How We Should All Invest – But Probably Won’t (Newbie Guide)

Hello all, welcome to my first post on this forum!

I have been a member of Freetrade since November and am loving the journey so far. I am a (semi) recently qualified Financial Adviser, so it may not come as a surprise that I have a somewhat of an interest in investing. I thought I would share my “wisdom” with the community to assist any people out there who are dipping their toes in the investment pool for the first time. Please note that the following is not intended to be a recommendation, and the standard DYOR waiver applies.

I want to talk about what I think is the best strategy for majority of “retail investors” (regular people). It revolves around the ever-popular world of passive investing…

If you have not yet had the pleasure of being introduced to the passive investing, then simply put, it is the process of buying a pooled investment (fund) which seeks to track the broader market, also known as the index. The following article is a solid starting point. If you have a little more time I would also strongly urge you to watch the late Jack Bogle (Father of the Index Fund) talk, as he can explain things much more clearly than I.

Why Passive

Look, I don’t want to be a downer, saying that your investment decisions suck. But the truth is that, statistically, 50% of the people reading this will under perform the index. Equally the other half will outperform. The main problem here is that everyone seems to think they are more skilled than they actually are! In the UK 80% of people say they are an above average driver (full disclosure, I am in this group). However any rational human being understands that this is impossible! The same can be said for investing! Already you are at a coin flip of whether picking a passive index tracking investment is going to be a better option for you. My next point is that of the 50% that outperform, what percentage do you think are regular people? And what percentage are “investment professionals?”

That being said, I am not saying that stock picking should be unthinkable… with enough education and practice it is perfectly feasible for someone to beat the index. However this is a topic for another day!

There is an ever growing supply of information on passive investing out there, which I strongly encourage you to go read. For the above mentioned reasons, and few others, I therefore believe passives to be the best options for the masses, or at least the best place to start. However before you rush off to invest in something a stranger on the internet told you to, there is a couple more things to consider.

Risk Tolerance and Asset Allocation

Risk Tolerance: The ability to tolerate fluctuations in your investment’s values

Asset Allocation: The weightings attributed to different classifications of investments (Equities, Bonds, Property)

These two are linked as one’s tolerance for risk should be the main driver of one’s asset allocation. Historically equities provide the highest returns over the long term, however they also exhibit the greatest fluctuations in value (volatility). Typically, Bonds offer a lower rate of return, but are steadier. Additionally, these asset classes tend to complement each other. With Bonds performing well, when equities do poorly and vice versa (for the most part). Therefore, I believe these two asset classes are a great starting point for any portfolio.

A good place to start is by completing a risk assessment such as the one found here although there are many other examples out there! My result of this assessment was 80% Equity, 20% Bonds.

Great so now we have a broad indication of asset allocation.

You could simply find a passive equity tracker and a passive bond tracker and be done with it, but I have included several other considerations:

Home Bias: You may wish to have a higher weighting to assets held in your home country. There are several reasons for this but the main one is that (most likely) your liabilities are based there also.

Overseas Exposure: There may be a potential for greater growth overseas, such as emerging markets.

Bonds Types: There are 2 main types; Government bonds (GILTS) which are lower risk, and Corporate Bonds which are higher risk but have the potential for higher returns.

Objective: Is your goal capital growth, or do you need an income from your investments? Eg. Needing income could mean seeking equities which pay high dividends.

These will obviously depend on your personal preferences, situation and objectives. I am sure there are as many further considerations as there are investors, so please do share yours!

Some Solid Options

Exchange Traded Funds or ETFs are pooled investments (Funds) listed on the stock exchange (Exchange Traded). These are great vehicle for passive investing. The following are a few of my favourites, available on Freetrade (as at Feb 2019)

Ticker Name Asset Class
ISF iShares Core FTSE 100 UK Equities (Large Companies)
FTAL SSGA SPDR FTSE UK ALL SHARE UK Equities (All)
IUKD iShares UK Dividend UK Equity (Dividend Income)
IWDG iShares Core MSCI World Global Equities
VFEM Vanguard FTSE Emerging Markets Global Emerging Markets
VHYL Vanguard FTSE World High Div Yld Global Equities (Dividend Income)
IGLT iShares Core UK Gilts UK Government Bonds (GILTS)
SLXX iShares Core £ Corp Bond Global Corporate Bonds (In Sterling)

