The Basic Concepts of Investing

The basic concepts of investing are well known but often ignored by individual investors. Many people have tried to reduce investing to a science so that the outcome following a given set of actions is predictable but to my knowledge without any consistent success.

Others treat it as an art and follow some obviously gifted investment expert with a good track record but there have been many occasions when the ‘artist’ has fallen from grace leaving their followers with large losses.

Investing certainly has some qualities as a science and some people do have a flare for getting it right more often than others. However, when it comes to your journey towards prosperity I would encourage you to rely instead on some tried and tested basic concepts.

Diversification

‘To avoid having all your eggs in the wrong basket at the wrong time, every investor should diversify.  If you search world-wide, you will find more bargains and better bargains than by studying only one nation.  You also gain the safety of diversification.’

Templeton Maxims by Sir John Templeton

You can reduce the risk to your investments by investing in a number of different companies.  The more the returns are uncorrelated (i.e. one is not affected through changes in the other), the greater is the overall reduction in risk.  But there are limits to the extent to which risk can be reduced.

The risk involved reduces as the number of companies in your portfolio rises, but it has been established in academic studies that the rate of risk reduction diminishes as the number of companies increases.  Private investors do not need to hold more than about 35 companies in different sectors to remove most of the diversifiable risk. 

Of course, choosing and following the results of 35 companies would need to be a labour of love for any individual as it would take up so much time.  For most private investors who do not want to devote their lives to managing their investments the same result can be achieved by investing in a single unit trust or OEIC (Open Ended Investment Company).  A unit trust or OEIC will typically invest in around 40 to 80 companies.  The ideal for most investors is to use some sort of portfolio service which invests in around 12 to 16 different unit trusts or OEICs spread around different world markets.

One lesson from the following chart is that a portfolio with 75% bonds and 25% equities provides a higher return over time and exposes your portfolio to less risk than a portfolios which is 100% invested in bonds.

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Balancing your investment portfolio

What constitutes a balanced investment portfolio will vary from investor to investor depending on such factors as your age, your employment status, your requirements for income and/or growth, your attitude to risk and capacity for risk.

However, each investor will want to include sufficient money on deposit or readily accessible for emergencies, a portion in equities for long term growth and a portion in lower risk investments for short term to medium term security.

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The circles in the diagram are not meant to convey the idea that you should keep a third in each.  For example, if your attitude to risk is:

  • Low – You might want a portfolio that is 60% easily accessible, 30% low/medium risk and 10% high risk/high return. 
  • Medium – You might want a portfolio that is 30% easily accessible, 40% low/medium risk and 30% high risk/high return. 
  • High – You might want a portfolio that is 10% easily accessible, 30% low/medium risk and 60% high risk/high return. 

Are risk and reward directly related?

The answer is – up to a point.  Some risks are just not worth taking as they can lead to a total loss.  If you invest in a risk-rated professionally managed portfolio over the long term it is generally true that if you invest in the higher risk versions of those portfolios you will achieve more growth than if you invest in the lower risk versions of those portfolios.  However, in the short term those positions can be reversed.  This is why it is essential that your investment strategy reflects your overall goals and objectives, short, medium and long term.

From the following chart of Fidelity portfolios you will see that notwithstanding the 2020 market falls due to Covid-19 the Adventurous portfolio has produced the greatest return over five years and the Defensive portfolio has produced the smallest return.

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The Risk Funnel

An important feature of investing is that the longer you are invested the more the risk of loss reduces.  The risk funnel illustrates that the corridor of returns narrows through the years, thus risk is diluted by time in the market.

The chart below plots the best and worst discrete annualised returns over twenty calendar years ending in 2018. 

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For example, if we take every one-year period during the 20 years to 2018, then the best year would have produced 58.2% and the worst would have produced a loss of 30.7%, giving an 88.9% range of returns.  However, if we take every five-year period, then the best period would have produced an annualised return of 20.9%, and the worst would have produced an annualised loss of 1.9%, giving a significantly reduced 22.8% range of returns.

Long term returns from the major asset classes

In the 2016 Barclays Equity Gilt Study (the most recent one publicly available) UK returns from equities, gilts and cash are shown from the end of 1899 to the end of 2015.

The two charts below summarise the real investment returns of each asset class (i.e. in excess of the Retail Prices Index) over various time horizons.     

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The following chart illustrates the performance of equities against gilts and cash for various holding periods. The first column shows that over a holding period of two years, equities outperformed cash in 78 out of 115 years; thus, the sample-based probability of equity outperformance is 68%. Extending the holding period out to 10 years, this rises to 91%.

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The following four charts show how reinvestment of income affects the performance of the various asset classes. One hundred pounds invested in equities at the end of 1899 would be worth just £177 in real terms without the reinvestment of dividend income, but with reinvestment, the portfolio would have grown to £28,232.

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Pound Cost Averaging

This is an investment strategy that can provide regular investors with comfort when markets are particularly volatile.  By investing a fixed regular amount you will automatically purchase more shares or units when the price falls until the price recovers again.  Whereas someone investing a lump sum will be discouraged when the price of their shares or units falls substantially. 

Where investments are to be made monthly you can take a more adventurous risk than you would if investing a lump sum.  This is because you do not have to try and ‘outguess the market’ – rather you can take advantage of the highs and lows.  Two examples are shown in the charts below.

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The investor has made a good return.  However, it is unrealistic to assume a constantly increasing unit price.

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The investor has made an even better return and rather than suffering as a result of the volatility in the unit price, he has gained because he purchased a much higher number of units overall. 

It should be noted, however, that an investor who was able to invest a £50,000 lump sum at the outset would have received even more, ie 50,000 x 190p = £95,000.

The purpose is simply to show that regular long term investors need have little fear of volatile markets.


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Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.