Investments

Investing can be an incredibly risky business if you do not know what you are doing.

The story of a Chinese farmer who invested his life savings in a local mining company illustrates the point perfectly. He lost $164,000 when the company failed. Not only that, but he went into debt to buy $1 million more stocks to recoup his losses.

Most of us can see the problem here and think we would never do something so foolish as to put all of our eggs in one basket. Yet many people do make investment mistakes, sometimes against their better judgement and sometimes without realising it.

This is where a diversified portfolio can help protect your wealth. By spreading your money across multiple asset classes and investment types, you can mitigate your losses whilst maintaining a steady level of growth over the long term.

Diversification: An Example

The 2008 financial crisis might seem long ago to some people. For many investors, however, the pain is still fresh. Some people lost as much as 30% of their portfolio value in one year.

Yet this period of recent history provides a valuable lesson about the importance of diversifying your investments. Those investors with bonds in their portfolios, for instance, fared the storm much better than those with fewer bond investments and higher levels of (UK) equities.

Some portfolios with over 60% (UK) equities lost over 20% of the value of their portfolio between the end of 2007 and the beginning of 2009. Those with over 60% bonds might have only made a minimal loss – or even none at all.

The point here is not to try and argue that it is better to invest in bonds rather than stocks. Remember, past performance is no guarantee of future returns. Also, each investment type brings its own potential risks and rewards. Stocks tend to be higher risk with higher potential return, whilst bonds tend to carry lower risk and lower potential return.

Rather, the point is to show the importance of diversifying your investment portfolio. Had an investor put all of their money into (UK) equities during the 2008 financial crisis, their portfolio would have almost certainly taken an unbearable hit. However, by having investments spread out across different kinds of stocks, bonds and other assets, you lower your risk levels and minimise potential damage.

A Diversified Portfolio: Common Components

Domestic equities

Equities are sometimes also called “shares” or “stocks”. Here, you buy a degree of ownership in a company or set of companies in order to gain an investment return (e.g. on their profits). For the British investor, domestic equities refer to your investments in UK companies and typically form an important part of your portfolio.

At the time of writing, large numbers of UK stocks have been sold off in light of Brexit. This might sound like a bad thing for investors, but it could actually present them with some new opportunities to make a return.

However, the uncertainty surrounding Brexit should serve as a warning to not put all of your investments into one country’s equities, where they will be subject to the health, nature and effects of that single economy.

International equities

One way to diversify the equities in your portfolio is to buy shares in companies outside the UK. For instance, you might invest in funds which buy shares in the USA, Western Europe or even across the world. Certain funds might focus on a particular region such as technology companies in East Asia.

International equities can be a great way to spread your investment risk and leverage opportunities outside of the domestic market. However, they can be subject to currency fluctuations which can impact the value of your invest – even if you make a return. So, once again, it is a good idea to spread your investments out rather than just invest in these equities.

Bonds

Bonds are essentially a kind of “IOU” and are generally seen as less-risky than equities. For instance, you can buy a UK government bond and you be fairly confident that they will eventually pay the principal back with interest.

Due to their lower level of investment risk, bonds generally provide a lower investment return compared to equities. Therefore, they offer less growth potential for investors looking to expand their wealth, but are an attractive “insurance policy” against market dips and are a useful tool for investors to protect wealth as they approach retirement.

Property

Quite often a portfolio will also include investments in property in the UK, and possibly abroad. One common approach is for investors to put some of their money into REITs (Real-Estate Investment Trusts), which allows them to buy commercial property using pooled funds with other investors.

REITs and other real estate investments can offer some strong returns, but they also carry their own risks. Looking at Brexit once again, the uncertainty here has raised a lot of questions about the future of the UK property market and house prices. So, the rule of diversification applies.

Constructing a Diversified Portfolio

When building a diversified investment portfolio, you should consider the tax efficiency of your investments, as well as some of the popular investment platforms. However, building a solid investment portfolio which meets your needs and appropriately diversifies is not easy.

At FAS, we ensure you make informed choices about how to invest your money whilst taking into account charges and taxation, as well reducing investment risk without necessarily hampering growth potential!

Markets can be intimidating beasts. They go up and they go down. Some people profit through their investments whilst others lose money.

