The Big Picture
A crucial part of successful investing is the ability to maintain focus on the risks that destroy wealth while not becoming distracted by the noisy risks that seem scary but are in fact just barking dogs.
For example, before flying should you be more concerned about the prospect of turbulence or that the plane has enough fuel to reach its destination? The answer of course is having enough fuel. Turbulence can be an uncomfortable, even frightening experience, but we accept that it is part and parcel of flying, if we want to see the world then we must put up with it. Having enough fuel on the other hand is non-negotiable. We could have the most serene turbulence free flight possible yet end up in the sea if we run out of fuel.
Investing can be a lot like this, the risk most of the financial news and industry focus on is the financial turbulence, in other words the volatility in the value of investments. Rather than the risk of running out of financial fuel, in other words maintaining the purchasing power of capital to counteract the effect of inflation.
The history of global equities is a story of a permanent growth of capital, punctuated with temporary declines (every 5 years or so). Each time markets have fallen they have always recovered and gone on to greater heights. The real risk to investors is inflation. If the purchasing power of capital does not keep pace or exceed the rate of inflation, then the risk of outliving your wealth is a real threat. The impact of even low rates of inflation on wealth is stark. Inflation at 2.5% will cause the real value of £100,000 to almost half to £53,000 over the course of a typical 25-year retirement. The best protection against this are equities (stocks and shares), which benefit from rising profits over time and therefore enhance purchasing power of wealth.
The long-term investment returns that investors can expect are almost entirely down to how much they have allocated to equities. The higher the allocation to equities, the higher the expected return; the lower the allocation, the lower the expected return. As there is no such thing as a free lunch, if you want higher returns then you must stomach higher volatility (volatility is both a positive and negative to the investor – acting as a tailwind in the good times and a headwind in the down times). As most people can’t tolerate the heightened volatility then bonds are introduced to the portfolio to smooth the returns (bond returns tend to be more stable albeit lower than equity returns). Moreover, investors with short time horizons will have a higher allocation to bonds as they do not have time to wait for their portfolio to recover in the event of an equity decline.
This makes intuitive sense when we consider what equity and bonds are in the simplest terms. Equity investors are simply owners of businesses, if the business does well and generates profits then they enjoy the benefits of this in dividend payments and capital appreciation. Conversely, a bond (also known as fixed income) investor is a lender to businesses (and/or governments) they lend capital in return for a regular fixed interest payment and the original capital back at loan maturity. Our own common sense and life experience tells us that owners of successful businesses generate greater wealth than the lenders to those businesses. Reason being is that owners take more risk. Historically the inflation adjusted returns for owners of companies has been upwards of three times that of the loaners. There is no evidence to believe that this situation will cease in the future.
Considering the historical evidence, the rational investor would conclude that they should invest 100% of their wealth into equities. The problem is that no one is truly rational, and most people would find this almost impossible to sustain, due to the emotional impact that extreme volatility can have. On average global equity markets fall by more than 30% every 5 years or so. They have always recovered but it is very difficult to hold your nerve throughout these periods and tell yourself that ‘a temporary decline is not a permanent loss’, when wealth is seemingly evaporating before your eyes and the financial media is awash with doom laden headlines.
There have been several studies that have shown that successful investing is dependent on behaviour and the avoidance of big financial mistakes. This is where we introduce the concept of investment returns and investor returns. The investment returns are what the underlying investment fund achieves, and the investor return is what the end investor in the fund receives. You would expect these to be the same, yet the average investor captures much less than half or so of the investment return. The difference is due to the investor making emotionally driven buy/sell decisions, the most common mistakes include buying funds based on recent outperformance, then selling those funds as they inevitably lag (due to the reversion to mean effect) and perhaps the biggest mistake of all is panicking during a market decline and selling at the bottom, then compounding the mistake by getting back in the market when it is deemed ‘safe’, however, the investor would have missed most of the recovery by this point.
It's worth repeating what these studies have found: the average investor underperforms their own investment fund. Ergo, the investor could be in the best possible portfolio but still greatly underperform due to their own destructive behaviour. Just as we tend to think we are better than average drivers, we also tend to think that we won’t make the same mistakes as the ones outlined above, despite evidence to the contrary. None of this overlooks the fact that investment management is a vital component in any financial plan, however, we shouldn’t forget that a significant part of our role as advisers is to not only ensure that investors do not outlive their money but help them control their behaviour and keep them seated during market turbulence. It doesn’t matter how great a portfolio or plan is if the investor isn’t able to stick with them.
As usual, if you have any queries or concerns, please don’t hesitate to get in touch.
James Bacon MSc. Chartered Financial Planner Chartered MCSI
This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The value of an investment can fall as well as rise and is not guaranteed – you may get back less than you paid in.