by Mark Dampier
Whatever you are investing for, the minimum length of time you should think about when planning an investment programme, I suggest, is five years – ideally even longer. Good investing is like an ideal marriage: you hope that it will last the whole of your life. Sometimes you may be pleasantly surprised to reach your target ahead of time, but don’t count on it. If you really do need the money on a shorter time horizon, you should consider more certain homes for your money, such as cash or fixed interest, even though the returns will almost certainly be much lower. You should only ever think about investing capital in riskier asset classes knowing that in the short term it could decline in value.
Equity performance
Number of consecutive years
2
3
4
5
10
18
Outperform cash
77
79
81
83
96
97
Underperform cash
37
43
31
28
10
1
Total number of years
114
113
112
111
106
98
Probability of equity outperformance
68%
70%
72%
75%
91%
99%
Outperform gilts
78
84
84
81
84
85
Underperform gilts
36
29
28
30
22
13
Total number of years
114
113
112
111
106
98
Probability of equity outperformance
68%
74%
75%
73%
79%
87%
Table 2.6: The odds on equities outperforming gilts and cash.
As long as history repeats itself, the longer you own a portfolio of shares, the more likely it is that they will do better than safer alternatives such as cash or gilts. Over five years, in both cases the chances that you will do better from equities is around 75% on this basis.
The good news for any investor who starts early is that the longer you can invest the better you are likely to do – and the more certain your returns are going to be. As the next chart illustrates, the range of returns from different asset classes narrows with the passage of time: the good and bad years tend to cancel each other out. In the same way the likelihood that riskier assets such as equities and property will outperform increases the longer you are able to hold them. Historically, if you are able to own equities for more than 20 years, the odds are over 90% that you will do better than keeping your money in cash.
Figure 2.3: How the passage of time reduces the variability of asset class returns.
Source: Barclays Equity Gilt Study 2015.
Projecting future returns is never easy and it is only fair to say that it is particularly hazardous today. The years since the financial crisis in 2008 have been characterised by very different conditions to earlier historical periods. With interest rates at such unprecedentedly low levels, no period in my lifetime has been quite like it. Policymakers have set out to make it easier for everyone – governments, businesses and individuals – to cope with the aftermath of the crisis, which has left the world lumbered with massive and unprecedented amounts of debt.
On the plus side, the low-interest policy has slashed the cost of mortgages and provided short-term relief for many of those struggling to repay what they owe. The downside is that the policy has also heavily distorted the traditional ways of valuing financial assets – working out, in other words, whether shares and bonds are cheap, expensive or about fair value. In practice the policy has had the effect of driving up the price of many financial assets to what seem very high levels by historical standards. However, you can be sure that it is not going to stay that way for ever.
The bottom line
Taking all these factors into account should allow you to come up with a figure for the kind of financial contribution or regular investment you are likely to need, and an idea of how long you will have to make it, in order to have a reasonable chance of meeting your financial targets in the future. I go on in the rest of the book to explain how to use investment funds to achieve the kind of objective that you might set yourself having done such an exercise.
Here is a simple example. Suppose you invest £5,000 a year for 30 years – how much will you have at the end? I have worked out some illustrative figures, based on the following assumptions. The investor has no tax to pay, thanks to using an ISA. The money is invested 65% in the stock market, 25% in different types of bonds, 10% in property and 5% in cash. Inflation averages 2%. Real rates of return assumed are equities 5%, bonds 2%, property 5% and cash 1%. The investor, as I do, uses funds to obtain the property and equity weightings. I have deducted representative fees from those funds. This produces overall rate of return of 5.6% per annum before and 3.6% after inflation.
Remember that this is a theoretical exercise. There is no guarantee that the results will be as I have said.3 If my assumptions turn out to be valid, however, you will have around £385,000 at the end of the period, having invested £150,000 along the way. After 40 years, with the full effect of long-run compounding coming through, your investment pot will nearly have doubled again, to approximately £725,000 in value.
