The past five years have seen exceptional stock market returns.
Far from being euphoric we are nervous, because we feel that the expectation is that these returns will continue, and that investors will become disillusioned (because the reality is that the returns will likely be lower in the future).
History is littered with similar patterns of exceptional performance often following a period of distress. Investor behaviour rarely changes; there are those who invest at the bottom and those who wait until confidence returns (and invest at the top). In most cases the same is spoken “what has been will be forever”.
As Wealth Managers / Financial Planners our role is to navigate through this and by its very nature ignore what is happening today, tomorrow or next week (and what has happened in the past).
Essentially we are there not to get carried away when the market spikes and not to panic when the market drops. We know this will happen, we just don’t know when. We therefore look to develop investment strategies (portfolios) which will focus on delivering consistently strong returns over the next 10, 20 or 30 years.
This strategy is best summed up as a “get rich slowly” strategy, and for the patient investor can deliver significant upside.
Playing the long game
All investors should play the long game.
The reality is that for those who manage their own money often they chase short term gain (for which they will sometimes suffer a lot of pain!)
Effectively they are traders trying to profit from what the market will do today, tomorrow or next week. For all they get right they will equally get some wrong, and in the process the danger is that that they lose sight of their goals.
It teaches us that it is very hard to play this game.
For us our fundamental goal is to “protect” and grow client assets to provide for retirement, or to provide an income in retirement (or other such goals).
Portfolios are a long game; essentially they take a basket of funds which together can benefit from the upside but provide some cushion on the downside. Fundamentally over the long term they can deliver considerable growth.
It is likely we will suffer short term pain but this is not our goal, it is not about 1 year performance but how it does over 10, 20 or 30 years that is important (especially if your pension is proving income – this must be maintained long-term).
It is best described as watching paint dry, it is not exciting but then investing shouldn’t be unless you want the thrill of gambling and that potentially comes with a great deal of pain.
Why Portfolios?
Very few people (if any) can predict which asset class will be the best for the next 12 months. They can in hindsight!
In 2013 investing in Japan would have delivered returns in excess of 50% (assuming the right fund was chosen), in 2014 (so far) Japan is one of the worst performing sectors. In 2014 Europe, Asia or somewhere else might take up the crown for the best performer.
And although equities are now back in favour, the best performing asset class over the past ten years up until a couple of years ago was fixed interest.
The truth is that we cannot predict what the future will be.
Portfolio construction is about taking away the guess work by:
- Considering the level of risk / reward an individual is prepared to accept (the greater the risk the greater the exposure to equities) and allocating assets accordingly
- Allocating assets globally and not trying to guess which market will do best
- Systematically rebalancing the portfolio – selling the winners and buying the losers to ensure the mix of the portfolio stays the same (holding onto the winners by the law of probability would mean at some point they will become losers)
Over time investors adopting this approach will do well because there is no guessing used, as to which sectors will do best. It also avoids being drawn into short term bets which often ends in tears!
In essence it’s a slow, methodical process with a focus on long term results.
Playing the short game
As individuals we may play the short game but it is becoming increasingly more difficult to identity good stocks which offer significant upside (2009 would have been the time to do this, but we can only say this confidently now!)
A plethora of new share offers have, combined with strong stock market returns encouraged investors back into the market. But many of these investors are expecting short term upside which in many cases they will not get.
Careful stock picking has the potential, especially in times of market distress, to deliver considerable upside but there is an element of gambling.
For example, investing in banking stocks will lessen the risk because it is unlikely that the banks will fail (again) and in reality are so mispriced that they will correct, however betting on a new share offer carries the risk that there is a hope one day that it might be ‘something’ when in reality it may never happen.
It is very easy in times when the short game is winning to compare against the portfolios but the two are very different beasts, carrying different risk / reward characteristics.
The reality is that over time if the overall performance of the short game (including sells, buys and holds) was compared to the portfolio over a 10, 20 or 30 year period then the returns may well be similar. The crucial difference is that the short game could be considerably bumpier and test the nerves of many investors.
How to test if a portfolio is any good?
It is often very difficult to compare one portfolio against another because they carry different characteristics so comparing performance appears to be really hard to do.
Our argument is simple; if the portfolio uses active managers then the portfolio should be able to significantly outperform one which simply tracks the index (effectively a like for like portfolio). If the portfolio can do this consistently over the long term then this is a good test.
Another test is to ensure that one part of the portfolio is not holding back the rest of the portfolio. For example, if the portfolio invested in 10 sectors and nine underperformed and one over performed, then this would raise a concern.
A final factor to consider is volatility – the risk / reward test. Are investors being rewarded for the additional risks being taken.
Conclusion
Portfolio construction is in essence a process which aims to ignore the noise and deliver on an individual’s goals over a long period of time. It is not trying to be exciting or trying to pinpoint individual stocks which might deliver significant upside because this will significantly increase the risk.
The frustration for individuals is that they love the thrill of the ride when the stock markets are racing, but the portfolios will not do this, they will capture some but not all of it in the short term. Individuals forget this strategy and take risks which they were not prepared to take in the past, but because they have forgotten previous events they are prepared to take more risk now. Often this ends in pain and disappointment which is what the portfolios aim to avoid.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.