rather than answers is the need of the hour.

As my old University Tutor used to say: attack the question and address issues. The two key issues in assessing whether stocks are "better" than funds (or vice versa) are: what is the benchmark (what is our target?); and what weight of money (the percentage of our overall investment) will we be investing?

So first up: what is the benchmark? Re-hashing Zig Ziegler "if you don't have a target what are you aiming at?". Telling me that Stock X "has made 20 per cent last year", and that Fund Y "has made 10 per cent last year", does not necessarily make Stock X a "better" investment — especially if investor has given us a benchmark of eight per cent per annum. Clearly 10 per cent is closer to the target than 20 per cent. More importantly, the risk reward trade-off means the stock could have veered down below the eight per cent.

All investments carry trade-off's and the one known to most 11-year-old economics students is the risk-reward trade-off.

For insight, we lean on diagrams 1 to 4 (below). As we are comparing stocks versus funds we must make the following assumptions:

•That "The Market "in diagram 1 is an equity index. Stocks are equities so there is no point in sticking a bond benchmark or an absolute return benchmark into our diagrams. If we did we would be comparing apples and oranges for no real value.

•The index could be the Dow Jones, FTSE, Sensex, DFM, you name it, as long as its a pure equity index.

•"The Market" in diagram 1 provides us with a benchmark for the purposes of comparing trackers, fund managers and individual stock selection.

•The ETF/Trackers and funds in diagrams 2 and 3 consist of equities selected from the same market constituents as "The Market" in diagram 1.

•The stocks in diagram 4 represent the performance range from stocks selected from the same constituents as "The Market" in diagram 1.

 Diagram 1: "The Market" represents an equity index. It can be described as a portfolio of stocks from a given exchange.

Many indices are "weighted' meaning that (for example), if we had a portfolio of 100 stocks, yet, by capitalisation, one of the 100 stocks was 50 per cent of the value; in this instance our one big stock will always influence market direction.

Given we are comparing one stock versus funds (many stocks), clearly, the selection of one of the smaller stocks WILL, definitely, provide a different result than "the market" being driven by the big stock to 50 per cent and the other 99 to 50 per cent.

Diagram 2: ETFs Tracking Error represents the performance of an ETF or Tracker fund.

The objective of "trackers" is to provide the market return. It's not easy, so we live with tracking error. In the so-called "efficient markets" (where information flows are hot-off-the-blocks) the tracking errors are smaller than inefficient markets where the tracking error widen. Tracking Vietnam is harder than tracking Hong Kong.

Diagram 3: Fund Managers Vs Markets shows within our concept-drawings that fund managers can, potentially, provide returns in excess of "the market", and in excess of trackers.

Our "artistic impression" in diagram 3 suggests that Fund Managers performing above "The Market" is possible, but, there seems to be a greater potential for fund managers to under-perform "The Market".

According to Jeremy Siegel (Stocks for the Long Run), in order for a Fund Manager to say with 95 per cent confidence that his choices were down to skill rather than luck, he/she would need to outperform the market by four per cent per annum for 15 years. According to multi-managers, momentum, the average fund manager sits at his post for between three to five years! They also suggest that the more efficient the market (where efficiency equates to high information flow), the harder it is to outperform the market.

Diagram 4: Stocks Vs Fund Managers Vs Markets.

Our final diagram implies that stock performance will blast around and to both sides of The Market, and fund manager performance.

Logic will tell you that this obvious. After all, The Market is an average of all stocks on the exchange. And an "average" is the addition of all the upward and downward movements. The individual stock prices will reflect all the individual upward movements (above the average) and those below the average. Translated? Yes, of course there is more risk associated with stock selection because your result can land up anywhere within the diagram 4 range.