Anyone who's had the misfortune to think about it knows that our tax system is a mess. It's so full of loopholes and fiddles that it serves its purpose only very badly. I fear that a similar thing is true, for similar reasons, of many readers' portfolios. The new year is a good time to change this.
What I mean is that our portfolios, like the tax system, suffer from the twin evils of good ideas and the passage of time. Chancellors have had ideas for improving the tax system - a relief here to 'encourage enterprise', a rise there to 'simplify' the system - and down the years these ideas have accumulated like barnacles on a boat to give us a tax code so complicated that it merely creates jobs for lawyers and destroys jobs for real people. Much the same happens with our portfolios. We get a good idea to buy a stock or fund and over time these ideas build up to leave us with a barnacle-ridden vessel that does a poor job of sailing us to our destination.
So, let's use the new year as an excuse to change this, to clean up our portfolios. Here are six barnacle-removing ideas.
1. Don't overdiversify
Buying stocks is fun; we can look forward to the money we make and to the buzz of proving ourselves right and the market wrong if the share rises. Selling stocks is depressing; it means having to acknowledge that we were wrong. It's very easy, therefore, to buy more than sell and to build up a portfolio of dozens of shares over time, and end up with a sprawling mess that is merely an expensive tracker fund.
To see what I mean, remember the maths of diversification. Our chance of beating the market by a big amount depends upon two things. One is the chance of any one stock doing so. This depends upon the individual stock's tracking error - its volatility relative to the market. The other is the chance of many shares doing so at the same time. This depends upon the correlations between the shares. As we add more stocks to our portfolio, the contribution of individual stocks to our chance of outperforming declines, while the contribution of the correlation terms increases.
Let's take an example. Say you have lots of shares each of which has a one-in-four chance of beating the market by 20 percentage points or more over a 12-month period. This is roughly the chance of Arm Holdings doing so, based upon its monthly volatility relative to the market in the last five years. What are the chances of a basket of such shares outperforming? It depends upon the correlations of their relative performance. If this is zero - such that if one stock outperforms there's a 50:50 chance of the other doing so - then the chances of a basket of 10 shares outperforming by 20 percentage points or more is less than 2 per cent. And the chance of a basket of 50 outperforming by that amount is less than one in a million.
Holding lots of stocks, therefore, dilutes your performance, quite possibly by a lot.
In one sense, I've actually understated the problem, by taking a stock with quite high volatility. If I'd taken a defensive stock or - worse still - a fund, we'd have even less chance of outperforming significantly.
Of course, you also cut your chances of underperforming. But the point is that if you want market-type performance, it is cheaper to own a tracker fund than a basket of stocks or actively managed funds.
You can mitigate this problem by owning speculative stocks, or by having stocks whose chances of outperforming are positively correlated - say, because they are in the same sector or exposed to similar risks. But doing so won't overturn the fact that it's easy to end up with an expensive tracker fund by accident.
Action: Use a core-satellite strategy. Use a tracker fund to get general exposure to the stock market, and complement this, if you want, with a few specific stock picks.
2. Don't be overoptimistic
You might object to my calculation. You're a good stock-picker, so the chances of having all your stocks outperform together are higher than I've assumed.
This brings me to my second lesson - dump the overoptimism.
Let's say that each stock you buy has a 75 per cent chance of beating the market. This would make you a very good stock-picker indeed. Then if you buy 10 stocks, you have a one-in-five chance of seeing three or more underperform. That's the maths of binomial distributions. And their underperformance would drag down your overall returns.
In fact, the chances of a 10-stock portfolio doing badly are probably greater than this, because there are diminishing returns to skill. Christopher Polk at the London School of Economics has estimated that the typical fund manager has only half a dozen good stock picks at any one time, and he dilutes their performance by holding lots of poorer shares. Why believe you are different from the typical professional?
There's another common form of overoptimism. We often invest in companies we know, such as local businesses or those in the industry we work in, in the belief that we understand these. However, research by Hans Hvide and Trond Doskeland, two Norwegian economists, has found that this is generally a mistake; people who own lots of shares in the industry they work in usually see poor returns.
Overestimating our ability, though, is not the only form of overoptimism. It's also easy to be overoptimistic about the risk and returns on the market.
Probability of a real loss on UK equities
| 1 year | 3 years | 5 years | 10 years | 20 years | |
|---|---|---|---|---|---|
| Expected real return | 5 | 15.8 | 27.6 | 62.9 | 165.3 |
| Standard deviation | 19.3 | 33.4 | 43.2 | 61 | 86.3 |
| Chance of loss (%) | 39.8 | 31.8 | 26.1 | 15.1 | 2.8 |
Since 1870, the average annual real return on UK equities has been 6.1 per cent, with a standard deviation of 19.3 percentage points. There are good reasons to think that 6.1 per cent won't recur. One is that we've had a lot of good luck over those years, by winning most of our wars, avoiding revolution and hyper-inflation, and enjoying very strong growth in the 1945-73 period. Some of that 6.1 per cent, then, reflects the benefit of relief rallies that won't recur. A safer assumption would be a real return of around 5 per cent - a 3.5 per cent yield plus 1.5 per cent long-term growth.
