How to make a success of your investment

Tue, Nov 6, 2012, 00:00

Learning how to save and invest is a crucial part of our lives, and we need to be more informed about it

The global credit crisis taught us all some hard lessons about investing – that we may seek returns but, more importantly, we must control risk.

Today and over the next two Tuesdays I will outline some of the main points that my recently published book has set out to make.

As we are all now aware, learning how to save and invest is not a luxury in life, it is a crucial part of our daily lives, and we need to be more informed. Just look at the consequences all around you – of us, a young nation, not having understood how to invest and control risk.

The disaster that has been wreaked on peoples’ savings and investments in the last five years, and the personal traumas it has inflicted, need not have happened if people understood how to invest.

We in Ireland have a number of hurdles to overcome when it comes to sound investing. We have had a preference for physical property-investing which necessitates the use of debt.

Perhaps now we will be more open to incorporating other asset classes into our investment plans.

We have an above-average propensity to gamble, and we associate the stock markets with gambling.

But for the vast majority of private investors, speculating can only lead to losses in the stock markets, just as it does in the bookies.

You must own an asset if you want the return from it. Trading assets does not give you the time to benefit from the natural appreciation in asset values that occurs over time. Trading assets, or speculating, is a mug’s game for the majority of private investors.

And, of course, the financial services industry – be that the banks, private client stockbroking or the network of financial and investment advisers across the country – are incentivised to sell you a product rather than provide genuine impartial advice.

Is it any wonder that technology funds were the top-selling funds in Ireland in 1999, and that leveraged property funds were the top-selling funds in 2006?

Educated

And in Ireland today, guaranteed funds and hedge or absolute return funds are the ones selling best. These funds cannot hope to deliver the returns investors have been led to expect, but few understand why.

It still mystifies me that the Regulator cannot see that the consumer is not being educated about how to invest in anything other than fee-generating products that encourage herd-like investment behaviour among both products’ sellers and their customers.

In my book, I suggest that there are just three steps to making a success of investing, which include:

(i) having a business-like plan to investing (ii) understanding volatility in markets and that volatility is not the same as risk and

(iii) having the patience to let compounding work its magic over time.

In 1973, Warren Buffett said: “To invest successfully, what you need is a sound plan for making decisions and the ability to keep your emotions from corroding that plan.”

Buffett did not say a “great” plan. He said a “sound” plan.

Regardless of whether you are a novice investor and just getting started, or someone who already invests in markets, each of us has the ability to implement a sound investment plan.

What might constitute a sound investment plan?

It is a truism that the value you obtain when you buy an asset largely determines your subsequent returns, once you have controlled risk (which I’ll deal with next week).

The book shows you how to value an asset and to build a portfolio based on solid values.

Portfolio

Most private investors are not equipped to buy and hold individual companies, and should consider investing through funds. My preference has always been for funds quoted on the stock exchanges and these include exchange-traded funds (passively managed index trackers) and investment companies (actively managed).

There are perhaps just five decisions you have to make in order to assemble a portfolio that ensures you are well diversified globally as well as across different industries and asset types.

The portfolio of funds highlighted in Table A consists of a global equity exchange-traded fund (ETF), a global property ETF, an emerging markets government bond ETF, a global higher yielding non-investment grade corporate bond ETF and a global hedge ETF.

A simple process of adding to this portfolio methodically over time and selling out of any particular asset class when it is obviously overvalued, as government bonds in the developed world are today, should ensure that you are both avoiding asset bubbles and taking advantage of down-markets, and the lower prices and better values that they bring.

For the more active, adventurous investor who would like to try and enhance the returns that have been on offer in markets over time, the book outlines in detail a simple plan for buying the cheapest stocks in the FTSE 100 Index – defined as stocks with the lowest price-to-earnings ratio – which has proven to be effective over time.

One simply has to screen out the 30 stocks in the FTSE 100 Index trading on the lowest price-to-earnings ratios and to select one stock from each industry to make up a portfolio of 10 to 15 stocks.

This approach ensures diversification across industries and a value bias among large market capitalisation stocks, and it has delivered an extra 4 per cent per annum to the index returns over time.

Chart A highlights the growth in value of a £10,000 investment in this approach since 1995. In selecting the stocks, no forecasts were needed and no subjective views from analysts were needed. The greater value you bought delivered the enhanced returns.

Simple as that.

Next week I’ll deal with stock market volatility and why it is not the same as risk.


Rory Gillen is the founder of Gillenmarkets.comand author of the recently published 3 Steps to Investment Success