Every investor faces the same conflict: how to balance risk and reward. Should you accept a lower return in exchange for peace of mind? Or should you attempt to make your money grow more quickly and face the possibility of losses? In fact, the best solution to the dilemma is? Neither!
As this article will demonstrate, the optimum way to build up your wealth is to:
• Set clear objectives - Know where you are going and what you want to achieve.
• Diversify - Invest your money in more than one area to combine growth and security.
• Be consistent - Don’t chop and change but stick to your strategy.
• Stay on top of it - Keep an eye on performance all the time.
• Avoid unnecessary expenses and charges.
Bear in mind the world’s wealthiest investor Warren Buffett’s philosophy is to preserve and grow his investments and in that order. He is still living in his Omaha Nebraska home where he has lived for over 50 years which cost him a modest $31,500 ( €28,125 ) He is also the author of one of my favourite quotes in relation to the very best return of any asset class …the stock market is a mechanism for transferring wealth from the impatient to the patient…
1. Basic Investment Planning
Your primary investment priorities should be to:
• Build up an emergency fund (ideally 3 to 6 months net annual income as a minimum)
• Start a pension plan (remember even at 20% tax relief, your fund would have to go down by 20% before the investment loses)
• Buy your own home (with decreasing values, still the goal for many investors)
What you should do next will depend on your circumstances. Whether you have a lump sum to invest or simply plan to save on a regular basis, your objectives will basically revolve around the following questions:
• How much money is involved?
• How long can you tie your money up for?
• What type of return are you looking for?
• What risks are you willing to accept?
• To what extent is tax an issue?
Let’s look at each of these in turn.
How much money is involved?
If you are saving regularly, then you have a choice between investing in a specially designed longer-term plan or building up ‘blocks’ of capital and investing each one somewhere different.
If you have a lump sum – or as you build up ‘blocks’ of capital – then the choice of investments available to you opens up. For instance, with some capital available, with affordable property values, property investment becomes an option, as does buying publicly quoted shares.
You must have a clear idea in your mind about how much you plan to invest and in what form. If you are saving on a regular basis, consider how long this will be for. Bear in mind that regular savings products have advantages and disadvantages. On the one hand, they tie you in and there can be strict penalties for early encashment or withdrawal. On the other, they force you to be disciplined and take away the tricky decision of how to invest your money.
You should also think about the cost of such plans.
How long can you tie your money up for?
Is there a date you need your money back? In other words, are you investing for something specific or just to build your overall wealth?
Investments have varying degrees of accessibility or liquidity. An investment that allows you to get at your money immediately is considered ‘highly liquid’. Cash in a deposit account or publicly quoted shares, for instance, are both liquid. Property and pension plans are not.
How long you stay with any particular investment will partly be determined by the investment vehicle itself (a ten-year savings plan is – unless you break the terms – a ten-year savings plan) and partly by events (there may be a good reason to sell your investment).
What type of return are you looking for?
Returns vary enormously. Since 9th March 2009 – the start of the current Bull market… 2nd longest and strongest - the stock market has grown more than 200%. Returns on savings accounts currently are negligible ( best demand account is Nationwide UK’s 0.76% - net 0.4484% after DIRT tax ) so investors are happy to risk some of their money where the return will be somewhat better.
What risks are you willing to accept?
In general, the higher the return, the greater the risk. The highest possible returns are to be made from investments such as managed funds, commodities and spread betting – but you can actually lose substantially more than your original investment. The lowest returns are to be made from investments such as bank deposit accounts and State Savings investments – where your money can be considered 100% secure.
In formulating your overall investment strategy, you need to consider your approach to risk. Are you willing to accept some risk in order to boost your return? How much?
To what extent is tax an issue?
If you are a higher-rate taxpayer – or expect to be – then you need to consider to what extent tax saving is an issue for you. Bear in mind that there are a number of highly tax-effective investment options available – though all carry above-average risk. Remember, too, that capital gains are taxed at a much lower level than income – which may make this a more attractive option for you.
