Nick Dewhirst answers some of the most common questions asked by beleaguered financial advisers on portfolio construction
Nick Dewhirst, CEO, INvestors-routemap.co.uk
New clients constantly surprise me by the questions they ask. With three decades experience in advising others about global markets, I should be a reasonably good litmus test for identifying gaps in the market. With a similar track record of taking my own advice, I should also be a good test case for what works in practice. Here is a Q&A session on how to prosper in practice.
Question 1: Should I invest in Wall Street? If so, which fund should I buy? Should I choose a manager who prefers a value or a growth investing style? Should one back this manager who likes technology or that one who prefers energy shares?
Answer: These are issues that investors typically get wrong. Most probably they will make their decisions based on the weight of evidence in their own private poll of expert opinion available to them. There is a large market in free money-losing advice, so if they rely on free sources like the media, stockbroker's research or fund manager's reports they will reflect consensus opinion, and that is why they will probably not prosper.
On the other hand, their chances of beating the markets are much enhanced if they obtain exclusive analysis, paying for it by subscribing to independent research services, or dealing through an intermediary who acts as a wholesaler of such services. Before developing www.investors-routemap.com, my favourites were the Bank Credit Analyst for top-down analysis and Value Line for bottom-up stock-picking.
If investors believe that they can eat the bait without swallowing the hook, they are either mean, greedy, lazy or ignorant. If the latter, they can be re- educated. If not, thank you for making it possible for the rest of us to beat the markets by doing the opposite.
However, this is not an issue that defies understanding. It is the psychological characteristic of human gullibility for something free, which explains how so many intelligent people make such bad investors.
Question 2: I have learnt something since losing a lot of money picking hot technology shares and it is to focus on asset allocation, because it is the big picture that makes the big difference. However I do not know how far I can risk my portfolio diverging from the weightings of a typical global asset allocation fund?
Answer: That is the right issue to prioritise. Think of your task in making investment decisions as a triangle (see graph Investment Decisions), with the horizontal axis representing quantity of information required and the vertical axis representing its importance. There are four layers, descending from the top, which represent global, regional, sector and company specific factors.
If each layer represents a quarter of what matters, it is easy to see that analysis of the top two layers accounts for half of what matters in an equilateral triangle, but only a quarter of the work. In my experience, the base is much, much broader, so the top-down approach accounts for less than a tenth of the information required, which is why I gave up stockpicking on leaving the City.
However, this is the wrong question for investors to ask, because risk is inappropriatey defined. The investment professional is primarily concerned about their personal career risk. If they make bad bets in good company they keeps their job, because their peers cannot all be sacked. If they make bad bets alone, their future earnings stream can be decimated by becoming unemployable. That risk usually substantially exceeds the bonus earned by making good bets, so is not worth taking.
In my opinion, investors who waste their time on weightings are being hoodwinked by professionals, as I can see no good reason for an 'underweight' position in anything. Surely a portfolio should primarily be constructed with as many up-escalators and as few down-escalators as possible. If so, the correct weighting for investments with poor prospects is zero (see graph Ideal Investment Weightings).
Question 3: Fine, but that still leaves many attractive investment opportunities. I cannot invest in them all, so how widely should I diversify my funds?
Answer: That is both the right issue and the right question to consider. Diversification is widely regarded as a good thing. However, one can have too much of a good thing, so a balance needs to be struck.
While the benefits of diversification are widely touted in academic treatises on investment theory, I believe that not enough is written about the disadvantages in practice. Firstly, those of limited resources will find their operating costs can soar as higher commission rates and minimum charges become significant. Secondly, beyond the point of balance, increasing diversification will mean increasing mediocrity. By definition only half of all investments can outperform, so a portfolio that contains more than half the relevant universe must contain some underperformers. In any event, diversification has diminishing returns, because each additional holding adds less diversification than the last.
However, the most important balance is not measured in financial but in psychological terms. Too few holdings and one risks falling in love with all one's favourites. Too many holdings and one cannot keep track of them all.
Personally, my equilibrium point is four broad spectrum of unit trusts or 10 specialist sector and single country closed-ended or exchange traded funds. To avoid Murphy's law destroying performance, I try to hold equal weightings in each of them. Typically I have found that my favourite turned out to be too good to be true, while many I thought were just okay became stars, probably because everyone else, unknown to me similarly thought they were also only okay at best.
