This post is intended as a short, common sense introduction to financial investment for normal people who have some spare money and don't have time to work out what to do with it. None of it is intended as advice.
ONE: What are you investing for?
You should be looking to make a 'Real Total Return'. This means your return after it has been adjusted for a) taxation b) inflation and c) currency depreciation. Many people do not consider b) and c) and so they become 'invisible taxes' on your money. With so many governments currently printing money, you may need to do more to protect against these invisible taxes in future.
Every individual will have slightly different goals, dependent on their needs e.g. are they looking for an annual income? Will they want their capital relatively soon for school fees or a house purchase? These individual requirements will affect their investment strategy and how they manage risk.
TWO: Who should do your investing for you?
Most modern money management companies are not fit for purpose. Their large corporate culture and the effects of globalisation and institutional involvement has made them self-serving. Their performance is not good enough, and for many other reasons they fail to look after the interests of their clients. This is in contrast to their antecedents, smaller, family-owned partnerships where fiduciary duty was paramount.
To remedy this, put simply, you need to look for 'John Lewis' money managers. This means that their three key qualities are Quality, Price and, above all, Trust.
TRUST: A great truism in investing is the small print statement, 'past performance is no guide to the future'. Yet so many people ignore this, and choose money managers purely on the basis of their recent performance. Since we cannot predict the future, one of the only measures we can rely on is our trust in them to outperform in future.
The simplest way of establishing trust is if the money manager's interests are aligned with yours. This is best achieved by the manager investing a substantial amount of their own money alongside you, and/or having a substantial stake in their company, so they are more personally invested than just being an employee.
QUALITY: While past performance is no guide to the future, it can still be useful for creating an initial shortlist. The minimum performance period you should really look at is ten years, as this is usually enough to show how a manager performed in both bull and bear markets. Five year figures can be very misleading – particularly as at early 2014, where the adage 'a rising tide lifts all boats' applies – yet they remain the industry standard.
Virtually no managers can consistently outperform in both bull and bear markets, therefore you should look to have quality managers of different styles in your portfolio, in the same way that a football team has both attacking and defending players. The manager cannot predict when the ball will be in each half of the pitch, so needs a team that can react to varied and unexpected events.
You need to know how much risk a manager took to achieve their outperformance. The big roulette winner at a casino who put everything on 7 isn't skilful. They took a lot of risk and got lucky. You want someone who can achieve their results by taking just a small amount of risk, and primarily using skill. When you are considering consistent future performance, it is much easier for someone to replicate skill rather than luck.
In the short term, the wrong process can produce the right outcome and the right process the wrong outcome. But the longer the period you invest for, the more likely it is that a quality process will produce the outcome you want.
PRICE: Finally you want a money manager who does not have overly high fees. Research, in as much as it is worth, indicates that variations in fees make a huge difference in performance over the long-term, due to the extraordinary effect of compounding.
THREE: What are the different ways you can invest?
'John Lewis' money managers are rare, so you need to take great care when you select a money manager. Alternatively you can consider doing it yourself. Your choice will depend on how much time you have to devote to it. If you don't have much time, your main options are:
A: Do it yourself, investing passively i.e. using cheap tracker products such as ETFs to track one or more chosen indices. You will then always 'achieve' your benchmark, less the small cost of the ETFs.
Since the vast majority of money managers underperform their benchmarks over the long-term after costs, you will by definition do better than most money managers. (Some passive investors believe that you will do better than all money managers.)
This option is good for the time-poor as it is fairly easy to set-up, requires little maintenance, and saves the time and trouble of finding elusive 'John Lewis' managers. Your only real task will be to construct your 'asset allocation', the mix of elements such as stocks, bonds etc. which make up your portfolio.
B: Allocate a one-off time period to research and find one or more 'John Lewis' multi-asset funds. These are effectively whole portfolios in a fund, with a mixture of stocks and bonds, and maybe also some gold, cash and other alternative assets.
This removes the need for you to think about market timing and whether to amend your asset allocation. Most multi-asset funds are active, but passive ones do exist. (n.b. if you have £250,000 or more to invest, you can research and find a 'John Lewis' wealth manager to take care of everything for you.)
