Our content this month are as follows:-

• Yet Another Award for Index Client
• Fun with Statistics - the Question.
• Charges
• Books We Have Read
• Quote of the Month
• Fun with Statistics – the Answer

The ever burgeoning roll of our clients who have won awards increased again this month. Edward Belgeonne, CEO of Destiny Wireless PLC reached the Southern Region Final of the Ernst & Young Entrepreneur of the Year Competition and won the Technology and Science Award. Our congratulations to Edward for his achievement in the teeth of fierce competition.

The Scenario

You go in to see your doctor. He gives you a screening test for a certain deadly virus. You are horrified when he comes back, saying that you tested positive.
"Are you certain?" you say, as your life flashes in front of your eyes.
By way of reply he tells you 3 things:

1. The test is 100% accurate in indicating a person has the virus when they have it. This means that is if you have the virus, the test always detects it.

2. The test indicates a person has the virus when they do not actually have it 5% of the time.

3. The virus is known to be present in one out of every 500 people.
Question: What is the probability that you actually have the virus?
You will find the answer at the end of this newsletter, but please have a go yourself first.

You may recall that last month we published some research from William Bernstein who analysed the costs of active management against indexing and found that index funds have the following advantage over active funds.

Large Companies Funds: Indexing Advantage 1.97% Per Annum
Small Companies Funds: Indexing Advantage 3.5% Per Annum
Emerging Markets Funds: Indexing Advantage 7.53% Per Annum
The Financial Times of the weekend 23rd, 24th June carried a supplement, Private Client Wealth Management, which we found to be of great interest as you might expect. It contained an interesting section on fees and we found when analysing the fees charged by other wealth managers including private banks and stockbrokers that our charges at 1% per annum are more or less the industry norm.

All other things being equal, then, the difference in charges between our approach and their's is the difference between actively managed fund charges and the fund charges on the institutional grade index funds we have access to.

The table below shows what that difference actually means in cash terms.

Cost Comparison
Assumptions

Portfolio

£1 million over 5, 10 and 20 years

Expected Return 8% per annum

Portfolio One:-

Actively Managed Funds - average annual charge 1.5% per annum

After 5 years: £1,370,086.66
After 10 years: £1,877,137.46
After 20 years: £3,523,645.06

Portfolio Two:-

Institutional Grade Index Funds - average annual charge 0.35% per annum.

After 5 years: £1,445,673.33 Gain: £75,586.67
After 10 years: £2,089,971.39 Gain: £212,833.92
After 20 years: £4,367,980.42 Gain: £844,335.36

Now, we cannot speak for everyone, but we are sure you can think of lots of things to do with an extra £75,000, £200,000 or £850,000.

This month's selection is "The Little Book of Common Sense Investing" by John C. Bogle. John Bogle is the founder and former CEO of the Vanguard Mutual Fund Group. They are one of the pioneers of Index fund investing and are huge in the United States and beginning to make their funds available in the UK.
This is an extremely well-written book with plenty of examples to illustrate his points.
A quotation from the book sums up his approach very well: -
Need more advice? With his customary wisdom, Paul Samuelson (Nobel prize-winning economist) sums up the difficulty of selecting superior managers in this parable. "Suppose it was demonstrated that one out of 20 alcoholics could learn to become a moderate social drinker. The experienced clinician would answer, "even if true, act as if it were false, for you will never identify that one in 20, and in the attempt five in 20 will be ruined." Investors should forsake the search for such tiny needles in huge haystacks.
You will not generally find the book at bookstores but it is available from Amazon; if you have any difficulty finding it please contact jayne@indexfundadvisors.co.uk.

"Problems cannot be solved by the same level of thinking that created them."
- Albert Einstein

Firstly, we can tell you that most people answer 95%. If you did not you might be on the road to being among the minority that get this right.
Let's go through this numerically, starting with the most relevant statistic:

One out of every 500 have the virus and 499 people do not. So we have 499 virus-free people. 5% of those people test positive.

499 X .05 = 24.95

So we can safely say that about 25 people out of every 500 get a false positive result. (They test positive, but they don't really have the virus.)
This means that out of every 500 people, 26 will test positive. (This includes the one person who tests positive and actually has the virus, plus the 25 people who test positive but don't have the virus.)

If only one out of every 26 people who test positive actually have the virus, then your odds of having the virus when you test positive are, in fact, only 3.85%. How is this calculated? Divide 1 by 26.

If your answer was 95%, rather than 4%, you should not feel too bad about it. This same scenario was given to 60 doctors and medical students at Harvard Medical School. At that time, only 11 of the 60 gave the right answer. The majority said the answer was 95%.

Why This Is Important

The world, in particular the financial world, is awash with statistics. Properly interpreted they can provide us with very valuable information. The problem in the investment world is that the investment industry uses all kinds of statistics to represent themselves and their funds in the best light; in the main these distortions are slavishly repeated by the press and the result is a great deal of noise and confusion. Any statistics presented by those with a vested interest should be treated with caution.

Happily there is a huge amount of disinterested research available from economists (some of them Nobel prize-winning) who simply do the research and publish the results, without having to worry about whether it will attract money to their favourite fund. This kind of statistical research is extremely valuable and is the basis of our recommendations to clients.