2. A Proven Investment Strategy
The saying ‘don’t put all your eggs in one basket’ is extremely relevant when it comes to building wealth. In fact, it forms the basis of the only investment strategy I believe can be relied upon: diversification. If your investment strategy is too safe, then you won’t enjoy decent growth. If your investment strategy is too daring, then you risk losing everything you have been working towards. The solution? To diversify your investments so that your money is spread across a range of areas…which leaves you two simple decisions:
- In which areas should you invest your money?
- How much should you invest in each area?
As already mentioned, you should start by diversifying into the three most important areas of investment – your emergency fund, your pension and buying your own home. Having done this, I would suggest putting your money into the following five areas:
- Pooled investments – managed funds
- A ‘basket’ of directly held stocks and shares - indexed funds.
- Investment property.
- Higher risk and tax-efficient investments such as hedge funds, emerging markets, energy & tech stocks
- Alternative investments such as art, antiques, gold and other precious metals.
Within each area there is much scope for choice, allowing you to vary the amount you invest, the length of your investment, the degree of risk and so forth. You must decide for yourself what mix of investments best suits your needs.
Your next step will depend largely on how active a role you want to play. One option is to investigate each area thoroughly yourself. Another option is to allow an authorised financial adviser to handle it all for you. My own suggestion would be to go for a combination of the two. Educate yourself, keep yourself informed but let an expert guide and support you. If the top golfers rely on their coaches, you too should do likewise for your finances.
When long-term means long-term
One of the biggest mistakes investors make is that they forget their own financial objectives. If you are investing for long-term, capital growth – a good, solid gain over, say, 20 years – then if you change your strategy half way through you must resign yourself to a poor return and even losses. This is true regardless of the investment vehicle you are using.
If a change of strategy is unavoidable, then try and give yourself as long as possible to enact it.
There are various areas where investors seem particularly prone to chopping and changing. A long-term savings plan – such as an endowment – is one. The stock market is another. In every case (leaving aside some sort of personal financial crisis) the usual reason is despondency over perceived lack of growth or falling values. If you have chosen your investments well you shouldn’t be worrying about the effect of a few lean years or an unexpected dip in values. If you are concerned that you have made a bad investment decision in the first place do take professional advice before acting. The biggest losses come when an investor panics.
3. Pooled Investments
A pooled investment – sometimes known as an investment fund – is a way for individual investors to diversify without necessarily needing much money. Your money – along with the money of all the other participants – is pooled and then invested. Each pooled investment fund has different, specified objectives.
For instance, one might invest in the largest Irish companies, another in UK companies, a third in US gilts and a fourth in tech and energy stocks. In each case the fund managers will indicate the type of risk involved. They will also provide you – on a regular basis – with written reports or statements explaining how your money is performing.
Since it would be impossible for all but the richest of private investors to mimic what these pooled investments do, they are an excellent way to spread your risk. A typical fund will be invested in a minimum of 50 companies and will be managed by a professionally qualified expert.
The fund managers make their money from a combination of commission and fees:
• There is often an entry fee of up to 5% of the amount you are investing though insurance company there are no entry fees..
• There will definitely be an annual management fee – usually c. 1.5% of the fund total at the end of each year.
• If you want to sell your share in a pooled investment, you may also be charged a fee.
It is sometimes suggested in the media that fund managers are rewarded too highly. My view is that if a fund is meeting its objectives, then it is only fair that the fund managers recoup their costs and earn a fee for their expertise.
A couple of other points before we look at all the options in a little bit more detail:
- The funds described below are all medium to long-term investment vehicles. In other words, you should be thinking about leaving your money in them for an absolute minimum of five years – and more like ten years or even longer.
- Although past performance – as it always says in the small print – can be no guide to future performance it is still useful to know. One thing to note is who is making the actual investment decisions and how long they have been doing it for. If the individual manager of a fund has changed recently then the past performance may not be so relevant.
I include several different types of investment in this category:
• tracker bonds
• unit trusts and other managed funds
• with-profits funds
• stock market ‘baskets’ (or guaranteed stock market active funds).