Examples

To try and make it a bit more useful I thought I might pop in a few individual examples:

Tom is 27 years old and wants to start saving £200pm to build up some extra savings for retirement. He is high risk and has decided on an 80/20 split in favour of equities. His main aim is to grow his investments over the long term (30+ years). His portfolio might look something like this:

ETF Asset Class Weighting
SSGA SPDR FTSE UK ALL SHARE UK Equities (All) 20%
iShares Core MSCI World Global Equities 40%
Vanguard FTSE Emerging Markets Global Emerging Markets 20%
iShares Core £ Corp Bond Global Corporate Bonds (In Sterling) 20%

Richard is 32 years old and is also saving for his retirement, but he is not comfortable with fluctuations in his portfolio value. He is still aiming to seek growth but has a lower risk tolerance than Tom. Therefore, he has decided on a 60/40 split in favour of equities.

ETF Asset Class Weighting
iShares Core FTSE 100 UK Equities (Large Companies) 30%
iShares Core MSCI World Global Equities 30%
iShares Core UK Gilts UK Government Bonds (GILTS) 20%
iShares Core £ Corp Bond Global Corporate Bonds (In Sterling) 20%

Harry is 65 and is ready to enjoy the money he has earnt from investing over the last 30 years. He has £200,000 which he is going to use to generate additional income. He is a medium risk investor and has opted for 60/40 split in favour of equities.

ETF Asset Class Weighting
iShares UK Dividend UK Equity (Dividend Income) 30%
Vanguard FTSE World High Div Yld Global Equities (Dividend Income) 30%
iShares Core UK Gilts UK Government Bonds (GILTS) 20%
iShares Core £ Corp Bond Global Corporate Bonds (In Sterling) 20%

NB. This portfolio has historically generated income of around 3.5%, or £7,000pa

Conclusion

I hope this was a useful start for anyone out there who is jumping on the roller coaster ride that is investing. For full disclosure, I am not 100% invested passively. However the core of my strategy is, and I believe everyone should at least consider passive investing and it is unarguably (IMO) the best starting point.

Again this should not be considered a recommendation, just my two cents. If there is anything I have missed or you have any questions I would love to hear them!

Best

Jack

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That’s a great way to look at it.

Is good practice to have the backbone in passives, to support the portfolio.

Then we can developing our stock picking skills, and use these to add value safely.

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No, I don’t think so. Education and practice, unfortunately, do not give you the ability to predict random future events. You can only beat the rest of the market by random chance.

The issue is that most people don’t understand randomness, and think a string of good luck means “ability”. In coin flipping, HHHHHHTTTTTT is just as likely as HTHTHTHTHTHT, but the guy that got HHHHHHTTTTTT in the stock market would be heralded as a stock picking genius… for the first 6 years anyway. :sweat_smile:

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I’d be interested in your (or anyone else’s) thoughts on things like asset class return estimates. Would you use one to figure out how much of each index to invest in? Or are these predictions as worthless as asking the fortune teller at the fair?

Thank you for you opinion, however I believe it is important to respect both sides of the coin (pun intended).

I think it is incorrect to assume markets are entirely random, although they frequently feel like they are.

Over the long term, quality companies provide excess returns. If one is able to select these companies then they will be able to outperform. There are many examples of experienced managers with 20+ year track records whom provide out performance over the long term. However there is no individual who can beat the index 100% of the time, and no one claims this is possible.

Even Jack Bogle does not say that is impossible to outperform the market over the long term - merely that the vast majority of investors will not be able to after allowing for costs.

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Asset class returns can be very useful in selecting index funds - however they are largely biased to historic returns.

I will look at writing up something on asset allocation in the near future. However I will probably start a new thread.

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There are those who argue there are exceptions.

I am not included in that group of people the author identifies as what I call being exceptions.

I think the author may be on to something. I have no intention to try to replicate the author’s approach in the foreseeable future, although I see he may have a point.

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Markets as a whole may not be random (for example, there is a general upward trend), but the future behaviour of any particular equity is for all practical purposes random. You can’t judge it from past performance, and you can’t judge it by considering current earnings and projecting forward. Studies show that the financial professionals that attempt to do these 2 things… cannot (on average).

