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Making the most of your pension investment

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Thursday August 2, 2012 at 10:00am
Andy Parker was invited to contribute to a new book being produced by the Institute of Directors, to be published later in 2012. Here’s a sneak preview of his Chapter focusing on the importance of taking a proactive approach to your pension investment strategy.

Given the turbulence in UK and international markets over the past 10 years you’d be forgiven for being cynical about investment, Stock Market returns and the advice you might be given on your pension investment strategy. Cynical or not, if you have a pension you really should consider carefully how and where your money is invested, perhaps more so because of the poor performance experienced by many traditional pension funds in recent years.

In this article we explain some principles of investing and apply them to pension investment strategies. In simple terms you’ll learn what to do with the money once you have it, what growth you can expect and how to manage investment risk. As a pension is simply a tax-efficient investment it has to be managed in a structured and planned way, the same as any other investment.

Many people dismiss the stock market as being a poor investment without really considering why this is. There are some good reasons to hold this belief which include:

  • The FTSE100 index was higher in 2000 than it was 12 years later in 2012. Hence an investment tracking that index would have fallen in value over the past 12 years.
  • The volatility of the stock market actually creates a herd instinct amongst investors. As the market rises more people tend to invest and as the market falls everyone sells. In other words they have bought when the market is high and sold when the market is low. This is the exact opposite of what all investors intend to do.
  • Wild fluctuations in stock market values give the impression of a lottery as money can be invested today and be worthless tomorrow. Although many advisors would consider a minimum investment period of 5 years plus for equity based investments many investors look at their portfolio value daily and make decisions on a much shorter time scale.
Our approach to investment is based on a wealth of academic research and takes an absolutely structured approach.

How to get maximum returns from the stock market

Although investing in an FTSE100 tracker would have lost you money over the past 12 years, a globally diversified portfolio of equities purchased in June 2000 would have returned a positive average return of 5.29 per cent every year up until May 2012. The annual returns were very lumpy with a negative return of 22% in 2008 and positive return of 22.5 per cent in 2005. If the investment was delayed until June 2003 the annualised return would have been 9.39 per cent per annum.

So how does a globally diversified portfolio produce an annualised return of 5.29 per cent whereas a FT100 tracker delivers a negative annualised return? Well there are a number of important investment principles hidden within the above figures and an understanding of these principles is important if you are going to invest wisely and securely.

Principle 1: Stock markets actually work
There is a large body of scientific evidence stating that it is not possible for an investor to outperform the market. This is because share prices reflect all available information and so are the best approximation of intrinsic value at any point in time.

Although some prices may not always represent the best approximation of fair value the academic research shows that such mis-pricing events cannot be systematically exploited either by fundamental research or timing the market. Remember that for every equity purchased there must be a seller of that equity and it is this world wide body of (probably well researched) investors buying and selling the same share that creates the market price.

So rather than pick individual companies in the hope that they will outperform the market as a whole , the better way to invest is to hold the whole of the market at as low cost as possible. But this does not explain why the stock market as a whole gives a better return than most other investments (for the same level of risk). Principal 2 explains.

Principle 2: Risk and returns are related
So why doesn’t everyone just invest in cash or better still short dated government bonds? The reason is that the returns are not so high. If returns on cash are 1% or 2% and inflation is 4% then the purchasing power of money is being eroded over time. £10,000 today will be worth £8,681 in 7 years time assuming inflation is running at 2 per cent above investment growth. Hence investors need to at least keep pace with inflation.

In order to make a greater return (such as the 5.3 per cent or 9.4 per cent per annum noted above) then investors must take more risk, this is the only way. Investing in say UK short dated treasury bills is secured by the ability of the UK taxpayer to make the repayments on those bills. Investing in company shares provides nowhere near the same security. In fact the security of ordinary shareholders in a company is the lowest security offered by the company. The bank lenders and bond holders in that company will already have a charge on the company’s assets such that they are repaid first should that company go into liquidation.

In order to attract investment away from government bonds companies must offer a higher return, regardless of whether this is provided by growth in the market value of the share or through payment of dividends. This higher return is known as the risk premium and has to be present to attract investors into equity.

Principle 3: Risk has to be managed
An investment portfolio which included only a single company’s shares would be very risky. However holding a broad basket of shares will spread this risk. The question is then what is a broad basket? One approach is to hold the whole of the global stock market by investing in proportion to the size of each countries' stock market.

At the time of writing 40 per cent of global equity value was quoted on US stock markets. Hence 40 per cent of share investment portfolio would be invested in equities quoted in the US. The thinking behind this approach is to obtain maximum diversification of equities as efficiently as possible. It is important to recognise that many, if not most of the companies quoted on US exchanges will themselves be globally diversified through earnings from across the world, e.g. Google or Microsoft. There are two classes of equity that have been shown by research to provide proportionately higher returns simply because investment in them is higher risk. These are companies with a small market capitalisation compared to their larger brethren. The others are so called value companies, that is those companies where their market capitalisation is similar to the net asset value of the company as demonstrated by the company balance sheet.

Investors demand a higher return from both of these type of companies because the chances of them failing is greater. Again by holding a large number of such companies much of the higher risk can be removed from an investment portfolio by diversification. In all cases it is essential to look at the return from a collection of investments rather than individual returns within the portfolio. It is the diversification that will provide the long term consistent returns.

The volatility (which is synonymous with risk) in a portfolio is the amount the portfolio fluctuates in value over a specified time frame. By adding short dated investment grade fixed interest securities into the portfolio, the volatility and hence risk is reduced. This means the long run return will be lower because risk and return are related.

Principle 4: Costs matter
If the long run market return is somewhere between 5% and 9% then most investors achieve typically half of this. Part of the reason is investor behaviour and the herd mentality of buying when the market is rising and selling when the market is falling as described above. Another significant factor is not holding the investment for long enough, a minimum holding period of 5 years is needed for equity investment, and generally much longer.

Costs also erode investment return and these can be explicit such as annual fund management charges, sales and trading commissions. There are also non explicit costs that simply erode fund performance such as taxes and increase in price as a result of trading large quantities.

Bearing in mind the complexities of investing, most people will seek advice before making a large investment. Here are some of the areas a caring competent financial advisor should guide you through:

  1. Help to understand the amount of investment risk you are prepared to take and construct an investment portfolio that reflects this with a mixture of equity and short dated fixed interest securities.
  2. Advice on properly diversifying your investment portfolio across global equity markets and with a suitable mix of value and small capitalisation companies.
  3. Help to maintain investment discipline in volatile markets and avoid buying high and selling low through herd instinct.
  4. Cost management by selecting low cost funds that meet investment criteria and risk profile.
  5. Tax reduction by advising on whether you would be better to hold your investments in an ISA, pension, bond or general investment accounts. Also by advising on other tax efficient investments and the risk associated with each.
  6. Probably the most important point is your advisor should understand your long term financial goals and help you to achieve these. A caring, competent advisor will add significantly to the chances of you achieving your financial goals.
Andy Parker is owner and managing partner in the Birmingham based firm Parker Chartered Accountants and Financial Advisors. Andy is a Chartered Financial Planner, one of the few Chartered Accountants in the country to be dually qualified. He regularly advises companies and individuals on investments, pensions and retirement strategies.

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Parker Chartered Accountants and Financial Advisors is the trading name for PLW Advisors Ltd (Registered No. 10396831), 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