If you do have time i.e. a good number of hours a week, you can consider doing it yourself and invest actively, constructing a balanced portfolio with individual 'John Lewis' fund managers, being aware that you may underperform your benchmarks.
FOUR: What should you look for in a 'John Lewis' money manager?
Qualities the right company should have include:
a) investing their own money alongside you, so your interests are aligned
b) a stake in the company they work at i.e. it is a partnership or employee-owned
c) a proven ability to outperform an index over the long-term (at least 10 years)
d) reasonable charges – preferably no more than a 1% management fee and no performance fee
e) a concentrated, high conviction portfolio i.e. they do not just hug their benchmark
f) a low-asset-turnover ratio i.e. they have a long-term investment horizon and rarely sell investments
g) a proven ability to preserve capital during the bad times
h) a stable team who have worked together for a number of years.
i) being comfortable holding cash when there is a lack of good investment opportunities
j) an ability to close the fund to new money (if a Unit Trust) if too much 'hot money' floods in
k) a portfolio which is 'different from the majority'. This is the only way they can possibly outperform.
FIVE: How do you 'Do It Yourself'?
To start with, beware most 'expert advice'. Be particularly suspicious of anybody who says they can forecast the short to medium-term direction of a stockmarket – they can't.
One key difference between you and most professional money managers is that you are Socrates. You are wiser than them as you know one thing – that you know nothing – whereas they believe they know something. Acknowledging your limitations is the first step to finding a solution to them.
If you choose to invest yourself, the solution to knowing nothing is to create your very own 'Hedge Fund' i.e. a portfolio of diversified, non-correlated assets, hedged to perform in all scenarios. The right portfolio means you don't have to know anything – you will have an automated, all-weather machine that can cope with the four main economic environments: prosperity, recession, inflation and deflation.
You should have realistic expectations for your Hedge Fund. It will not be perfect, but to be worthwhile it should perform better over the long-term than most money managers, and with lower volatility.
Your portfolio needs to be able to protect you against problems you've never seen before. Many money managers are like generals who 'prepare to fight the last war', but the next stockmarket crash is likely to be caused by different factors from the previous one. History does not repeat itself, it just rhymes.
'When you're one step ahead of the crowd, you're considered a genius. When you're two steps ahead, you're a crackpot' Rabbi Shlomo Riskin. The stockmarkets can behave irrationally for a long time, and you must be prepared for even the most experienced money managers to occasionally be two steps ahead. This is where a strong, long-term record comes in useful – it is easier to have confidence in a 'crackpot' if they have previous form (e.g. having stubbornly avoided an event like the 1999 tech-stock bubble).
It can be painful and costly waiting to be proved right – another reason for having not only diversified assets, but diversified equities with a mixture of e.g. defensive and aggressive styles, geographical diversification and investment styles e.g. value and quality. This should mean that some of your portfolio is always 'right'.
SIX: What is the right asset allocation for your Hedge Fund?
Asset allocation is a real art, and one of the most difficult and important aspects to investing. It will come as no surprise therefore that there has been a lot of academic writing and disputes about 'the Perfect Asset Allocation'. You can spend a lot of time worrying about it, or just accept that in investing, nothing is perfect.
For the average person a good starting point is 60 / 40 (Equities / Bonds, Gold & Cash). The best, long-term performing multi-asset funds tend to have an equity allocation varying between 50% and 70%. Obviously your asset allocation will change over time depending on the performance of different asset classes.
SEVEN: What are the different types of assets you can choose for your Asset Allocation?
The classic assets for diversifying are Bonds (including Index-Linked Bonds), Gold and Cash. n.b. while Stocks are normally riskier than Bonds, the price you pay for an asset affects its inherent riskiness i.e. if you overpay for a 'safe asset', it becomes riskier, as it will be harder to make a profit, and vice versa.
Short-dated Bonds tend to be a proxy for cash, long-dated bonds a hedge against deflation, and index-linked bonds a hedge against inflation. The behaviour of gold is controversial, but it appears to be a hedge against monetary and political instability e.g. for volatile movements in both inflation and deflation.
