So you’ve decided to take charge of your own money. You’ve opened an account (preferably a tax-efficient one, such as an individual savings account, or a self-invested personal pension) with your stockbroker, and you know how much you plan to invest each month. But before you invest a penny, you need to think about how you are going to put together your investment portfolio.
There are very few sure things in investing, but here’s one: you won’t get everything right. You will sometimes lose money. That’s why investments are called ‘risk’ assets. The key is to ensure that none of those mistakes is catastrophic, so that, in the end, the money you make far outweighs the amount that you lose.
So the first rule is: don’t put all your eggs in one basket. In the City, this is called ‘diversification’. If you put all your money into one share (or commodity, or bond), then you are making a very big bet. Even large blue-chips can suffer huge share-price falls: just look at oil giant BP’s 2010 Gulf of Mexico disaster. So of course you need more than one stock. But it goes deeper than that. Say you buy BP and Shell and eight other oil companies. That protects somewhat against ‘stock-specific’ risk. But what if the oil price collapses? Your whole collection of oil stocks will be hit.
So as well as holding a range of stocks, you need exposure to a range of sectors. And what if the ‘big picture’ is simply hostile to stocks as a whole? As a rule of thumb, for example, during periods of falling prices (deflation), bonds tend to beat stocks. If prices start to rise rapidly on the other hand (inflation), that’s toxic for bonds, but good for gold. So your portfolio must spread your risk across a range of companies, sectors, and asset types: what’s known as ‘asset allocation’.
You might ask: what’s the point? If one half of my portfolio is going up when the other is going down, how will I ever make any money? The answer is that while different assets may be affected by different factors at different times, that doesn’t mean they act as precise mirror images of each other.
The point is not for moves in your portfolio to ‘cancel’ one another out. It’s to reduce your risk, without damaging your returns. If you spread your eggs across various baskets, you can make as much money as if you’d put it all in a single basket – but without the risk of ruining yourself if your one bet fails to work out. Harry Markowitz first proved this in the 1950s and ended up winning a Nobel Prize for it. It’s been described as “the only free lunch in finance”.
So how many assets do you need? Like any other good idea, asset allocation has been hijacked by the City for marketing purposes. Investors are sold all manner of assets on the basis that they are good diversifiers: hedge funds, private equity, antiques – you name it. But asset allocation should be far simpler than that. You can buy bonds (IOUs from companies or governments). You can buy equities (an ownership stake in a company). You can hold cash (giving you the option to invest when bargains come up). You can own property (although you might group this under the ‘equity’ heading too). And we’d suggest you hold some gold as a hedge against currencies collapsing, as the world’s central banks experiment with money printing. Those are the main asset classes in our view.
What about commodities or currencies? We’d class these as ‘speculative’: direct bets on prices rising or falling, rather than an investment for the long run. For long-term investors, a better way to get exposure to any given commodity is to invest in companies that produce it. Clearly, there’s more to investing than this. If you want to take control of your money, and you need a beginner’s guide, sign up for our free MoneyWeek Basics email.
Stocking with your IFA? Here’s what you need to ask him
If you’d rather stick with your financial adviser (IFA), but are wondering how the RDR changes will affect you, it’s worth asking a few questions, writes Phil Oakley.
If you are using a fee-only IFA (as MoneyWeek has been suggesting for years), you’ll probably have a good idea of what you are paying and what you are getting in return. But if you are using an IFA who has been paid via commission up until now, you definitely need to find out exactly how you’ll be paying in the future. First and foremost, find out what level of service you will receive. Will it be the same as before or will it be different and at a different price? You should then ask what the IFA’s hourly rate is. Many are expected to charge their clients a percentage fee based on the value of their portfolios. Check this is not too high, as it can seriously eat into the value of your savings.
One way to work out whether the fee is reasonable is to see how many hours’ work it is equivalent to. Say you have a £250,000 portfolio and your IFA wants to charge 1% a year to look after it. That’s £2,500 a year. If the IFA’s hourly rate is £150, that implies nearly 17 hours of work. If that sounds reasonable, then fine. But as an alternative, you might want to try to negotiate a fixed fee, with a profit share on top if the IFA’s skills actually make you some money.
Finally, if you’ve been with your IFA for years, there’s a good chance they will continue to get trail commissions from some of the funds in your portfolio. You should ask your IFA to disclose these and take them into account when they are billing you for advice.