There are two ways in which you might react to these figures. One is to say, “Gosh, those final numbers are surprisingly large, even for what seem like very small rates of return.” The other is to say: “Oh dear, even if I am lucky and get a reasonably high rate of return, I am still not going to end up with enough for my future needs.” In reality both responses are perfectly valid. On the one hand it is rare that I meet anyone who has done this kind of planning exercise who comes away thinking, “I am investing too much.” Most people, I know from experience, should be doing a lot more than they are. On the other hand I also rarely come across anyone who isn’t heartened and encouraged by the remarkable way in which even little sums, saved regularly, can compound over time into something much bigger.
You can see again from this example how the value of the investments starts to grow faster as the number of years goes up – that is compounding again. By the end of the 30-year period, the value of your investments will be 2.57 times the amount you have put in. Of course i
n the real world, the progress won’t be as smooth as this. There will be lots of ups and downs along the way. But note also this: if you could improve the annual rate of return by just 2% per annum, the final sum would not be 2.57, but 3.53 times as great as the total amount you put aside – an extra £175,000 in round figures! Small differences in investment returns can make for hugely different outcomes if you let time do its work. It is all the more reason to get started straightaway, however small the amount you can afford – and all the more reason to put an effort into finding the best extra unit of return.
Lump sums or regular contributions?
Is it better to invest a lump sum or make regular contributions to your investment pot? My answer is: it does not necessarily matter. In real life most of us combine periods when we are able to save regularly with others when we are unable to afford anything at all. Once every few years you may find yourself with a one-off lump sum to invest – from a legacy perhaps, or redundancy, or the payoff from some shares or share options. My advice to clients tends to be: try to save what you can afford on a regular basis, but be willing and happy to top it up with a bigger sum if and when a cash windfall comes along. Think of regular investing as good discipline and one-off sums as a welcome bonus.
Sensible to start simply
In the old days, when I met a person with a lump sum, in order to give them some guidance I would normally start by saying something like: “Why not split the lump sum into thirds – one third cash, one third fixed-interest and one third equities?” I still think that is a good starting point for newcomers to investing; it is easy to remember and there is logic behind it. It recognises that the important thing for any investor is to become comfortable with what they are trying to do. As you go on and get more experienced, and as your circumstances change, you can start to think of changing the percentages and giving more thought to how you split up the three components (What kind of equities? What kind of bonds? And so on), as I did in the example above.
Is having a third of your money in cash a good idea as a starting point? Between 2000 and 2008 the answer was clearly yes – interest rates on cash were much higher then (and we all stupidly thought that banks knew what they were doing and money deposited with them was safe!). It is harder to justify today when interest rates are so low, but you always need to compare the return, as I have said, with both your actual cost of living and your appetite for risk. If the prices of the things you need or want are falling, even cash that earns no interest can still leave you better off at the end of the year and you have not risked losing anything in the process.
To take another example, if you’ve just retired or are coming up to retirement, you also might want to start off with at least 50% in cash. Why? Because you can’t be quite sure how things will go in your first couple of years of retirement. People often find that what they actually spend is different to what they expected. You should not be in a rush to tie all your money up straight away. It is always a good idea to stop and think what you’re trying to do. Look at all the options and take your time. You won’t regret it. It is a big decision you are making.
For those who are starting out, or investing on a regular basis while still quite young, the issues are not so difficult. The younger you are, and the longer you have to see your investments bear fruit, the more logical it is to put more of your money into riskier equities and property. If you can afford to wait for the good years to cancel out the bad, and are investing on a regular basis, it matters much less whether what you are buying appears cheap or expensive. As the years go by, the price you pay for what you own will average out, and the returns you get will move closer to the long-run historical averages. The weightings that I used in the long-term portfolio example above (60% in equities, 25% in bonds, 10% in property and 5% in cash) might be more appropriate.
Once you have been through the planning exercise, the next challenge is how to make the investments that will give you the best chance of meeting the objectives you have worked out in your financial plan. This is where funds and investment platforms come into their own.
