Investment is defined by the Oxford English Dictionary as “the action or process of investing money for profit”. However, as with all things, it is not quite so simple. Investing, in every sense of the word, involves exposing your assets to risks. These may include market risk, inflation risk and liquidity risk. All of these are risks that exist everywhere and, as such, if you want to invest, you need to be comfortable with being exposed to one or all of these risks in some form or another.
However, there are aspects of a portfolio that can cause a huge amount of damage, but are able be controlled. These ‘enemies’ to a portfolio are what we are going to focus on, as the key to investing is to recognise what theses enemies are, and how we can avoid or minimise them.
1. Lack of Diversification
We find that the world over, people chase stocks, themes, asset classes, trends and anything else they believe will make them a profit, but ultimately expose themselves to an increased amount of risk by allowing the investment to be concentrated. However, this breaks the first rule of investing… ‘not putting all your eggs in one basket!’
Diversification through holding different stocks, asset classes and sectors has been shown through Nobel Prize winning economics to reduce risk. There are two type of risk, systematic and unsystematic. Systematic risk is the effect that market activity has on a portfolio. It is uncontrollable and you cannot remove it. Unsystematic risk is stock specific and is inherent in each investment, and although unavoidable, the effects of stock specific risk can be reduced through diversification. For example, if your entire portfolio is invested in one company and that company loses a big contract and drops in share price, you will suffer a big loss on your portfolio value. However, if you hold shares both in that same company alongside other companies, the negative effect on your portfolio is potentially reduced.
This seems fairly obvious; however, it becomes more difficult to see when looking at a portfolio’s fund construction. A lot of funds can hold similar stocks, especially when they reside in the same sector. You can have a collection of 10 funds within your portfolio that makes it look diversified, but when you dig deeper you find that it is actually skewed towards one sector of the market. This is why it makes sense to know exactly what is in your portfolio, rather than just pick funds that have performed well in the recent past.
2. Market Timing
The second aspect that can work against your portfolio is that of market timing. There is often a belief that investors and their advisers can time their entry and exit from the market in order to profit. There is nothing more encouraging than having someone who is supremely confident that they know which way the market is going. However should you pick up any financial supplement, it is most likely that there will be the latest guru telling you the stock market is about to crash with the next guru on the page after that telling you why it is about to rally. Both have a compelling argument backed up by facts and figures, however, which way to follow? There are so many conflicting views at any one time that it is pot luck as to who is correct. There is enough information and indicators out there to suggest anything from a global meltdown to the next huge rally. This makes market timing nigh on impossible.
At best, a market timing strategy can decrease your returns by missing out on the first part of a rally. At worst, this strategy can lead to huge losses when the wrong call is made. No-one knows which way the markets are going, so you need a strategy that doesn’t rely on someone guessing correctly using their crystal ball.
3. Stock Picking
This falls under the same kind of heading as market timing. The difference is that instead of calling when markets will rise and fall, the focus is on finding specific companies that are ‘undervalued’ and are expected to rise substantially in the near term. Once again, we have the problem of calling when the share price will stop falling, and when it will start rising. It sounds very much like speculation.
Equally, in this day and age, information is available 24 hours a day, 7 days a week. Many people would suggest that actually we suffer from information overload. You can find out almost anything using the internet, especially when it comes to public companies. This leaves us with the problem that if the same information is available to thousands of investors and analysts, why is a stock not priced correctly? If the price is wrong today, how can one be sure the market will eventually arrive at the “correct” price in the future? Is the market inefficient today but efficient tomorrow, or is there a chance an investor will go to his grave as the only one who knows the right price?
Stock picking, like market timing sounds exciting and a route to riches, however, it is a dangerous and erratic way of investing akin to gambling. This is more likely to work against your portfolio than for it.
4. High Fees
The aspects that determine a portfolio’s return are capital growth and dividend income, less expenses. The expenses can take the form of transaction costs, annual management charges, stock-broking fees, adviser fees as well as entry and exit fees.
High fees provide a much higher hurdle for your portfolio to overcome if it is to provide a profit. If you invested £1,000,000 in a portfolio and it gained a 6.5% return each year over 30 years, a portfolio with a 3% annual fee (i.e. a 3.5% compound annual return) would have a final value of £2,806,794. A portfolio with a 2% annual fee (i.e. a 4.5% compound annual return) would have a final value of £3,745,318 giving a benefit of £938,524.
This view becomes more alarming when you look at fund fees in the UK. According to the Lipper UK Fund Charges Report January 2011, the average global equity fund charges 1.66% per annum. When combined with the fact that high stock turnover can add as much as 1.8% per annum to this figure, we start to see that some fund managers will have costs of 3% plus per annum to surmount before making a profit. This is a large hurdle to clear, showing the importance of managing and reducing costs.
5. Flashy Marketing
The fifth aspect that can work against the generation of positive returns is that of flashy marketing. This is marketing from investment fund houses, advisers and ‘expert’ commentators. I lose count of the amount of articles, magazine covers and advertising promising extortionate returns, advice on selling/buying stocks or access to the latest ‘star’ fund manager.
When reading or listening to this marketing and commentary, you always need to remember that the writers of this marketing do not have the same goals and objectives as you or your portfolio. Their sole aim is to sell. Be it magazines, funds or services, they all have the goal of increasing sales. They are not trying to help you have a successful investing experience or hit your investment goals.
The easiest method for them to sell to you is to appeal to the basic human trait of greed, by offering incredible returns and/or downside protection. However, with all marketing I tell my clients to bear in mind that if it seems too good to be true, it usually is, and that the writers of this marketing are all trying to sell something to someone. If there was really someone out there who could predict the next winning stock/manager or asset class, the last thing they are likely to do is share the knowledge.
The sixth and final area we are focusing on is the emotions of investors. This is the reason that most investor’s fall foul of all of the above enemies to portfolio returns. As human beings we tend to let our emotions rule our life, which is counterproductive when investing in the long term. Our emotions encourage us to dive in to markets when they are doing well in a vain attempt to avoid missing a good run, and to bail out when they plunge in a misguided attempt to miss the worst of it. They also make us fearful of the short term when we should be focusing on the long term.
Uncertainty is an integral part of investing. Successful investing is not about making a good call on a stock or timing the market, it is about focusing on the aspects of the investment experience you can control and that make a real difference to your end result.
More than anything, a good investment strategy involves recognising the risks worth taking, and the risks that work against your investment goals. It is in this area that a knowledgeable and well qualified adviser becomes invaluable.
This article originally appeared in the October supplement of the Barrister Magazine