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Four Basic Investment Principles

It’s easy to get swept up in the mood of the moment, says Neil Cowell, head of UK sales at Vanguard Asset Management – the economy, the gossip, the latest investment fad. But there are no secrets to investment success – just some timeless principles .


We believe a very straightforward investment philosophy made up of four timeless investment principles lays the foundation for investment success. Each of these principles rests on the premise that investors and their advisers should focus on what they can control, rather than chasing performance or trying to time markets.
It’s very easy, and very tempting, to focus on the markets, the economy, manager ratings or fund performance. But this could lead your clients to overlook the basic principles that we believe can give them the best chance of success. We think you can use these principles with your clients to help them make decisions that give them a better opportunity to meet their investment goals.
Sharing a core set of investing principles with your clients can differentiate you from other advisers. In our experience of working with fee-based advisers in the UK and overseas, this can strengthen relationships by clearly communicating a common-sense investing philosophy. And it can tie your value proposition to things you can control.

 


Goals: Create clear, appropriate investment goals
Appropriate investment goals are measurable and attainable. Success shouldn’t depend upon unrealistic investment returns, or unsustainable savings and spending requirements. Defining goals clearly and being realistic about ways to achieve them can help you steer clients away from common mistakes that can derail progress.
Without a plan, your clients may build their portfolios bottom-up, focusing on investments piecemeal rather than on how their whole portfolios serve their objectives. They may indulge in ‘fund collecting’ – buying seemingly attractive funds without thinking about how or where they may fit in their overall portfolio allocation.


Balance: Develop a suitable asset allocation
A sound investment strategy starts with an asset allocation suitable for the portfolio’s objective. The allocation should be built upon reasonable expectations for risk and returns. It should also use diversified investments to avoid exposure to unnecessary risks.


Assuming that your clients use broadly diversified holdings, the mixture of those assets will determine the returns and the variability of returns for the aggregate portfolio. Attempting to escape volatility and near-term losses by minimising equity investments can expose your clients to other types of risk, including the risks of failing to outpace inflation or falling short of an objective.

Figure 1 provides a simple example of this relationship using two asset classes – UK equities and UK bonds – to demonstrate the impact of asset allocation on returns and the variability of those returns. The numbers within each bar show the average yearly return since 1900 for various combinations of UK equities and bonds. The bars represent the best and worst one-year returns. Although this example covers an extended holding period, it shows why an investor whose portfolio is 20% allocated to UK equities might expect a very different outcome from an investor with 80% allocated to UK equities.
Figure 1. The mix of assets defines the spectrum of returns
Best, worst, and average returns for various equity/bond allocations, 1900–2012
 
Note: Equities are represented by: Barclays Equity Gilt Study from 1900 to 1964; Thomson Reuters Datastream UK Market Index from January 1965 to December 1969; MSCI UK Index from January 1970 to December 1985; the FTSE All Share Index from January 1986 to present. Bonds are represented by: Barclays Equity Gilt Study from 1900 to 1976; FTSE UK Government Index from January 1977 to February 2000; Barclays Sterling Aggregate Index from March 2000 to 31 December 2012. Returns are in GBP with income reinvested.

Cost: Minimise expenses
The lower the costs, the greater your clients’ share of an investment’s return. In addition, research suggests that lower-cost investments have tended to outperform higher-cost alternatives.


Index funds and ETFs tend to have lower costs. As a result, index investment strategies can give your clients the opportunity to outperform higher-cost active managers – even though an index fund simply seeks to track a market benchmark, not to exceed it. Although some actively managed funds have low costs, as a group they tend to have higher expenses.
Figure 2 shows how low-cost index funds as a group outperformed actively managed funds in common asset categories over the ten years to 2012.

 

Figure 2: Percentage of active funds outperforming the average return of low-cost index funds over the ten years to 2012
 


Notes: Fund universe includes funds available for sale in the UK. Performance is for periods ending on 31 December 2012, calculated relative to prospectus benchmark. Fund performance is shown in GBP, net of fees, gross of withholding tax, income reinvested, based on closing NAV prices. For more details on the universe of funds, see The Case for Index Fund Investing for UK Investors (Westaway et al. 2013).
Survivors are only those funds that continued to exist throughout the period, e.g. not closed or merged. Excluding the performance of these funds can distort the result so we correct it by including data for these funds. See The Case for Index Fund Investing for UK Investors (Westaway et al. 2013).
Source: Vanguard, based on data from Morningstar.


Discipline:  Maintain perspective and long-term discipline
Some of your clients may find themselves making impulsive decisions or, conversely, becoming paralysed by fear, unable to implement an investment strategy or to rebalance a portfolio as needed. Discipline and perspective can help investors remain committed to their long-term investment programmes through periods of market uncertainty.


Although the asset allocation decision is one of the cornerstones for achieving an objective, it works only if the allocation is adhered to over time and through varying market environments.

Figure 3 shows the impact of fleeing an asset allocation during an equity bear market. This example shows a move out of equities at the end of December 2008. The portfolio escapes the stock market’s further declines in January and February 2009, but it also misses out on the significant bull market that started in March 2009.


Figure 3: The importance of maintaining discipline: Reacting to market volatility can jeopardise return
 


Notes: The initial  allocation for both portfolios is 60% global equity and 40% global bonds. The rebalanced portfolio is returned to this allocation at the end of each June and December. Global equity is defined as the MSCI All Country World Investable Market Index, unhedged in sterling. Global fixed income is defined as the Barclays Global Aggregate, hedged to GBP. Returns are in GBP with income reinvested.
Source: Vanguard, based on data from MSCI and Barclays.


Helping your clients achieve their goals
Educating your clients about sound investment principles helps you establish a foundation upon which to build deeper client relationships and differentiate you from the competition. When your clients understand the importance of clear goals, diversified portfolios, low costs and sustained discipline, they better understand the reasoning behind your advice. As a result, they are more likely to make decisions that give them a better opportunity to achieve their investment goals.
By basing your investment philosophy on things that are within your control, you’re not making promises you can’t keep in terms of investment performance. As a result, you’ll never have to apologise to your client for the disappointment that may result from trying to beat the market.

 

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