Points to remember
The primary objective of investment is to improve your quality of life.
Money spent on a financial plan is almost always money well-spent.
If you do nothing with your money, you cannot end up with any more than you started with.
Asset-allocation means deciding how to allocate your money between equities, bonds, property and cash.
Wealth only grows if you can outpace inflation in the things you want or need.
Shares and property have provided the highest returns historically, but bonds have done equally well since 1990.
Small increases in rates of return can be extremely valuable if you let time do its work.
Whatever else you do, make sure you take advantage of tax breaks on ISAs and pension contributions.
* * *
1 ‘Real’ is the word that economists use to describe what something is worth after deducting the effect of inflation.
2 See chapter 8 for my thoughts on buy-to-let.
3 Because this is a long-run planning exercise, I am assuming that returns will at some stage revert to their long-run historical averages. The money invested today, as opposed to in future years, may produce lower returns, given relatively high valuations at the time of writing.
Chapter 3. Getting Started
So you have decided to start making regular savings into an investment programme. Maybe you are already an investor but want to rethink whether you are approaching it the best way. Or maybe you have just come into a lump sum. The same questions always then arise: how do I go about investing? And what is the best way to put those investment decisions into practice? In this chapter I give my views on these questions. I explain why for most people I believe the answer to, “Why use funds?” is: “Because it is the simplest and most convenient way to do it”, and the answer to, “How?” is: “By using an investment platform”.
Of course, you may say that, working for one of the largest platform providers in the country and specialising in fund research, I am simply ‘talking my book’ – well, yes, but please hear me out. There is a reason so many more investors invest in funds than directly in stocks and shares. And there is a reason why the use of investment platforms is growing so rapidly every year and such platforms now account for 50% of all fund business. Whether you are buying funds, shares or both (as many do), they are the simplest and most convenient solutions investors can choose. In making my case, I am only echoing the way that investors themselves have voted with their wallets and the way that most sensible professionals do it too.
Why invest in funds?
I have been researching and analysing investment funds all my working life. They have been my professional speciality for as long as I care to remember. My own money is predominantly invested in funds rather than in individual stocks and shares. Even without knowing your personal circumstances, I am confident that funds are probably the way you should be investing too.4 Funds are the building blocks from which you are going to construct your overall investment portfolio. Pick them sensibly and you are on course to do well: but pick them randomly, or without the right guidance, and you run the risk of disappointment.
A one-minute history
Investment funds have been around for a long time in one form or another. First there were investment trusts, which date originally from the 19th century, and some of which, like the venerable Foreign & Colonial Investment Trust, are still with us. Then in the 1930s came the first unit trusts (or mutual funds, as the Americans know them). The honour of being the first unit trust in the UK goes to M&G, a company that is still going strong today. It created the first UK unit trust in 1931.
Unit trusts started to become popular consumer items in the 1960s and have continued to grow steadily in popularity ever since then, punctuated
by periods of innovation and change. The most notable recent innovations came in the 1990s with the launch of the first open-ended investment company (OEIC) and the first exchange-traded fund, or ETF for short. Other variants, such as horribly named UCITS 3 funds, have also come on the scene.
Frankly, whoever came up with these stupid names and abbreviations deserves to be shot, as all these different and strangely named creatures are basically variants of the same thing. For simplicity and convenience, like most people in the business, I prefer to give them all the umbrella name of ‘investment funds’. And that is because the basic idea behind all of the types I have mentioned is the same.
What funds offer you as an investor is the opportunity to pool your money with that of hundreds or thousands of other investors in a single entity which is managed or administered on your behalf by a professional investment manager. The legal structure differs from one type of fund to another, as does the kind of things that they invest in, but what they all have in common is that each investor holds units, or shares, in the fund and each unit has the same value as any other.
That makes funds, among other things, a very democratic way of putting your money to work. But there are other more important reasons why funds have become so popular over the years. They can be summed up as: convenience, diversification and tax. As I explain in chapter 7, the great majority of my own money is invested in funds for these very reasons.