Five key principles for successful investing
Tim Bennett Jan 04, 2013
If you’ve been meaning to take charge of your own money, but haven’t quite got round to it, 2013 is the year to start. The Financial Services Authority’s Retail Distribution Review (RDR) is now in force.
You can read more about here (What the new IFA rules mean for you), but in short the cost of financial advice is set to become a lot clearer – and many investors will get a nasty shock when they realise just how expensive advice can be.
So there’s never been a better time to get to grips with the basics. Even if you don’t want to invest for yourself, you’ll at least know what to look for from your adviser. Here are five key principles to follow.
Buy low, sell high
‘Buy low, sell high’ is one of the oldest investment adages around. But for many reasons – such as our tendency to stick with the crowd (see below) – we tend to do the opposite. One way to break this habit is to ‘rebalance’ your portfolio.
Take a simple portfolio that starts the year made up of 60% shares, 30% bonds and 10% cash. These are your target ‘weightings’. A year later, equities have done well, but bonds have not. So the portfolio now consists of 70% equities, 20% bonds, and 10% cash.
There are two problems. Firstly, the portfolio has moved away from your target allocation, changing the overall level of risk. Secondly, your portfolio is now heavily weighted towards an asset that has been outperforming, and so is more likely to be overvalued relative to other assets. A simple rebalancing exercise would see you sell some equities and reinvest in bonds, to return to a 60/30/10 split.
There are transaction costs associated with buying and selling, so we’d advise only rebalancing annually, unless markets are very volatile. But it’s worth the effort. In their book The Permanent Portfolio, authors Craig Rowland and JM Lawson note that, between 1972 and 2011, a portfolio split equally between shares, cash, bonds and gold delivered 9.5% a year if rebalanced annually, compared to 8.8% for one that was left alone.
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Don’t follow the crowd
One reason why we don’t make as much money as we could is that we all feel more comfortable doing what other people are doing, even when it’s pretty stupid. This explains why investors get caught up in bubble after bubble, from the tulip bulb fever of 1637 to the dotcom frenzy of 2001. So don’t run with the crowd – think with your head, not your heart.
How? Avoid popular, crowded trades – one example right now is the corporate-bonds market, which has attracted floods of capital as investors flee stocks and hunt for income. Instead, look for unloved, unpopular and, above all, cheap opportunities – places that other investors think you’d be mad to buy.
Just now, beaten-up Europe ticks the boxes. For example, Italy trades on a cyclically adjusted price/earnings ratio (a useful measure of how cheap or expensive a market is) of around seven, against more than 20 for America. It can be bought via the exchange-traded fund iShares FTSE MIB (LSE: IMIB).
Ignore the noise
Investors are constantly assaulted by opinions: from brokers to TV pundits to bloggers, everyone has an urgent view on the market that demands you make some sort of trade right now. But every time you do so, you lose a bit of your wealth to the middle men in the financial industry.
Costs include bid-to-offer spreads (the gap between the buying and the selling price); dealer commissions (say, £9.99 per trade); and perhaps even tax (in Britain you are charged 0.5% stamp duty on the purchase of many shares).
Over time this can seriously dent the value of your portfolio – even paying 1% more a year in costs makes a huge difference to the end value of your pension pot over several years. So don’t be tempted to over-trade and derail your long-term strategy on the back of a few panicky headlines.
With interest rates at a record low, it’s tough being a saver. So you owe it to yourself at least to get as much of your return tax-free as you can. So ensure you use your individual savings account (Isa) allowance before the 5 April deadline this year. The current maximum you can invest is £11,280, with up to half of that in a cash Isa, and the rest in stocks and shares. And start planning for your 2013/2014 allowance of £11,520.
Only buy what you understand
Complex products are not your friends. They are usually both more expensive and riskier than they first appear.
While this isn’t intended to be a comprehensive list, we’d generally suggest that long-term investors avoid the following: structured products (‘70% of the rise in the FTSE over five years or your money back’); exotic exchange-traded funds (including anything that offers twice or three times the performance of an index, or that uses the word ‘inverse’ in the title); hedge funds (they rarely perform); absolute-return funds (also poor performers); and finally any other product you don’t understand.
If you don’t know how and why a product makes money, you are better off betting on a horse; at least you’ll have fun losing it that way.