Can there be a secret to winning the game of investing?
Why is it that some people have a positive experience when they invest, and others don’t? Surely the underlying market, the stock market, is the same for both investors?
The question has been asked for many years. Some say there is no free lunch when it comes to investing, which I would agree with in part, but professional or institutional investors use a skill that’s benefited them over time and is not often used by the individual (retail) investor.
The first thing to understand is that your total investment capital (money) is referred to as your portfolio. And within your portfolio you often have different individual investments.
A bit like your diet, where you have proteins, carbohydrates and fats and each macro-nutrient serves a purpose, the same is true for your investments in your portfolio.
At a basic level, you have two types of investments in your portfolio:
Equities, also known as shares. Your equities often represent part-ownership in a publicly listed company. When you buy shares for example in Apple, you actually become a part-owner of Apple; what a shame you can’t get ‘mate’s rates’ on the latest iPhone! If the company decides to pay out some of the profits it made, it pays a dividend payment and as a part-owner/shareholder of the company, you receive this income.
The second component is fixed income, or bonds, and this represents a loan to a company, or to a government. The latter can have a specific name: a loan to the British government is called a Gilt, after the gold edging on the original certificates, and a loan to the American government is called a Treasury. Loans to companies or governments allow the recipient to expand and achieve objectives without giving up ownership; or in the case of a government, raise taxes. In return for you lending the money you receive an income, or coupon, paid periodically.
Because of the risk associated in owning or lending money to just one company you can invest via ‘funds’ often referred to as Collective Investments. These funds are a collection of the underlying shares and/or bonds. The benefit of buying a fund, rather than one company’s shares/bonds, is that you automatically spread your risk across hundreds, perhaps thousands of companies, therefore if one company does not go ‘according to plan’ then this has less impact on your overall portfolio.
Active or passive?
There are two ways these funds can be managed: active management, where for a higher fee the fund manager ‘tries’ to beat the overall market performance (but rarely does) by buying and selling regularly; or through index or passive management, where you simply, for a much lower fee, buy the whole index and minimise buying and selling.
Because of many reasons not relevant to this article, and including the higher fees, I’d rather buy the whole market index and pass on the active manager fees. If you want to know more on this, see the Standard & Poors Active verse Passive report which should be enough to convince you.
I want to increase the odds that my portfolio will deliver the market return. There are two things I can do to try and achieve this: buy low-cost index/passively managed funds, and hold them for a long time. This way I get a pure experience of the stock market and remove the risk of an active manager having a bad day, or worse.
What does winning look like to you?
Winning at investing is relative to your own objectives and this will come down to your own financial situation and outcome. You may want lots of risk and growth and have many years to remain invested so your expectations of returns reflect this; or you may have sufficient capital to meet your needs, enjoy a worry-free life and want more certainty and regularity in your returns.
Whatever you want will mean you need a different portfolio – not all portfolios are created equally!
Think of it like a nutritionist tailoring your diet to suit your needs. If you’re preparing for a marathon they might increase the carbohydrates and fats and reduce the protein allocations, but if you’re looking to get leaner and build more muscle, they might increase your protein and reduce your carbohydrates.
An investment portfolio is the same and the mix of the assets in your portfolio is referred to as its ‘asset allocation’.
Asset Allocation is the best kept secret in investing and is a key component to your investment success. It’s been the source of academic research and government reports for decades:
“Institutional investors may be devoting insufficient resources to Asset Allocation which may contribute the majority of their investment performance.”
Myners Report, March 2001
“For the individual investor, the Asset Allocation decision is by far the most important factor in determining returns.”
Sandler Report, July 2002
And according to a well-known study by Brinson et al, more than 90% of the variability of a portfolio’s performance over time is due to asset allocation.
What this means to you is, if you want higher returns from your portfolio, you need to amend your asset allocation to hold more equities and less bonds – but be mindful you’ll take on more volatility risk. Conversely, if you want more certainty of return, you need to increase your fixed income allocation and forgo investment return from equities.
Increasing your equity allocation may seem an obvious solution to increase returns, but what is essential in my view is that when I invest, I want to own as many induvial shares as I can, across as many different sectors as possible, to reduce the risk of an individual share.
“Diversification is the only free lunch in investing”
Nobel Prize winner
Global stock markets work, and they have worked for centuries. The MSCI World Index has delivered a return of around 10%pa on average, however it’s very rare it returns 10% in any single year, it’s usually higher or lower. This volatility is the price you pay for participating in these markets. We can’t remove this volatility completely, but with sensible asset allocation we can tailor it to suit your needs.