How is an investor supposed to approach this picture? Should you put your money into markets given the risks involved? If so, how much should you commit and what should you invest it in?

Moreover, when should you put it in and when should you take it out? Should you withdraw your money as markets are falling or during periods of volatility to try and curb your losses?

This latter question is the one we want to focus on here. This is known as “timing the market” and, generally speaking, it is a bad idea.

It might seem counter-intuitive, but it is ultimately better to stay in the market for a long period of time rather than trying to time it. Here’s why:

The Difficulty of Prediction

If you are already investing, remember why you invested in the first place.

It might be because you wanted to build up enough money for a comfortable retirement one day. Markets can be a great way to achieve that. Consider, for instance, that equities in the UK have grown by 5% on average each year since 1900.

However, you likely knew that it wouldn’t be plain sailing when you first started investing. The very nature of markets is that they stop and start. They bring short-term risks but also the potential of longer-term growth.

Consistently predicting the short-term dips and troughs is incredibly difficult, if not impossible. Think about the number of variables involved leading up to a market crash or substantial rise. There are human decisions made within governments and companies, which themselves are very hard to anticipate. Then there are local and world events which come down to bear.

Trying to see the near-future in this ever-shifting puzzle (where new pieces are constantly thrown into the mix) is clearly beyond normal human capacity, although this does not stop lots of stock brokers from trying!

It is very hard to see a market fall coming and pull your money out to protect it in time. In fact, trying to time the market in this way can really cost you both in the short and long term…

The Cost of Getting it Wrong

Consider for a moment what might happen if you missed some of the best days on the stock market because you pulled your money out at the wrong time.

One study actually tried to demonstrate this for the FTSE 250. It showed that if you invested £1,000 in 1987 and left it there for three decades it would be worth £24,686.

However, if during that time you put your money in and pulled it out, missing the FTSE 250’s best 30 days, then the money would be worth £6,878. That’s a difference of £17,808.

When you spread out the annual return over the thirty-year period, you would have seen an 11.3% return if you had kept your money in the FTSE 250.

Had you missed the best ten days it would be 9.3%. Had you missed twenty of them, it would be 7.9% and if you missed all thirty days it would be 6.6%.

These percentages might seem small, but over thirty years the difference amounts to a lot of money due to the nature of compound interest. There might be just 4.7% between 11.3% and 6.6%, for example, but remember that represents £17,808 in the above scenario.

In other words, rather than trying to time the markets it is almost always better to stay put and aim for longer term growth.

Should I invest now?

The answer to that question depends on your own financial circumstances. At the time of writing, it might be tempting to think that you should not invest right now given uncertainties surrounding the U.S.-China trade war and Brexit.

However, this is not necessarily a reason not to invest. Historically, some of the best investment returns have happened during times of great economic challenge.

One sensible way to protect yourself from short-term market dips and shocks is through “pound cost averaging”. Very simply, this means that you put your money into the markets gradually rather than in one bulk.

So rather than putting £20,000 straight away into stocks (which might then suddenly go down) you could put £2,000 into stocks over a 10-month period, reducing your risk exposure. It might mean that you actually end up making a better return in the long run, because you could end up buying more stocks at a cheaper price during a market dip. If these then rise in value down the line then you actually will have gained a higher investment return because of the dip. Conversely, of course, you could lose out on gains if the markets continue to rise during your phasing period.

Investment Tips

Unfortunately, you cannot completely shield yourself from short-term investment risks and market falls. However, there are some tactics you can use to increase your chances of gaining a higher investment return over the long-term:

Diversify your investments across a range of stocks, funds and asset classes. That way, if one company or market falls your other investments will help balance the risk.

Invest sooner rather than later. Remember the power of compounding. £10,000 invested over ten years produces about £16,288 at a 5% annual return. Over twenty years it gives you about £26,532. Over thirty is gives you about £43,219. Over forty years, you are potentially looking at £70,399.

Take advantage of ISAs and other tax allowances to make sure you keep as much of your investment returns for yourself as possible.

Stay in the market. Remember the potential costs of missing the best investment days because you incorrectly timed the market.

