18 Dec The Foundation Stones Of Good Investing. Part 2 – Five Effective Investment Practices
Photo credit: fatboyke (Luc) on VisualHunt.com / CC BY-NC-SA
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioural discipline that are likely to get you where you want to go.”
Benjamin Graham
Last week, I set out five lifelong principles for investing. This week, we’re looking at five effective investment practices to give you the best chance of having a successful investment experience.
Build a well-structured portfolio
Once you accept that returns come from markets and are rarely enhanced by the judgmental approaches of individual investors or professional managers of market timing and stock picking, it is evident that structuring a well thought out mix of different types of investment (referred to as asset classes) should sit at the heart of your investment programme. Your long-term portfolio structure will dominate the investment returns obtained during your investment lifetime[1].
Successful investing is all about taking on well-understood risks that deliver a positive return expectation. These are carefully selected market risks associated with ownership and lending[2]. It avoids taking on risks that add little (or worse) to the portfolio, such as illiquidity, small numbers of holdings, poor predictive portfolio manager performance and opaque, expensive and complex product structures.
Use diversification to manage an uncertain future
Not putting all your eggs in one basket is an intuitive and valuable concept. No-one knows what the future holds. Owning a highly diversified portfolio spread widely across asset classes (bonds, equities and commercial property, for example) helps to make sure that you are prepared for whatever the markets throw at you over time. A portfolio for all seasons, if you will. Diversification is the key tool that we all have against the uncertainty of the future and the future is, by definition, always uncertain.
Owning a diversified portfolio brings its own challenge. Inevitably there will usually be one or two parts of the portfolio that are doing well but one or two that are not. The patient and disciplined investor knows that there is little point in knee-jerk responses. This is simply the way that markets are. The impatient and ill-disciplined will seek to change their strategy. More fool them.
Avoid cost leakage from your portfolio
Costs eat away at the market returns that you should be gathering for yourself. Small differences in costs will compound into large differences over extended periods of time. Investment industry costs are high, particularly those related to predictive (active) managers. The costs of investing are more than simply the explicit annual management charge (AMC) charged by the fund or portfolio manager. Other fund-related costs (marketing, accounting, registrar fees etc.) can also be offset against the fund’s performance. These combine with the AMC into the ongoing charges figure (OCF). Yet that is not all. When a manager buys and sells equities or bonds, they incur transaction costs, which eat further into returns.
The more transactions that take place and the more expensive it is to trade those assets, the harder the portfolio must work to overcome the drag effect of them.
If we take two portfolios with the same gross (pre-costs) returns – one with a cost of 0.25% a year and the other with a cost of 1.5% a year – the low-cost strategy will, on average, end up with a staggering 65% more money in the pot over 40 years[3].
Control your emotions using a systematic, disciplined approach
Unfortunately, evolution has hard-wired the human brain to be particularly poor at making investment decisions. A deep-seated subconscious battle is constantly being waged between greed and the desire for reward. And against the fear of uncertainty and loss, which creates ongoing anxiety and irrational decision making in many investors. Investing is certainly not emotionally easy.
Evidence of wealth-destroying, emotion-driven decision making is plentiful. Impatient and ill-disciplined investors have a propensity to chase fund managers, and markets, which have previously performed relatively well and sell those which have performed relatively poorly. Buy-high, sell-low is not a good investment strategy. Research reveals that this bad behaviour may cost investors around 2.5% per annum, on average[4]. Given that equities have only delivered an average long-term return of around 5% above inflation[5], that is a material erosion of potential wealth.
We recognise that both investors and advisers suffer from a range of behavioural biases that are more likely than not to result in the erosion of wealth. We believe that the design of a disciplined, systematic and understandable investment process, and its ongoing implementation, is central to your success as an investor, reducing this ‘behaviour gap’, as the industry calls it.
Manage risks carefully across time
Our approach to investing positions us as risk managers, rather than performance managers as advisers have traditionally been. We have identified three key areas of risk management which we believe everyone should employ.
The first is rebalancing a portfolio. Having spent considerable effort ensuring that your portfolio is both suitable for you and robustly structured, it is important to keep it that way. Rebalancing involves selling out of better-performing assets and buying less well-performing assets, i.e. selling, rather than buying, ‘hot’ asset classes. This enforces a systematic, rather than a market valuation-based, defence against possible market bubbles. Rebalancing is simple in concept but in practice, it is hard to do; it requires considerable discipline and fortitude, particularly at times of market turmoil when our emotions, particularly fear or greed, are heightened.
The second is fund selection: choosing which funds to recommend to our clients is a big responsibility that we take very seriously. We employ a detailed and insightful due diligence process to ensure that we are asking the right questions of product providers. Our focus is always on risk management that starts with eliminating fraud, explores operational risks, then focuses on product structure risks and finally looks at the ability of the fund firm to deliver market returns effectively.
The third is ongoing governance of the investment programme: for us, at Bloomsbury, it is entirely possible, and indeed likely, that our clients’ portfolios will look much the same between one time period and the next, with little activity except for rebalancing. That most definitely does not mean that nothing is happening. We hold regular Investment Research Committee meetings which focus on reviewing any new evidence (whether supporting or challenging our approach), the latest research on asset classes and additional due diligence aimed at ensuring that our ‘best-in-class’ funds remain just that.
In conclusion
Employing a systematic investment approach – like the one we have developed – provides the discipline and objectivity that is required to avoid the pitfalls that all investors inevitably face. It certainly makes investing far simpler and easier, but never easy.
“The most important quality for an investor is temperament, not intellect.”
Warren Buffett
[1] Brinson, Gary P., Hood, L. Randolph, and Beebower Gilbert L. (1986), ‘Determinants of portfolio performance’, Financial Analysts Journal, vol. 42, No. 4, pp 40-48.
[2] Fama, Eugene F., and Kenneth R. French (1993), ‘Common risk factors in the returns on stocks and bonds’, Journal of Financial Economics 33, 3-56.
[3] Sharpe, W. F. (2013), The arithmetic of investment expenses, Financial Analysts Journal, Volume 69 · Number 2, 2013 CFA Institute.
[4] Mind the gap 2014 by Russel Kinnel, Morningstar. http://news.morningstar.com/articlenet/arti-cle.aspx?id=637022
[5] Barclays Equity Gilt Study 2016, data from 1900 to 2015