2014 resolutions: investment mantras that could yield a happy new year
There is no better time to review your portfolio of investments and make sure they are working for you
The New York Stock Exchange can be fun for traders with the requisite temperament and discipline, but most people shouldn’t trade at all as only a tiny minority ever beat the market. photograph: bloomberg
A new year means new resolutions. Following them is another matter, of course, but it’s worth making the effort with the eight suggestions below – your wallet will thank you.
The magic of compound interest means that, generally, the best time to start investing is now. Take a 25-year-old who invests €3,000 yearly into an account earning 8 per cent annually. Aged 35, he stops investing, but leaves his lump sum intact. Aged 65, his account will be worth over €537,000.
Alternatively, take a 35-year-old who also invests €3,000 into an account yielding 8 per cent, and continues to do so annually until he is 65. By then, his account will be worth €397,000. Despite investing three times as much money, he is €140,000 poorer.
Think about asset allocation
Asset allocation – your mix of stocks, bonds, commodities, cash, etc – is much more important than stock selection. Some people stick to a standard 60:40 or 70:30 mix between stocks and bonds. A more thoughtful approach is to take more risk in your youth and less as you near retirement.
Some suggest you subtract your age from 100 (or perhaps 110 or 120), the answer being the per centage of your portfolio that should be in stocks.
US investor Larry Swedroe suggests you have all of your money in stocks if you won’t need your money for at least 20 years. Reduce it to 90 per cent when retirement is 15-19 years away; 80 per cent from 11 to 14 years; 70 per cent when a decade years away; and then reduce by 10 per cent annually, ensuring all of your money is in bonds within three years of retirement, to protect against sudden market falls.
No one approach is “right” for everyone.
If you can’t handle market volatility, says US index investor Rick Ferri, accept a low equity weighting and maintain this allocation rather than running the risk of panic selling in a bear market. “This isn’t a sign of weakness; it’s a sign of intelligent decision making,” he says.
Ordinary investors tend to buy high and sell low – more money went into equity funds in early 2000, the peak of the internet bubble, than ever before.
More money than ever before was withdrawn in late 2008, near the bottom of the bear market induced by the global banking crisis.
A better approach is to rebalance annually. For example, US equities have trounced most major equity markets in recent years. Not only do they now look expensive, their gains mean they now occupy a greater percentage of people’s portfolios than previously.
Emerging markets, by contrast, have stagnated. Many asset managers argue they are priced for better long-term returns. Similarly, the performance of bonds or other asset classes means an asset allocation mix designed some years ago may now be out of whack.
The Japanese stock bubble meant that by 1989 it accounted for 45 per cent of the total capitalisation of major developed markets, leaving investors dangerously exposed to the crash that followed.
A 2010 Vanguard study found rebalancing is needed if asset allocations move more than 5 per cent away from their original model. Rebalancing annually, accordingly, makes sense.
As asset manager Barry Ritholtz says, “You buy more of what has become cheap, sell a little of what has become dear and keep the diversification of the original design.”
When it comes to choosing an investment fund, studies confirm past performance is no indicator of future performance. What is a good indicator of future performance, however, is fees – the lower, the better.
Over time, high fees seriously erode returns. A €10,000 investment that earns 8 per cent per year will be worth over €217,000 40 years later. Deduct annual fees of 2 per cent, however, and your returns more than halve, to less than €103,000.
One of the most documented findings in all of finance is that the vast majority of fund managers fail to beat the market. A few do manage to do so, but it’s very difficult to identify the winners in advance – and picking past winners is a recipe for failure. Actively managed funds attract higher fees, and these costs ultimately doom the fund to underperform, both in bull and bear markets.
If you can’t beat ’em, join ’em. Opt for cheap index funds that simply track global markets. Even if you fancy a more active approach – for example, you may be interested in particular sectors or a value-based investment approach – you will find cheap passive funds that allow you to do just that.
Finance professors all over the globe routinely take the passive approach. So should you. It makes no sense to pay for underperformance.
Most people shouldn’t trade at all, as only a tiny minority ever beat the market. It’s also unnerving and most people lack the necessary temperament, discipline and knowledge to succeed.
If you are going to trade, don’t overdo it. If you are following a mechanical strategy – say, one that buys the S&P 500 at a 10-day low and sells when at a 10-day high, or one that buys a basket of high-dividend shares at the start of the year and sells at year-end – then follow it. Don’t sell early, at the first hint of a profit. Don’t buy or sell on hunches. Don’t force a trade because you’re trying to make up for money lost elsewhere. Plan the trade; trade the plan.
Know your timeframe
There’s an old Wall St joke that a long-term investment is a short-term speculation gone wrong. A stock may be a potentially good trade but a lousy investment or vice versa. Over-valued stocks can become much more overvalued, just as cheap stocks can get much cheaper.
The rules of the game are very different for a short-term trader than they are for a long-term investor. The old adage about cutting your losses and letting your winners run is generally good advice for speculators, but will be utterly unproductive if you are a long-term value investor.
Various stock recommendations are made for a particular time frame; it’s important to know what yours is.
As the global bull market rolls on, more companies – especially in the “
hot” social media sector – are making their debuts on markets through initial public offerings (IPOs), and this year is likely to see the hype increase.
Ignore it: IPOs are a losing game. One study covering the 1970-2010 period compared IPOs to similar stocks and found they underperformed by 4.8 per cent for the first year and by an average of 3.3 per cent annually after five years.
There will be exceptions. Twitter hit $75 within two months of its $26 IPO; Facebook is roughly 50 per cent above its May 2012 IPO price. Great, although no ordinary investor bought Twitter at $26 – it opened for trading at $45. As for Facebook, it more than halved within months of its debut and took a year to reclaim its IPO price. Even now, despite having tripled from last year’s low, its 19-month returns are broadly similar to the S&P 500.
More pertinently, these are cherry-picked cases. The stats confirm that overall, IPOs rarely live up to the hype. Remember Eircom, whose investors are still nursing losses.