What makes gambling different from investing? If pushed for an answer, we would say that one of the key differences is “diversification.”

In other words, the former is primarily about rolling the dice on one hoped-for outcome, based mainly on chance. The latter, however, involves spreading your money out across many different asset types and classes which you reasonably expect to grow.

Images can sometimes present investing in a way which makes it look like gambling. Many of us are familiar with the hectic scenes of traders shouting and running around on the floors of the stock exchanges, buying and selling manically.

Prudent investing, however, is far removed from this image. Rather than putting all of your money into the fate of one company (such as Facebook or Amazon) and hoping it grows, you minimise your risk by putting your money into many different investments.

This way, if one or even several of your investments fail, your other investments should help carry you through and minimise your losses.

An example of diversification in action

When you look at different countries, you may notice that certain countries seem to be more vulnerable to economic shocks than others. This is partly because, like investors who do not spread out their investments, these countries are putting their “economic eggs” in one basket.

For instance, many countries hinge their economies on an important resource which they can produce and trade – such as oil, or coffee. When these commodities do well, their economies boom. When demand for the commodity falls, however, it can cause a huge deficit.

This is one reason why countries often seek to diversify their economies, so they are not reliant on one particular commodity, product or service in order to grow (e.g. manufacturing). Similarly, a wise investor will recognise that by diversifying their investments, they protect themselves from investment “shocks” whilst continuing to benefit from positive performance from other assets.

For instance, suppose you have two investors. Investor A has an investment portfolio (i.e. a set of investments) comprising 100% stocks (i.e. shares in various companies). Investor B, however, has a portfolio comprising 50% stocks and 50% bonds (we’ll come onto this later).

When the stock market experiences a dip or shock, which investor should fare better throughout the storm? Investor B should lose less money than investor A, because his/her bond investments should continue to deliver an investment return even as his/her stocks decline.

Different asset types

Another analogy sometimes used for diversification is the modern military.

Advanced military nations such as the USA, UK, France and Russia all have a range of defence assets at their disposal including infantry, mechanised vehicles (e.g. tanks), air power, naval units and cyber warfare technology.

These different military “assets” exist not just to counter different threats on the battlefield within a theatre of war. Each asset also exists in order to support the other. For instance, armoured vehicles and airpower assets are used to protect infantry during assaults.

Investing can also be conceived in a somewhat similar way. Just as military assets support one another, investment assets can “cover” and “carry through” other assets which might struggle on their own within particular market contexts. For instance, when your commodity investments are declining in value it might be your stocks which keep your investment portfolio moving forward.

Let’s take a quick look at some important asset classes you can include in your portfolio…

Cash

One of the most familiar types of investments, cash investments, are usually seen as lower risk but also tend to carry a lower investment return.

For instance, up to £85,000 of your cash in recognised UK Building Societies and Banks will be protected by the Financial Services Compensation Scheme.

However, many cash investments deliver a poor investment return due to low interest rates, which are largely eclipsed by inflation.

Shares

Sometimes these are called “equities”, and they refer to the stake(s) you have in one or more companies. For instance, you could invest directly in the shares of one company (which is very high risk). Or, you could put your money into an “investment fund” (e.g. a Unit Trust) together with a range of other investors. This fund would then invest this money into a collection of select companies. This is lower risk, because if one company in the fund declines or fails the others should help to keep the overall value of the fund growing.

Property

Many of us are familiar with the idea of house “flipping” – which involves buying a house and later selling it at a profit (often after a period of household improvements).

However, other lower-risk investment opportunities exist when it comes to property. For instance, you might invest in property funds – which are similar to the “share” funds described above, except in this case the investment money is put into residential or commercial property.

Property can be a great investment, but it does carry risk and you also face the issue of your money not being easily accessible once it is invested into property. If you need the money quickly, you might need to wait a lot longer than you would have otherwise liked.

Bonds

When you need money from the bank you can sometimes get a loan. This involves the bank giving you money provided you pay it back over time, with interest (so they make a profit).

In a similar way, you can “lend” your own money to companies and governments through bonds. So, if you buy a UK government bond you are effectively loaning money to them.

