Happy New Tax Year – Invest Options

OK the Tax Year end is over, so Happy New Tax Year 2018/19; it doesn’t have the same ring to it, does it!

Because I have covered tax and allowances recently I wanted to switch it up and cover investing.

Now is a great time to make an ISA and Pension investment, taking advantage of your ISA and Pension allowances early in the tax year means you get an extra 12 months tax free growth plus you’re sat happy when everyone else is rushing around at the last minute!

We all know that a Pension & an ISA are not investments, right?  That they are only wrappers which investments sit inside of, so where are you going to invest your money that sits inside these wrappers?

If you have 5-7 years or less until you want to realise the investment back to cash, you shouldn’t invest, keep it in cash, the markets are too risky or volatile for short term investing and for clarity, that means a rolling 5-7 years, once you have started investing.

5 years for the more cautious investor/more essential money and 7 years for a more adventures i.e. risk-taking investor/less essential money.

But, if you have time on your side, and you can hold your investments for more than 7 years, you need to be invested in the stock markets, to gain a return which you expect to beat inflation.

There are two decisions to make, before taking the plunge;

  • Firstly, how much risk do you want to take with the money?
  • Secondly how are you going to invest it, which management style will you choose?

Investment Risk

Understanding Investment RiskLet’s start with risk, which I define as the potential for loss, how much can the investment go down, before you begin to feel uncomfortable?  Ask yourself the question now?  How much?

As a rule of thumb, you can expect your equity allocation to fall by 50%.  Now this is not a maximum that it could fall, but looking at history, a 50% fall in equities should be expected.

So, if you invested £100 into a 100% equity portfolio, you could, over the course of your investment life, see your £100 investment to fall to £50, before recovering.  Therefore, if you invested into a 60% equity and a 40% fixed interest (short-or medium duration) then you should expect a 30% fall in value (50% of 30% equity allocation).

I don’t like using only volatility as a measure of risk, because volatility shows how much the investment will fluctuate up and down.  If your investment is fluctuating up and down it could be trending up, or trending down, the volatility measure will be the same, not that helpful!

Management style; Active vs Passive

Then we look at investment management style.  Do we use an active investment management approach, or do we use a passive (a.k.a. indexing) investment management approach?

At Lexington Wealth and Lexo.co.uk we favour a passive investment approach because in my 20 plus years of being a Chartered Wealth Manager I haven’t seen evidence that justifies an active investment approach and the academic community agrees with me that after costs, actives don’t out perform

Even Warren Buffet agrees!

Warren Buffett for those that do not know is one of the world’s greatest investors, he’s generated his personal billion-dollar net worth from equity market investing, and he’s left his estate on his death, not to a managed fund, but an index fund.

He’s so passionate about index investing that about 10-years ago he offered the investment community worldwide a bet, a $1 million bet to anyone who wanted to beat, not him, but a simple S&P 500 index fund.

Only one person came forward and that person chose a basket (not wanting to risk being isolated to one active fund) of hedge funds (a managed fund which is supposedly able to make a return when the markets are going up or down!).  The bet closed early after 9-year because the S&P was so far ahead, it was acknowledged that the active managers could never catch up.

So, when your financial adviser comes around to your home or office and tries to persuade you that they are skilled in choosing these brilliant active funds, or when you go to that web-site or receive that marketing communication ‘selling you’ the next best active fund, remember the Warren Buffet bet and ask them about the survivorship bias of the sector.

Survivorship bias

Survivorship bias with investing

When you or your adviser compares active funds in a comparison league table what they are comparing is todays funds, what they are ignoring is a thing referred to as survivorship bias.

With survivorship bias we are comparing statistically a set of data what has survived the period, not the original data set.

Let me explain with an example;

A team was asked where the best place was to fit armour to a plane. The planes that came back from battle had bullet holes everywhere except the engine and cockpit.

Where do you think the armour plating should be fitted?

Counterintuitively, the team decided it was best to fit the armour where the data was showing there were no bullet holes.

But if you think about this, these planes survived the shooting.  The armour plating was required by the planes which were shot down, and we didn’t analyse these?

Investing is the same, 10 years ago active funds started, if they didn’t do well the fund management company would wind them up, or merge them, so we never know how poorly they performed.  We only see the winners and the winners, generally aren’t beating the indices, on average over time.

Only 43% of UK equity funds running in 2008 were still going in 2017, the ones that closed were the ones which did not make the grade.

There are a number of reasons why the concentrated selection from the universe of active funds which started, say 10-years ago, don’t beat the index.  The main reason is that trading shares is expensive (taxes, broker fees, price slippage) and these costs are paid from the fund.  Therefore, the additional costs, referred to as charges drag, eat into the returns.

Another problem with active management is that the stars, the ones that do well take on too much money, which can dilute their returns due to reduced opportunities.

The returns quoted reflect the fund return, not the investors return, let me explain.  They may start small, perform well and attract investor attention due to their performance.  Say a fund had £20m in the first year returned 20%, which generated £100m of new cash inflows.  So, at the start of year 2 it has £120m and returns 5%.  The fund will have an average return of 12.25% but most investors will have only achieved a 5% return

Take a variable out of the equation and stick with passive/index investing, in fact take a look at Lexo.co.uk where I offer a range of portfolios and I am sure you will find one to suit your needs.

 
New tax year: what’s changed for 2018/19
Tax year end: making the most of your last-minute opportunities

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