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.
The Money Doctor, John Lowe, demonstrates the optimum way to build up your wealth:
- 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 over 50 years which cost him a modest $31,500 (€27,391). 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".
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 (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 – through 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.
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 and 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 a 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.
Next week we will look at those 5 investment areas more closely. Stick with me.