The idea is that, over time, you get the principle back as well as interest payments. These investments are generally seen as lower risk (particularly UK government bonds because they have a reputation for paying people back). However, the more reliable the bond-issuer the lower the investment return tends to be, because the risk is lower.

Bonds are usually a vital part of an investment portfolio, because they provide a solid investment foundation and “buffer” in the event that your other investments fall in value.

There are many different funds available to the mindful investor, each offering their own respective pros and cons. Some are better than others.

The difficulty is, it can all get a bit confusing if you aren’t familiar with the terrain. One example is global equity investing. What is it, and how does it help your portfolio?

In this article, we’ll be defining what global equity investing is and why we feel it’s important to consider this when constructing investment portfolios.

Global equity investing: an overview

To get one part of the definition out of the way, “equities” is a term often used for “stocks” which are shares in a company that are typically traded on the stock market.

You can invest in equities (or stocks) individually, by picking a specific company and buying one or more of its shares. This might be a UK-based company, in which case you would be buying a domestic equity.

The other common, less-risky route is to invest in equity funds. This is where you pool your money with other investors into a collection of companies. If the companies are based in the UK, then the fund can fairly be described as a domestic / UK equity fund.

If the fund comprises of businesses which are based abroad, however, then the fund is no longer domestic and might take on another name. For instance, if the companies are based in Western Europe then the fund’s name might be “Western Europe Equity fund”.

Accordingly, a fund comprising businesses from developing countries might be termed a “developing world equities fund”. It might even pick other companies to join the fund, provided they are companies which are based in what is commonly-accepted as “the developing world.”

This is where global equity investing starts to come to the fore. Global equity investing is where you include investments in businesses from outside the UK into your portfolio. As such, a global equity investment fund therefore can pick businesses from across the world.

What’s the value of global equity investing?

The main benefit of a global equity investment fund is that it is not limited to the domestic or regional market when it comes to asset selection. Instead, it can pick the most attractive markets – and stocks – from across the world and include them.

As many people know, certain regions or parts of the world excel in particular sectors of the market. Switzerland, for instance, has a strong reputation for banking and drugs manufacturing. Australia is renowned for its mining businesses. The UK, USA and Israel are making a name for themselves in cyber security, and parts of Asia are excellent for technology.

The manager of a global equity investment fund can survey the world’s markets and pick the strongest companies from the strongest sectors. In addition, fund managers can identify the sectors of the global economy which historically perform better at certain times of year, and tailor their fund planning/strategy accordingly.

The downsides

As always when it comes to investing, it is important to consider the risks as well as the positives when looking at global equity investing.

One risk to factor is currency fluctuations. For instance, a strong pound against foreign currencies (e.g. the dollar or yen) will result in lower international stock values when these are converting into pounds.

Another risk is the potentially higher volatility (i.e. swings up and down) experienced by certain international stock markets. China and Venezuela, for instance, have often shown themselves to be more volatile markets than Germany or France.

Balancing global equity investments

Many people can get nervous about global equity investing, particularly due to “home bias”. This refers to investors’ natural tendency to invest in stocks from their home country, even when faced with strong evidence that diversifying abroad would bring great benefit.

An important balance needs to be achieved by the wise investor. On the one hand, you do not want to take needless, excessive risk when investing in overseas markets and businesses. On the other hand, you do not want to miss out on some great potential returns that are often hard to achieve elsewhere.

When it comes to discerning how to integrate global equities into your investment portfolio, this is where we come in. As experienced Financial Planners we can identify the risks and opportunities, as well as having the resources and means available to construct a solid investment strategy for you.

In 2014, Vanguard delivered some fascinating research. It showed that in 2013, nearly 50% of the global equity market resided in the United States. Yet at the same time, mutual fund managers in the U.S. held only 27% of their equity allocation in funds not domiciled in the U.S.

Certainly this illustrates the subject of “home bias” quite nicely. Yet it also brings an important issue to the fore. Investors who concentrate their investments in their domestic market (e.g. the U.S. or UK) are arguably taking a big risk, because they are subjecting all of their equities to domestic economic and market forces.

If that domestic economy declines or even crashes, then all of the equities in that investment portfolio are exposed. If, however, an appropriate amount of global equities are incorporated into the mix, then these equities will likely not be as affected.

