A strategy for the once-a-year investor
If the professional classes gave a little more attention to their portfolios, says Jonathan Davis, the results could be startlingly better ‘T ell me frankly’, I asked my friend Robert, a successful City lawyer, over a modest lunchtime bowl of pasta in Holborn the other day: ‘How did your investments do last year? Are you cutting back on your equity exposure this year?’ Robert is not a man given either to imprecision or to extravagance — hence the Italian restaurant, rather than 1 Lombard Street, or some such expensive City eatery. I wasn’t expecting a crisp lawyerly answer.
Even so, his answer still surprised me. ‘Quite frankly,’ he said, ‘I haven’t a clue. I had a look at the portfolio valuation on Boxing Day, or thereabouts, and it seemed to have done all right. Does something like 12 per cent last year sound about right to you? As to my equity exposure, all I know is that everything seems to be going up at the moment, so I’m fairly happy.’ Such hopelessly casual attitudes towards investment have long been the norm among my generation of fortyand fiftysomethings. The insouciance towards the stock market, usually coupled with a partiality for lockerroom tips above serious analysis, reflects genuine diffidence, I have come to think, rather than affectation. If professional middle-class families were to give their investments even a fraction of the time and attention they give to researching a new car or washing machine, their results could be startlingly better.
According to Warren Buffett (who turned every $10,000 his original investors provided him with in 1957 into more than $400 million today), the principles of sound investment for the irregular non-professional investor are simple. They can be summed up like this: buy low, sell high; bet big only when you know something others don’t, avoid popular fads and don’t trade very much, as the transaction costs will kill your returns. These basic principles don’t change from year to year.
The problem, as Buffett also concedes, is that putting simplicity into practice is not easy. In part this is because we all have a natural urge to get busy; and in part because genuinely valuable professional advice (which would include saying don’t get too busy) is not easy to come by. In his latest annual report, Buffett criticises the layers of fees levied by what he ironically calls the ‘Helper’ family. These are advisers, brokers, fund managers and other professional intermediaries whose avowed objective is to help you ‘beat the market’, but whose effect more often than not is simply to transfer a slice of your returns to their own pockets. ‘The burden of paying Helpers may cause ... equity investors, overall, to earn only 80 per cent or so of what they would earn if they just sat still and listened to no one,’ he says.
There is one obvious exception to Buffett’s general exhortation to go easy on pricey professional help. If you haven’t already done so, it is worth paying a one-off fee for a session with a tax-wise financial planner. He or she will urge you to do all the things Ian Cowie writes about in this issue, plus sort out a tax-efficient will and write life insurance in trust to avoid inheritance tax. These are all must-do steps for those hoping to leave wealth to the next generation.
But having done that, what then? The biggest difficulty non-professionals face in planning an investment strategy is appreciating that there are good times to be committing capital to financial markets, and times when greater caution, or even retrenchment, is called for. The odds in the markets do not stand still. All the evidence points to the fact that the current climate requires relative caution, not risk-taking. As in poker, another game of probabilities, there are times to play and times to stand pat.
Yet the monthly fund business statistics tell us that more money is being committed to stock market (equity) funds this year than at any time in the last five years. One reason is that the stock market has been rising steadily for three years. The strength of markets makes most investors feel good about the potential for further gains. Few professionals with a vested interest in the way you manage your wealth are going to tell you anything other than that this trend is set to continue.
In fact the strength of markets should be sending out warning signals, because most types of financial asset are now looking risky and expensive, rather than glaringly cheap. The fact that money is now flowing into shares from individual investors is a classic contrarian indicator, making it likely that the short-term prospectus is for disappointment, not gain. There is a well-documented negative correlation between where retail fund money is flowing and subsequent performance. The bigger the flows, in general, the poorer the probable returns over any medium-term (threeto five-year) perspective.
Three years ago advisers were mostly telling clients to cut down on their risk exposure and pushing them towards supposedly safer corporate bond funds and/or (if they had enough money) hedge funds. That does not look so smart today: the average corporate bond fund has returned 14 per cent over the past three years and the average hedge fund not a huge amount more, while the then ‘risky’ equity funds have made 80 per cent, and some emerging markets double that. Now after three years of price rises, it is stock market funds, commodities and emerging markets, all of them riskier assets, that are topping the fast-seller lists.
So you can be fairly sure you won’t go wrong at this juncture by holding your fire and keeping a healthy reserve of cash and liquidity, looking to commit more capital only when financial investments start to fall in price once more. A quick trawl through the main investment asset classes reinforces the case for caution. Start with government bonds. ‘There has never been a period in the last 105 years when, after allowing for inflation, investors buying long-dated government bonds on their current miserly yields have made a positive return 15 years later,’ reports Tim Bond, head of asset allocation at Barclays Capital, one of the London market’s biggest players in bonds.
If you are going to buy bonds, then, the message is clear: stick to short-term maturities (those that promise to repay your money in no more than five years’ time, now yielding around 4.5 per cent) and steer clear of most corporate and emerging market bonds, which are mostly not priced to reflect their greater risk. You want to lend money to the Brazilian or Mexican governments? They will pay you around 6.5 per cent and 8 per cent respectively — best to stick to their tortillas.
The forces that have until recently been driving down bond market yields have also been driving up the prices of most other financial instruments. For five years, the global financial system has been awash with surplus liquidity, or money looking for a better home in a low-interest-rate world. The US Federal Reserve’s deliberate low-interestrate-policy is only now coming to an end, with short-term interest rates up from 1 per cent in 2003 to 4.5 per cent today, but they are only now approaching what would normally be regarded as an equilibrium level, given the strength of the global economy.
While stockbrokers can still make a plausible case for buying shares at current prices, when you boil down their argument to essentials all they are really saying is: 1. shares don’t look quite as expensive as bonds; and 2. we are seeing a lot of takeover activity the next bid could be for a company whose shares you own. Beware of such self-serving arguments. The first duty of prudent investors is to think long-term and preserve their capital, not to chase possible takeover targets. As with any traded commodity, it is only worth taking risks when prices offer sufficient value to justify the risk.
So, while shares will always logically form the biggest chunk of any sensible long-term investment portfolio, after three successive good years it would be unwise to expect much more from them now. If you must commit more long-term capital to the stock market at this point, there is still, however, a lot to be said for looking at an Aim or private equity Venture Capital Trust, which (providing the scheme survives next week’s Budget) offers up to 40 per cent immediate income tax relief on a risky small-cap equity portfolio.
Braver folk might also take a look at biasing their purchases towards those sectors that have done relatively poorly over the last five years — telecom and media stocks, the chief victims of the internet bubble, being among the obvious candidates, with pharmaceuticals another. There are those who think that technology stocks may also be due for a recovery after six pretty lean years. Some beaten-up retail stocks also look quite good value on the same measure.
As for the mining and resources sector, which have been very good performers for the last 18 months, expect to see some headline-grabbing collapses in the next few months. Mark Twain famously described a mine as ‘a hole in the ground with a liar at the top’. Some of the stronger, more established mining companies (such as BHP and Rio Tinto) may offer good value on a fiveto ten-year view, however, as commodity prices look set to continue rising over that timescale, a move that probably has still not yet been fully discounted.
In summary, the key to success for the once-a-year investor, with an eye on his family’s long-term wealth, is to buy only those things that are obviously cheap. The rest of the time, bias what you hold against what is currently most popular and you won’t go far wrong.