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An investment philosophy that will let you sleep at night

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Thursday May 26, 2011 at 10:00am

In a previous blog I talked about why many investors feel confused and uncertain about investing for the future. Part of this is because the emphasis of the financial services industry is to convince investors that they can beat the markets through company research and stock picking and by getting the timing right. This results in high advisory and transactional costs paid for by the investor. Part of the problem lies with the inherent volatility of markets causing investors to feel greed when markets are rising and fear when they are falling. Investors relying on their emotions tend to buy when prices are high and sell when they are cheap.

There is an alternative and here it is:

  1. Understand that risk and return are related. The more risk you take on by investing in equities the more return the market will pay you for holding shares rather than fixed interest securities. Over the last 10 years a portfolio of equities held in proportion to the global market would have returned 7.46%. A portfolio of gilts would have returned 3.82% and cash would have fallen in value in real terms, after inflation.
  2. Risk can be reduced. The risk of a portfolio can be reduced by holding a proportion of fixed interest securities. This reduces the overall volatility of the portfolio, which is the amount the value moves from the average over time. Everyone’s risk profile is personal and the best way to assess your risk preference is by taking a psychometric risk profile test.
  3. Get the balance right. Diversification within a portfolio is essential in order to remove the many types of risk associated with holding equities. These include credit risk, inflation risk, and maturity risk. By holding a spread of investments all risk other than market risk can be removed. Market risk is the risk that the whole market can go up or down in a short period of time. Over longer time periods even market risk disappears.
  4. Reflect the bigger picture. Logic would suggest that in order to obtain the market returns you need to hold a sufficiently diversified portfolio that reflects the global market. Make sure your portfolio reflects the same weighting as the world equity market. Needless to say all of our standard portfolios reflect the global market weightings in equity.
  5. Understand the long term historical returns of your portfolio. It should show that portfolio volatility (the variance in average annualised returns) reduce over long time periods. Likewise, the more equity you hold in your portfolio the more risk and so higher return you will achieve over the longer term.
  6. Keep costs down. Costs really matter and so the lower the total expense ratio the better. There are also hidden transaction costs that are particularly high in actively managed funds. These can run to 1.5% to 2% of additional cost on top of the annual management charge. To put this into perspective a passive fund total expense ratio will be around 0.5% and transactional costs minimal. An actively managed fund will have an expense ratio of between 1% and 2.5% plus transactional costs of 1.5% plus.
  7. Keep your emotions under control. Buy and hold is the only real option as no one has a crystal ball and can second guess the market. Otherwise you will tend to buy when markets are rising and sell when they are falling. This buy high, sell low behaviour arises when emotion is not held in check. 
  8. Hold for at least 5 years and the longer the better. Investment theory tells us that the volatility of returns in a portfolio reduce with the amount of time you hold it. That is why a holding period of at least 5 years is recommended for equity investments. Any shorter and you don’t have enough time in the market to recover from the bad years. Likewise the power of compounding of returns increases the overall return of the portfolio the longer you hold the investments
  9. Focus on what’s real. Remember that real returns are the only returns that matter. Real returns are actual return minus inflation. Clearly you must obtain a return above inflation to ensure you maintain the purchasing power of your money over time. This is only achievable with an equity element in the portfolio.

So the next time you are tempted by an emotional response to current market conditions take another look through the advice above.

Andy Parker
Chartered Financial Planner, Birmingham

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