Indeed, the Vanguard research cited earlier even suggests that adding a prudent amount of global equities can reduce the volatility of an investment portfolio. That said, this is not an objective fact and all investment portfolios are different. Indeed, two investment portfolios will likely perform differently within the same time period, even with a similar percentage of global equities comprising the mix.

Regardless of whether you are a novice investor or an experienced one, timing the market is a temptation you should really try to avoid. Some people will claim they are able to predict market outcomes and make big investment returns but from our own professional experience, we can confidently say this is incredibly difficult and indeed there are far better ways to invest, in order to protect and grow your wealth.

A Tale of the South Sea

To illustrate our point of view, let us consider the case of Isaac Newton. Notorious for his groundbreaking scientific work, he is perhaps less well known for his role as an investor. Newton witnessed first-hand the growth of shares in the South Sea Company. In January 1720, these shares were trading at nearly £130. Yet 6 months later they had risen to over £1,000.

Sensing an opportunity, Newton invested. Yet he also suspected the rise in share price was unsustainable and decided to sell his stake before it crashed but this did not happen. In fact, the price continued to rise and so Newton decided to re-invest in the same company. It was at this point, as luck would have it, that the share price dived to £175 and Newton’s life savings were virtually wiped out in the process.

Perhaps those close to market speculation such as Warren Buffett with his insight, have a higher probability of success in timing the market but everyone else relies broadly on the same information with very limited knowledge.

Cognitive Biases

We have spent many years working with clients across Kent & the South East, speaking with other financial planners and following stock market investing. We have learned many things along the way, one of them being that people do not always make rational decisions in the world of investing.

Cognitive biases influence people’s investment decisions so the role of a good Financial Planner is to help clients identify and mitigate against their own biases, in order to make smarter decisions for their money. Quite often it takes an impartial, experienced observer to see identify something missing or draw attention to something that is perhaps more important than originally thought.

For instance, one common cognitive bias in investing is called the “bandwagon effect”. In this scenario, you invest in something because everyone else is. This makes the investment look less risky, because we think: “How can so many people be wrong?” Unfortunately, lots of people can all be wrong at the same time. There are countless examples throughout history of dozens of people rushing to invest in the next ‘big thing’, only to see it crash later that day, week or month.

Another cognitive bias is called the ‘gambler’s fallacy’. Just think about the times you have rolled a dice. If you roll four sixes in a row, you might start to believe that a six is less likely to come up if you roll the dice one more time. However, you face exactly the same probabilities as you did for each of the previous four rolls. We can often bring this thinking to our investment decisions. Like Isaac Newton, we might be tempted to sell because our investment has performed so well up until now. Yet, as we say time and time again to our clients “past performance is not necessarily a guide to future returns” in the world of investing.

Emotional Biases

Let us consider two scenarios. In scenario one, someone offers you two choices of either taking a guaranteed £400 home or giving you a 90% chance of taking £500. In scenario two, however, you get a different choice. You can either lose £400 or you can take a 90% chance of losing £500.

What would you do? Most would accept the guaranteed £400 in scenario one and then take the chance of losing £500 in scenario two.

Why does this tend to happen? It is because, broadly speaking, human beings tend to feel loss much more acutely than they do gains. So, if you are not careful, this can often lead to highly irrational, erratic investment behaviour. You might see your investment plummet in a short space of time, for instance, and the emotional loss you feel, drives you to want to sell before things get any worse. Yet this isn’t always the right decision. Sometimes, waiting things out even whilst others are bailing, is the best course of action. It is our job to help you see through this.

Fighting the Chimp Brain

Human beings are highly sophisticated and intelligent creatures, yet there are still parts of our brain that are considered ‘underdeveloped’ or even ‘primordial’. Such parts are known collectively as the Chimp Brain and they tend to exhibit the following traits.

• Irrational thinking and/or behaviour
• Decisioning making based on emotion
• Jumping to a conclusion rather than waiting and weighing things up
• Paranoid thinking
• Catastrophizes
• Seeing things as black or white, rather than shades of grey

With investments, it’s important to recognise this part of our human make up and the best way to deal with these traits is to recognise them when they emerge, put them into perspective, and then set them to one side.