Yes, You Can

On 12th July 2015 by good2us

Investing is all about managing risk, both financial and psychological. We advocate a step-by-step approach of first understanding where your money goes and then managing the financial setbacks that may come into your life before moving on into the world of investing and being able, financially and psychologically, to ride-out the financial setbacks that WILL occur with your investments.

 

Investing is NOT for everyone. Investments are NOT savings, which may be covered in whole or in part by deposit guarantees. Investments contain the risk that you may lose some or all of your money.

Although it is worth recognising that savings are not risk-free. Savings are what economists refer to as ‘deferred consumption’. Your nominal capital may be preserved but inflation may erode that and so savers can lose value, i.e. the real value of their savings reduces and the consumption deferred is similarly reduced.

The quote, normally attributed to Benjamin Franklin, that “Nothing is certain except for death and taxes” should also include risk – “Nothing is certain except for death, taxes and risk.”

The trick is to maximise reward whilst reducing risk. Risk reduction being effected by taking the psychological precautions appropriate to the individual, their tolerance of risk, and the financial precautions, also appropriate to the individual, which reduces the possibility of an enforced sale of investments at an inauspicious time.

However, even if investing is not for you, the initial steps those wishing to invest need to take will also be of benefit to those who simply want to build up their savings.

The degree of risk appropriate for a given individual isn’t jus a function of their psychological make-up but also their age and personal circumstance. Age is particularly important as mistakes in investment choice happen and, that being the case, time (in the shape of future earnings) will be required to make good losses.

Naturally, we seek to help investors deal with this.

Risk profiling

Confidence is clearly key to the tolerating of risk. For an individual not confident in their own ability to identify and manage investments they are likely to delegate that activity to a financial services company. Such companies most certainly do not lack confidence in tehor own abilities.

However that confidence is overwhelmingly misplaced, as the following charts show.

hedge In 2012, The HFRX, a widely used measure of hedge fund industry returns, was up by just 3%, compared with an 18% rise in the S&P 500 share index. This is part of a consistent pattern not simply a bad year. The S&P 500 outperformed its hedge-fund rival for ten straight years up to 2012, with the exception of 2008 when both fell sharply, as the chart shows.. A very, very basic portfolio of 60% shares and 40% sovereign bonds delivered returns of more than 90% over that decade. This compares very unfavourably with a meagre 17% after fees for hedge funds .as the chart shows. Hedge funds are considered to be the real whiz-kids of the investing world when they look more like damp squibs.

The claim that such exotic funds shine when times get tough also looks untrue

The top decile of managers served up returns of over 30% in 2012, according to Hedge Fund Research. But a third have lost money, including some of the stars of yesteryear: So consistency is not common-place and luck in making the right bets probably plays a significant part in annual performance.

diyhedgeThe merits of allocating investment funds between equities and bonds can be seen with the chart to the right. The S&P 500 fell very sharply in 2008 but the 60:40 equity to bond fund performed as well as the average hedge fund in reducing volatility and out-performed the typical hedge fund afterwards.

DIY investing being more effective than the typical edge fund manager and a gret deal cheaper.

A less exotic investment vehicle is the bog-standard actively managed fund where an archetypal ‘star-performer’ is an excellent asset picker. Unfortunately, they too have some performance issues.

perfm

Fund performances compared with UK All Share Index. To end December 1998. Data supplied by Virgin Direct.

The chart to the left shows the percentage of funds that out-perform the market,, in the shape of an index of all UK stocks, over a 1 year, 3 year, 5 year and 10 year basis.

Whether we look at a one-, three-, five- or 10-year horizon we can see that the vast majority of funds can’t even keep up with the market. And statistically speaking, there are bound to be a few that beat the market, but only by chance.

In addition, such figures enjoy what is known as ‘survivorship bias’.

Survivorship bias, or survival bias, is the logical error of concentrating on the ‘survivors’ of some process and inadvertently overlooking those that did not because of their lack of visibility.

With funds, a management company’s selection of funds today will include only those that are successful now. Many losing funds are closed and merged into other funds to hide poor performance. So the chart is over-optimistic as to the medium- and long-term performance of the vast majority of funds.

One option could be to invest in a fund that does the opposite of all other funds, so-called ‘contrarian investing’. Sounds good in theory, but in practice the management fee and transaction costs probably mean that that would be a poor investment too. This doesn’t prove that markets are random, but it does indicate that the most efficient investment vehicle is via an index-tracker fund.

Index funds have existed for several decades, but there is a modern index instrument, the Exchange Traded Funds (ETFs). Both fundamentally do the same thing but there are significant differences.

This means that the individual is no win a position to do as least as well as the typical active fund manager and can expect to do significantly better. However, the one thing neither an actively managed fund nor a tracker can do is make you immune to risk.

 

 

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