Everything I thought I knew about investing was wrong

There are two “qualities” that have come to be cherished in the culture of investment management. They also happen to be detrimental to the interests of savers and damaging to economic growth.

In my last column I wrote about the problems created by index targeting — in defiance of long-term client interests — in investment management. This week I want to talk first about liquidity, and secondly, the focus of many investors on index benchmarks and the resulting obsession of investment managers with controlling “tracking error” over the short term.

These factors are given too much weight at almost every stage of the investment process, through a combination of innate human behaviour and perverse incentives — no matter the damage to real long-term interests. They have made many participants exceedingly rich along the way and bring huge incentives for the winners to maintain the status quo, while savers and the economy are left short-changed.

Let’s start with liquidity. People love its ability to get them in and out of an investment quickly and at low cost. Advisers love it because they can switch their clients’ money around, fund managers love it because advisers love it, regulators love it because they think it reduces “systemic” and “consumer” risks and many investors love it because it means they can cut and run if they change their minds or the going gets unexpectedly tough.

Of course, the “liquidity premium” means lower returns over time, but that’s a price worth paying for the flexibility, right? Wrong. Investors may have short-term time horizons, but objectively their interests lie in optimising returns many years or even decades into the future. Liquidity is almost irrelevant.

Short-term volatility of indices and desire to control “tracking error” is the second key source of misjudgment. Most of the actively managed funds available to investors see the risk they face as putting in a performance that lags far behind an index benchmark; they fear that investors will capitalise on all that lovely liquidity by taking their money (and their fees) with them.

This is the wrong risk to focus on. For a start, the one that really matters for a long-term investor is the permanent loss of capital. And the one thing that you can be sure of with a fund that is trying to control tracking error is that if there is any permanent loss of capital going around, you are going to get at least some of it.

Short-term volatility is actually the friend of the long-term investor. As Warren Buffett, the veteran investor, said: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

In pursuit of these two false idols, investment management can become a glorified form of gambling, of traders swapping pieces of paper with each other. It may be portfolio management, but investment management it is not.

Investment is about researching and selecting companies that are capable of creating wealth sustainably over the long term and then staying close to the management and board to make sure they stay on track. Investors must understand what the company does, how it does something that has inherent value for its customers and how it is capable of creating enduring competitive advantage.

Supporting companies and working with them to encourage long-term strategies for lasting success is the way for the investment management industry collectively to raise all ships. This is how managers can play the pivotal role in improving long-term returns for clients as well as productivity, job creation and economic growth.

In pursuit of false idols, investment management can become a glorified form of gambling, of traders swapping pieces of paper with each other. It may be portfolio management, but investment management it is not

Many investment managers do this already, but the sheer volume of money that is measured against a rolling 12-month performance vs an index benchmark and the rewards available for “success” means voluntary change is hard to imagine happening any time soon. The cost to investors and the economy is real as short-term performance pressure causes company executives and boards to prioritise (and incentivise for) short-term dividend growth and share price appreciation as opposed to long-term wealth creation.

As the ultimate providers of capital we can all play a part. Look for investment managers who do not measure themselves against a benchmark over short timeframes, who tell you clearly what they aim to achieve over the long term, who invest and engage with investee companies with conviction, who have good long-term records and who invest a considerable proportion of their personal wealth in their funds.

There are no guarantees, but the lion’s share of growth will come from a small proportion of the market. To generate the returns you need over the long term, you want a fund manager who is very fussy in selecting those companies that have the potential to succeed over the long term.

It really doesn’t have to be rocket science. There are companies and individual fund managers who are able to help us overcome our natural instincts to focus on the short term and who have the skill to identify long-term winners. You should seek them out.

Daniel Godfrey is former chief executive of the Investment Association. Twitter:@danielgodfrey_; daniel.godfrey@ft.com