This is because all of them are what I would describe as ‘tailor-made investment vehicles’. That is to say they have been specifically designed to meet the needs of ordinary, private investors. This is in direct contrast to, say, un-tailored opportunities – such as buying a publicly quoted share or an investment property – which aren’t aimed at any specific group of investors.
This is a fund that guarantees to return your initial investment plus a return based on a specific stock market index or indices. For example, it might give you all your money back after five years plus 80% of any rise in the FTSE 100.
Your money is used to purchase ‘units’ in an investment fund. The price of the units will vary according to the underlying value of the investments. For instance, if the unit trust specialises in European technology shares then it is the value of the shares it holds which will determine the price of the units. You can sell your units at any time but you should be wary of buying and selling too quickly as charges and fees can eat up your profit.
As above, but with the added element of a tiny bit of life insurance so that they can be set up and run by life insurance companies.
Again these are – in essence – unit trusts. The term is used to denote a fund which makes a wide spread of investments – thus theoretically reducing the risk – though you should not assume that this is the case. I particularly like Irish Life’s Multi Asset Portfolio (MAPS) Standard Life’s MyFolio funds and Zurich’s Pathway funds.
Ranging from #1 fund to # 7 depending on the company, the lower the number the more cautious the fund. With these, you don’t have to worry about individualising your stock selections you just stick to your lanes depending on your attitude to risk with the free swaps.
A fund that concentrates on a very specific market opportunity – such as oil shares or companies listed in an emerging market. This is obviously riskier but if the underlying investment performs well, then you will make above-average returns.
This is a fund that aims to match the overall market performance. For instance, you might have a fund that plans to achieve the same return as the UK’s leading 100 shares (FTSE 100).
These funds are run by insurance companies and they guarantee a minimum return plus extra bonuses according to how the fund has performed over the longer term. These bonuses might be added annually (annual bonus) or when the fund is closed after the agreed period of time (terminal bonus). The terms, conditions, objectives and charges for these funds vary enormously.
Stock market ‘baskets’
Investors or their advisers choose a number of stocks, which can range from blue chip shares (such as the big banks and retail groups) to downright risky stocks. Depending on how risk-averse you are, a percentage of your ‘basket’ will be conservative solid choices, while the smaller percentage will be a little bit of a gamble. Diversification is again the buzz word – the greater the spread or choice of stocks, the softer the fall if there is to be a fall.
4. Specialised Stock Market Strategies
Futures, options, hedge funds, exchange traded funds, derivatives, contracts for differences (CFDs) and the like all form part of the specialised investment sectors of the stock market. Good solid advice is essential if you wish to participate in this area – not for the feint hearted.
5. Alternative Investments
There is a large number of alternative investment options, all of which come with varying amounts of risk. Some, such as gold or other precious metals, are easy to buy and sell. Others, such as art, may have a limited market, making them difficult to find a buyer for when you want to dispose of them.
Examples of alternative investments include:
• paintings and other art
• antique furniture and other objects
• debentures at Wimbledon
• rock memorabilia ( á la the Jerry Lee Lewis jacket displayed in my Stillorgan office )
• gold and other precious metals
• diamonds and other precious gems
• collectables such as rare stamps, coins, classic cars or watches.
In general, alternative investment is ‘direct’ – this is to say, you purchase the actual items. Specialist knowledge is vital if this is to be a genuine investment and you should not consider alternative investments until you have a reasonably high net worth and a portfolio of more conventional investments since the risks can be high. Always seek professional independent advice.
John Lowe, Personal Insolvency Practitioner and Fellow of the Institute of Bankers, is founder and managing director of Providence Finance Services Limited trading as Money Doctor, (www.independentfinancialadvice.ie) regulated by the Central Bank of Ireland and author of the best-selling The Money Doctor 2016 plus 50 Ways to Wealth (both published by Gill ) now available for seminars and one to one consultations : email firstname.lastname@example.org or email@example.com or call Dublin 278 5555