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The science of investing

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Tuesday May 13, 2014 at 11:14am
If you think success in investment is more an art than a science, think again. Eugene Fama shared the Nobel Prize for Economics last year for his work on stock market prices. Comfort, we hope, for our clients as a large proportion of funds we manage on their behalf are invested using the principles developed by Fama and others.

Let’s take a look a these scientific rules of investing. You might want to measure your own financial plan and investment strategy against each one.

  1. You’ll struggle to beat the market. The academics have proved that markets are sufficiently efficient that they cannot be reliably taken advantage of. As investors become aware of new information it is almost immediately reflected in the price of shares. This simple reality leads to a number of conclusions. The current market price is the best estimate of current value. Trying to anticipate events or time market movements simply burdens investors with increased risk and cost.
  2. Risk and return can’t be separated. Because markets are efficient the only reason a share is priced at a lower price to its peers is because the risk associated with it is higher. This relationship is why it’s so important to get proper financial advice, to match your expectations of risk with the level of return you need to achieve.
  3. Diversification is really important. Individual stocks behave randomly within the market. The only way to avoid this is to buy the whole market in many asset classes, geographical areas and industries.
  4. Costs matter and they are not always obvious. A portfolio that trades little will have lower costs than one that trades frequently. This is simply because there are a number of costs associated with each transaction. Hence skilful portfolio management and smart patient trading can produce real cost savings over time. These savings accrue directly to the investor.
So in order to maximise your returns as an investor it is wise to try and capture the return the market pays you above holding cash. The reason you get this higher return is because you take on more risk by investing in equities.

It is important to understand what growth you need on your portfolio and your psychological predisposition to risk. A risk profiling tool will answer this latter question. The best way to answer the question about required return is to have a financial plan.

Most investors understand the need for diversification but what is often overlooked is what this actually means. An active fund may only hold 200 companies and will certainly have an industry, country or asset class bias. True diversification means spread in all of these areas.

Costs are probably the least understood by investors and break down into visible and invisible costs. An example of a visible cost is the fund annual management charge levied by the fund manager or creator. An invisible cost would be stamp duty at 0.5% on each share traded; such cost is usually added to the cost of initial purchase. However, it does mean that a fund that trades frequently will have a higher hidden cost than one that hardly ever trades.

And finally the biggest cost of all is investor behaviour. If you are wondering how you can mess up your own portfolio with no help from anyone else look back to 2008. In that year the UK market fell by 30% and then recovered by 30% the following year. Anyone who came out of the market when the pain was most acute, i.e. at the bottom would have actually realised a 30% loss.

If you’re sitting there wondering about your own investment portfolio, ask yourself is it built on sound investment principles? Have you fully understand how much volatility it is subject to and what levels of return you can reasonably expect from it? If you’re struggling to answer these questions it may well be time to take a fresh look at your own financial plan.

Andy Parker
Chartered Financial Planner Solihull

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Parker Chartered Accountants and Financial Advisors is the trading name for Parker Business Development Ltd (Registered No. 4116664), Parker Tax and Trust Ltd (Registered No. 06950353) and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here