Cash is an underrated asset and at times can be a useful 'ultimate insurance'. The occasional 'black swan' event will cause all asset classes to fall in tandem – in these instances cash will be the only available hedge.
These days some people use Absolute Return and Hedge Funds to further diversify their portfolio. Many of these funds have failed to consistently achieve their objectives since their launch, and few have 'John Lewis' qualities, but the small minority of good ones can be useful.
It is extremely hard, even for the experts, to predict the timing of prosperity, recesion, inflation and deflation. Therefore it makes sense to have an allocation to different asset classes which benefit in each environment so that you have insurance against every occurrence.
Always appreciate why you hold bonds, gold and cash – as insurance against unforeseeable, future monetary events. They are often boring assets and may not help you for years. But just like any other insurance, while you cannot predict the timing of when you'll need them, when you do they are invaluable.
EIGHT: What is the golden investment rule?
Avoid Mistakes! If you lose 50% of your money, you have to make 100% to recover it. It is much easier for you to boringly increase your funds by a bit each year – the phenomenon of compounding takes care of the rest. Losing money means you have to work much harder to make it back.
NINE: What are the main types of investment structure?
The three primary vehicles for investing are: Unit Trusts or Open-Ended Investment Companies (OEICS), Investment Trusts and ETFs. Each has their upsides and downsides, and it is important you are aware of these when choosing them. Some of the key issues to consider are as follows:
Unit Trusts / Open-Ended Investment Companies (OEICs)
Pros: A huge fund universe to choose from.
Cons: If they get too big their performance can suffer as they can't invest as nimbly. They tend to be run for their company rather than for the investors. They have to keep a wasteful cash float for sudden redemptions.
Pros: The company directors offer an extra level of protection in looking out for your interests. Better for investing in illiquid asset classes. They can increase performance by using gearing (i.e. borrowing money).
Cons: Adverse movements in the Premium / Discount to NAV can affect performance i.e. it can be dangerous buying successful ITs on large premiums. Gearing can work against you if not handled properly.
Pros: An efficient, liquid way of investing passively.
Cons: You need to understand the structure of each ETF: e.g. they should be Physical not Synthetic, the provider should not lend out too many securities and give you most of the proceeds of the income, there should be a low portfolio turnover rate to keep costs low, you need to know what index you are tracking e.g. MSCI or FTSE, and that there is minimal tracking error.
TEN: What to do after you have invested your money
Once you have invested your money, try to leave it alone. One of the greatest and most costly mistakes investors make is tinkering with their portfolios. Every transaction costs you money and affects the compounding of returns and dividends which you benefit from by holding investments for the long-term.
The French philosopher Blaise Pascal summed it up well: 'All men's miseries derive from not being able to sit in a quiet room alone'. Successful investing requires an enormous amount of emotional control.
Since the stockmarkets can remain irrational for long periods of time, you need immense conviction and patience to survive them. One aid for this is to try and ignore the 'background noise' of most of the financial press: remember that newspapers do not sell copies by telling you everything went OK that day.
ELEVEN: The rare occasions when it is right to sell, and how to simply rebalance your portfolio
Correct reasons for selling might include if the money manager leaves the firm, if their investment approach changes or if the firm is taken over by another firm. A period of underperformance is not necessarily a good reason to sell, as long as the manager's style has been consistent. No investment style works all the time, and so you should expect even the best money manager to underperform on occasion.
If you do not need all the income your investments generate, you should normally reinvest it with the money manager who has done worst. Doing this will help to rebalance your portfolio to the original percentage split of your asset allocation, and maintain the level of your risk profile.
TWELVE: What should you measure your portfolio's performance against?
You need a benchmark to measure the performance of your portfolio against. If you have a 60/40 portfolio, a good starter is the passive, multi-asset Vanguard Lifestrategy 60% Equities, a 60/40 fund with low costs. Consider also having a second benchmark of UK inflation (CPI) to check that you are preserving the purchasing power of your capital.
You should measure your performance over rolling five-year periods – with a shorter period the benchmark performance will be too random to measure against. If your self-created portfolio consistently underperforms its benchmarks over 5-10 years, swallow your pride and invest in the benchmark fund instead.