There lies the rub. You can’t reliably pick what is a “quality” company. Not any better or faster than the rest of the market can, at any rate. Since the rest of the market got there before you, the price you can buy stocks in that company already reflects its relative quality. So you won’t make outsized gains compared to anyone else.

For people like Buffet it’s a different story, since his ability to buy unlisted companies and his name making them successful is a very different play to retail people like us “picking stocks”.

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Thank you for putting me on the spot!

Obviously you mentioned Buffett, some other (UK) names that ring a bell include:
Anthony Cross (Liontrust)
Nick Martin & Alec Foster (Polar Capital)
Alexander Darwall (Jupiter)
Michael Lindsell (Lindsell Train)

Think Darwall and Lindsell might be slightly short of 20 years.

Edit: got to throw in Austin Forey too (JP Morgan Emerging Markets) am considering writing up a review/analysis on the investment trust as it is available on FreeTrade

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Unfortunately we need both active and passive investment as without it the market does not function.

Passive investing is fuelled by the market as a whole selecting better companies and raising their price over time, and therefore becoming a larger part of the index. Whilst poorly run companies dwindle.

If everything suddenly became passively tracked then there would be no change in any companies market cap and everyone would just be throwing money into brilliant and awful companies alike.

Please don’t think I am trying to push active investing (I strongly advocate passive investing - hence my post) but I understand that there is two sides to the argument and it is important to consider both points of view.

It might be worth starting an Active vs Passive Thread where we can discuss further.

The intention of the post was to provide first time investors with a starting point.

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Cheers

Strangely I have Lindsell out performing over the same period. - Maybe it is due to currency? The fund being Sterling and the Index in Local currency?

(Will check if I have clearance to post charts from our software)

Total agree with your examples - not that long ago Woodford was a poster boy for active management! Now he is the poster boy for passives… Will be interesting in 5-10 years if Terry Smith and Nick Train suffer similar fates!

Why not pick the best performing funds and select their top 10 stocks?

Only reason on HL I invest in funds as it’s too expensive to buy and sell shares hence why I am here (awaiting android).

I invest 100% in funds thst are mostly equity. Why invest in anything else?

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Interesting idea Ben - my concern would be that these may be companies who have already played out… Maybe it would be more interesting to look at what the top fund managers are adding too?

Totally agree with your point on HL! - I use the app on my iPad, but patiently waiting for the android app!

Regarding equity - As is commonly agreed, equity outperforms over the long term. If you are young and risk tolerant then I would have no issue with being 100% equity. However for some people, those who require an income or in a market down turn may panic and sell up, it may be prudent to diversify asset classes to “smooth” the journey

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I believe the software I used factored in the fund managers costs (OCF). As well as using the Total Return Index - However I agree that it is unnecessarily difficult to get “clean data”

We also use Eikon at work, but i’m not hugely experienced with it yet! - Will have a look on there in the near future when I get a moment.

Totally agree - we all hate to admit it, but boring is usually better

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I suppose the problems are that

  1. the average retail investor (admittedly someone who doesn’t actually exist but you know) has no edge on the market at picking stocks or at picking clever investment managers, and
  2. the historic returns (even 20 year records) of stocks or clever investment managers aren’t particularly predictive of future performance.

Isn’t that what eg the SPIVA data says?

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Great points, active investment managers bring in an additional level of risk as you’re taking a chance on them being able to add value.

If people are comfortable with that risk then that’s their choice in the pursuit of greater performance.

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Thanks for a simple and neat write up.

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Thank you so much for the thorough explanation! Just one question so far, us the term “equity” synonymous with “stocks”? You say the result of the assessment for you was 80% Equity, 20% Bonds, but the assessment gave me 20% stocks, 80% Bonds, with no options for equity. Have I missed something? Sorry for the newbie question!!

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Yep, stock == equity.

80% bonds is very risk averse. What timeframe are you looking at and how old are you?

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I largely agree with your post but it is 50% of the market that will underperform, and 50% of the market will outperform, not 50% of the people. Statistically, more like 80% of the people will underperform the market over a 5 year period.

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