Dedicated follower? Or asset allocator?

627

Three simple rules – pay less, diversify more, and be contrarian – will serve almost everyone well who invests.

Most investors simply do what others do. You can do a lot worse. The strategy of replicating the portfolio of a typical institutional investor, such as a large pension fund, is both easy and cheap to implement.

With a few clicks of a mouse, and a combination of exchange traded funds (ETFs) and real estate investment trusts (Reits), you can construct such a portfolio for a total expense ratio (TER) of well below 1 per cent. You will do worse if you employ advisers to build such a conventional – closet indexed – portfolio for you, paying charges of perhaps three times as much.

But you will do better if you make your own decisions. Working out what you want to achieve is a good start. In the last decade or so, the mantra of investment consultants has been “liability-driven asset allocation” – ie your objectives should determine your investment choices.

Such investment objectives are necessarily personal and therefore so must be your concept of risk. Some people save for a specific purchase. But most plans for future expenditure are uncertain and ill-defined – as well as risky.

The same is true of your income and your personal circumstances. Risk is the antithesis of security. Most investors want to secure their consumption in the medium and long term, without specific notions of the items of expenditure or the times when it will be incurred. They save for retirement or a rainy day.

Cash and short-dated bonds are often described as low-risk investments. But do not confuse certainty with security. The knowledge that you are going to be executed tomorrow confers certainty but not security.

Security for you is likely to be confidence in your long-term standard of living, the ability to be relaxed about retirement or the knowledge that you can one day buy the property you have dreamed about. Cash does not provide such security.

Long-term savings can achieve security, in a world vulnerable to inflation, only if they are linked to real assets.

Bonds can sometimes be a good investment. In fact, for a UK-based investor, bonds issued by foreign governments have been one of the best performing asset classes over the past two years. But bonds are a risky form of long-term investment.

The inflation protection provided by index-linked bonds offers greater security. But, even then, it is difficult to match the bonds exactly to your personal objectives. Unless investors have a specific, short-term objective in mind, they will generally be best served by a portfolio of real assets with a value based on variables such as rent and profits that will, in the long run, broadly track the value of money.

This is true for almost everyone. It is easy to exaggerate how much difference there is in personal investment objectives. Even for someone aged 60, most of the expenditure they plan is more than a decade away.

So how much should you assign to different investment categories? Most discussion of asset allocation proposes that you should earmark a proportion for bonds, a proportion for UK equities, a proportion for overseas equities, a proportion for property. But this supposes that the securities within each of these categories are more like each other in their behaviour than the securities in the other categories. They are not.

BP and Exxon Mobil are similar to each other though one is a UK company and the other US-registered – but BP is not like British Land and Exxon Mobil is not like Florida Power and Light.

The basic principles of asset allocation are diversification and contrarianism. Choose securities with returns poorly correlated to each other.

The conventional investor follows the fads and fashions of the markets – and if you follow the sectors that are promoted to retail investors, so will you.

In 1999, tech stocks were aggressively marketed. In 2006, it was property. In both cases, small savers got in at the top of the market and made immediate losses. Resist such blandishments.

In defying fashion, the retail investor potentially has an advantage over the professional. Professionals are judged by their relative performance. But relative performance does not pay bills. You can take a more detached view, and you should.

Most investors will, and should, begin with funds rather than individual stocks. ETFs are a good place to start. Plan to build up a portfolio of such funds, emphasising sectors that are out of favour.

Then consider an allocation to actively-managed funds. Pick two or three idiosyncratic funds with widely different styles and approaches: this gives a better balance of risk and return. But keep a close eye on charges. A company that charges 1 per cent or more for a closet index fund is ripping you off. Buying a closed-end fund with a low TER and a large discount to asset value keeps down the effect of charges.

Three simple rules – pay less, diversify more, and be contrarian – will serve almost everyone well. Financial markets are complex, but much of the complexity is for the benefit of providers rather than consumers.

If you don’t understand it, don’t do it. That simple maxim would have saved amateurs and professionals alike billions of pounds in recent years.

Print Friendly, PDF & Email