Question 4: Buying is easy, but when should I sell? If my investment falls, should I cut my loss or hold it till it recovers? If it rises, should I conservatively top-slice my holding, or aggressively run my winners? What if my winners become two or three times the size of my average holding?
Answer: When stockpicking in the past I used to top-slice my winners, so if a holding doubled, I sold half, and if it doubled again, I sold a half of what was left. That came naturally to me as a value player. However it meant that I held no gold shares in 1980, no Japanese shares in 1990 and no technology shares in 2000. The problem for value investors is that they are too modest. We knew that we had to leave something on the table for greater fools, but modestly assumed that they could only be a little more foolish than us.
Then I rated myself as a competent investor, in a world where the incompetent jumped into every fashion, shortly before it became unfashionable and the geniuses did the opposite. As a competent investor I made above-average profits when my game was in vogue and below-average losses when it was not in vogue. When fund managers write that they focus on stockpicking because no-one can predict the market, they are either self-serving or admitting that competence is the best to which they aspire. Nevertheless, over a long-enough track record, the stock market is a friend to the competent.
To graduate to genius level, it is necessary to focus on which investment game to play and when to change one's game. That, in turn, requires concentration of resources on top-down investing, which itself divides into three separate analytic philosophies - valuation (on whatever yardsticks), momentum (whether of price, earnings, or economic trends) and investor sentiment (also know as contrarian investment).
The most helpful comment I ever found in any how-to-invest-book is a selling discipline. It was that "the time to sell is when your reason for buying no longer applies". In other words, when the sum total of valuation, momentum and sentiment strategies becomes negative. That can be refined in terms of opportunity cost by replacing 'negative' with 'less positive' than alternatives. Note that the rule refers to reasons for 'buying', not just 'holding'.
Investments can be described as rotating through a cycle that starts with good value, unpopularity and poor momentum, which equates to Hold. Only when momentum also becomes good, does it become a Buy. As it rises in price and popularity, it becomes poor value, and is downgraded to Hold, but does not decline to Sell until it is excessively popular and momentum turns negative.
Those playing opportunity cost, should switch from investments rated Hold to others rated Buy, whereas those interested only in total return should Hold until the rating falls to Sell and only invest when it improves to Buy.
Question 5: That also seems fine in principle but in the real world, dealing expenses and taxes get in the way of putting this into practice. There are many fine track records on paper for various investment systems, but they make unrealistic assumptions when converting that into practice. Meanwhile stockbrokers are in business to welcome high dealing costs and duck the issue of capital gains tax (CGT) by referring clients to their accountants. Then fund managers are in the privileged position of dealing within a fund ring-fenced for CGT purposes.
Answer: You are right as can be seen for example in the track record of Investors RouteMap on our website. Since launching our service in March 2000, the recommendations of our Shares RouteMap have appreciated by 73%, as against a loss of 6% by the FTSE World index over this period. We make a couple of simplifying assumptions, namely that dealing costs are zero on the basis that turnover is low and liquidity is high and that where markets are rated negatively liquid funds are held in US Treasury Bills.
Using the investment lessons learnt above to manage my pension fund, I utilised the switching facility within the family of funds available to me. I relied exclusively on Investors RouteMap, but even then I needed to interpret the output because of the limited range of funds available to me and the policy of holding no more than four of them. As a result this fund appreciated in value by 40%. That is considerably less than the paper track record but better than all but 5% of the 500 global asset allocation unit trusts available to the public.
In respect of the first cost consideration - expenses - there are several tips that I have found helpful. When making contributions to investment plans, do so annually rather than monthly to obtain volume discounts of up to 2%. When dealing in closed-ended or exchange traded funds, do so through a US discount broker. Commission rates are lower, liquidity is greater so spreads are narrower and dealings in the US do not suffer Stamp Duty.
In respect of the second consideration - CGT - the best quote is from a letter to The Times on 5 April 1965: "Dear Sirs, Regarding CGT, where do I apply?" Certainly residents in those countries like the UK where allowances exist and losses can be offset should take full advantage of these respectively to take profits and cut losses, provided the selling rule above is observed. Certainly residents in countries where CGT applies only to short-term gains like Germany should prefer long-term strategies to minimise tax. In both types of situation there is a good case for a wrapper which permits switches without generating taxable events. However, in the end it is better to have gains and pay taxes.
Author's message: The best investment policy is to focus on making a small number of big decisions, decisively.
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