The investment world has never appeared more complex and daunting. New financial products are regularly pushed at investors by salesmen and often without regard to personal circumstance. The media regularly bombards investors with notoriously short focussed ‘glee’ or ‘panic’ stories. Then there are the unfortunate investors who’ve found themselves the victim of financial fraud.
It appears a discouraging landscape to navigate, yet it’s really quite simple. If you acknowledge markets are unpredictable, but their rewards can be captured; if you don’t fall prey to media distraction; and if you don’t expose yourself to unproven methods, it is possible to have a successful investment experience. At Spencer Private Wealth we don’t take unnecessary risks and we don’t adopt unproven strategies – we focus on what drives investment returns. When investing for clients we focus on these key principles:
- Markets work
- Risk and reward are related
- Diversification reduces Investment Risk
- Asset Allocation determines performance
- Maintaining discipline
Traditional active investment managers strive to beat the market – they rarely succeed. Studies have shown less than 10% of active investment managers consistently outperform the market and when their fees are taken into account that figure falls to less than 1%.
Markets throughout the world have a history of rewarding investors for the capital they provide. Allocating funds to the sections of a market that offer long-term risk and return characteristics is shown to be the most successful way to capture market returns.
So the question is: why continually try and outwit the market when it exists to work for you?
This chart compares the returns delivered by the US share market over a 30-year period, against the returns of the average equity investor.
As you can see, there’s a significant difference between market returns and what the average investor achieves. And there are pointed reasons why the average investor continues to deny themselves those higher market returns:
- Paying high fees
- Focussing on pre-tax returns
- Trying to time the market
- Failing to diversify
- Chasing last year’s winner
Risk and Reward
Risk and Reward are Related
Evidence from investors and academics points to one undeniable conclusion: returns come from risk. Investment rewards are rarely accomplished without taking a risk, but not all risks carry a reliable reward. Everything we have learned about expected returns in the equity markets can be summarised in three dimensions:
Shares are riskier than bonds. In turn they offer higher expected returns as a reward.
Small companies have higher expected returns than large companies. This makes sense because small companies are more of an unknown quantity.
Lower priced ‘value’ stocks offer higher expected returns than higher priced ‘growth’ stocks. A value stock is one that is out of favour for one reason or another. The level of exposure to these areas will determine the risk and reward.
These charts show the benefit of risk premiums over various time periods. Illustrating while we might want to invest in great companies, the most successful companies aren’t always the best investment.
In Australia, this chart shows the benefit of risk premiums afforded to the value index over the last 30 years.
And over a longer time frame, this US chart shows how small risk premiums have delivered.
The small and value premiums are not always present, that’s why they are called ‘risk’ factors. However, as the charts show, they are more likely to be rewarded. And they are available to investors if they stay disciplined over the longer term.
At Spencer Private Wealth we understand the risks worth taking.
Diversification reduces Investment Risk
Investing without diversification is exposing yourself to unnecessary risk. Avoidable risks are holding too few securities, speculating on specific industry sectors or countries and following the predictions of others. These are risks that don’t provide a reliable reward.
By spreading your investments across different types of asset classes you can build a portfolio for all conditions. This is because while one asset class is performing poorly, another may be doing well. This is not to say diversification is complete protection, but it is insulation to reduce the volatility in your portfolio.
At Spencer Private Wealth our clients’ portfolios are broadly diversified across asset classes such as shares, fixed interest, real estate and cash.
But the diversification doesn’t stop here. Shares, fixed interest and real estate are further diversified according to size and geography.
These aren’t a handful of direct investments in individual companies, bonds or real estate trusts. These are investments into funds which encompass thousands of companies and bond maturities.
A Spencer Private Wealth portfolio may hold upwards of 5000 individual companies across Australia and the world. Your fortunes are never riding on the performance of one company, one sector, one country or one asset class.
After all, who can really predict what will happen next? This chart shows the highest and lowest returns from each asset class this century – can you see any pattern?
At Spencer Private Wealth we build diversified portfolios that are structured to capture returns and minimise risk.
Asset Allocation determines performance.
Once the sources of risk and return are understood, the task of putting together a portfolio is a relatively simple one.
Step 1: Growth-Defensive Split
The broad asset categories of a portfolio are growth or defensive.
Growth assets include local and international shares and property.
Growth assets offer better returns, with more volatility. Defensive assets include cash and fixed interest. Defensive assets are less volatile, but offer lower returns.
How your portfolio is tilted towards growth or defensive assets depends on your personal situation, age, investment goals and risk profile.
Step 2: Broad Asset Classes
After the Growth-Defensive split, those categories are broken into broad asset classes.
For Growth, the choice is domestic and global shares, emerging markets and property. In Defensive, the choices are cash and fixed interest.
Step 3: Sub Asset Classes
This step divides domestic and global shares into three further classes: large, value and small.
Tilting a portfolio further towards value and small shares increases the expected return; however, it does come with higher risk.
These steps in asset allocation account for more than 90% of portfolio performance1. In contrast, market timing and picking individual shares have a minor influence.
When it comes to investing, we can all be our worst enemies. This is because we let our emotions get the best of us – and at the worst possible times. Maintaining discipline is never easy, but it’s something that can be mastered with education.
Many investors tend to get excited about investing after their prices have risen. This happens because people feel comfortable and confident as markets rise. In reverse, when markets are in a downturn fear begins to set in. This results in investors selling often at the bottom of a cycle.
Think about the role of the media and finance industry in this cycle. The media needs drama, movement and colour to attract audiences and the financial industry makes a great deal of its money from clients continually buying and selling investments. If clients continually trade in and out of investments the main beneficiaries are investment houses who charge fees based on those trades.
It’s important to remember market uncertainties will come and go. More of often than not, those that panic miss the inevitable rebound when it comes. And as your investment partner, we’re here to help you take the longer term view with your portfolio.
If you’re not convinced about the futility of jumping in and out of the market, this chart underscores the potential to miss available gains.
If you had invested $1,000 in the ASX/S&P 300 Accumulation Index in July 1992 and left it untouched, you would have a balance of $7,644 by the end of December 2013. If you had missed the best 25 trading days in that period, the balance would have reduced by almost 5.2% to $2,702.
We’re constantly reminded by the media about investors who’ve lost their life savings in complex, dubious or untested investment schemes, and then there are those who were the victims of outright fraud. Investors often find themselves in these situations because they were not fully informed about risk and reward.
A higher return is only possible with a higher level of risk and there is no such thing as a guaranteed return. When an investor understands these points, they can understand what is possible and what isn’t.
At Spencer Private Wealth we counsel clients to understand why their investments are structured the way they are and the potential risks and rewards of any investment plan. Furthermore, we offer a completely transparent and secure relationship.
We operate on a fee for service basis where clients’ interests come first.
We provide a written statement of any investment strategy that will be developed in accordance with your risk profile.
We provide a written statement of any financial plan with recommendations developed in accordance with your personal circumstances and lifestyle goals.
Advisors are consistently studied on the most up-to-date financial & legislative research and educational programs.
Advisors who provide advice relating to financial planning and investments are qualified and licensed to FYG Planners Pty Ltd, an Australian Financial Services Licensee and Australian Credit Licensee.
We have no financial interest in any firms that we use to structure your investments and we prefer not to receive commissions or third-party payments.