If we assume volatility of 19.3 per cent, and that returns one year are uncorrelated with those the next, this allows us to estimate a probability distribution for future wealth, as shown in the table above. This shows that, even over periods as long as 10 years, there is a reasonable chance (roughly one in six) of you losing money in shares.
Action: cut down on your trading activity: it often just loses money. Make sure you are able to bear largeish short-term losses even on apparently good stocks - for example, by holding enough cash to see you through bad times.
3. Remember that what matters is your whole portfolio
Most of us have got money salted away in various places: a self-invested personal pension (Sipp), a few individual savings accounts (Isas), employers' pension funds, direct holdings and so on. Don't get befuddled by all these pots. What matters is the riskiness and returns of your entire wealth. Losses in one pot are more tolerable if they are offset by gains elsewhere. Most of you know this. What is easy to forget, though, is that you have two big pots that you might not think about - your house and your human capital, or earning power. This should affect your investment decisions.
For example, if you're hoping to use part of your housing wealth to pay for your pension, then it's dangerous to be heavily invested in shares, as there's a danger that losses on your house might be amplified by losses on your shares: this is especially so over longer periods, because an economic downturn could cause shares and houses to fall together.
Or, for example, if you're a younger investor with decent job prospects, you can afford to take on more equity risk, because losses on shares should be offset by gains in human capital; you can earn money to make up for any stock market losses. Similarly, if you are approaching retirement age and have a reasonably safe job you enjoy, you are well-placed to take equity risk, because you can make up losses on shares by working longer. If you dislike your job, or think it insecure, you don't have this luxury and so should hold more cash.
Action: regard your job as an asset. Integrate it into your portfolio accordingly. If it's a safe and enjoyable job, you can think about being more adventurous with your shareholdings.
4. Ask of any asset: what is this doing for me?
The fact that it's the whole of your portfolio that matters does not, of course, absolve us from thinking about its constituents. Ask of each asset: what is this doing for me? Ultimately, there are only two possibilities here: it's either giving an expected return, or it's providing a diversification benefit. (Only if we’re very lucky does an asset do both.) As a rule, equities should do the former, and other assets - cash, bonds, gold - do the latter.
One common problem here is that we can own superfluous assets. These are those - often general equity funds - that tend to rise and fall as our other shares rise and fall and so offer no diversification gains, without the prospect of stellar returns.
Another problem is a misunderstanding of government bond funds. These offer two benefits. One is for the short-term investor; they often do well as share prices fall, and so act as a hedge against the latter. The other is that they hedge against annuity risk. If you're approaching the age at which you want to buy an annuity, you face the risk of annuity rates falling further. Bond funds help protect you from this danger, because they would do well as gilt yields fall.
What such funds don't do, however, is offer you a certain return. To get that, you need to own government bonds with a maturity date. This matters, because with government bond prices so high now, there's a fair chance they will fall over coming years.
Action: Cut out superfluous assets. Make sure your low-risk assets really are protecting you from the risks that trouble you.
5. Think about risks
Pretty much all assets carry risk. If you think they don’t, you’re missing something. However, some risks matter more for some people than others, for example:
■ If you're retired and on a flat-rate annuity, you face more inflation risk than a younger working person, who can expect pay rises to compensate for rising prices. For you, then, inflation protection such as index-linked gilts, is a better idea than it is for a younger investor.
■ If you own a small business or are in a precarious job, a recession or long-term economic decline would hurt you more than it would hurt a retired person. Other things equal, this means cyclical shares are a worse idea for you than they are for retired people. Conversely, government bonds – which should do okay in recession - are more attractive to you than the retiree.
■ If you're thinking of migrating - either retiring abroad or returning to Blighty after working overseas - you face exchange rate risk. You should then hold the currency of the country you plan to move to. Someone planning on staying in England doesn't face so big a danger here.
You might think there's another obvious example: younger people are better able to cope with short-term equity losses than older ones, as they have more time to recoup them through better returns later. This, however, is not clear. Although younger people can cope better with the large risk of short-term falls, they are more exposed to the small risk of long-term losses, such as in Japan's lost decades.
All this matters because assets that protect us from risks rarely offer good returns. If we hold assets that protect us from risks we’re not bothered by, we are therefore sacrificing returns.
Action: ask: which risks bother me? Hold the assets that protect you from this danger, but not those that protect you from risks that don't trouble you. And remember - there's always a case for holding cash.
6. Remember your objectives
Your wealth has come at a cost. You've had to work and save for it. There has to be a purpose to such sacrifices. So let's make sure that our portfolios fit the purpose for which we intend them.
One thing this requires is that we are clear about our objectives. One common error is to consider oneself a long-term investor, but then to throw in the towel and sell after being burnt by short-term losses - often doing so at the bottom of the market.
Another requisite is to ask: how far are you from your target level of wealth? If you're around the target - so that you have enough to retire comfortably on or to buy your dream house - then you should be concerned to conserve wealth rather than build it.
This is because, for you, gains and losses are asymmetric. A big rise in the market would give you money you don't really need, thus making you only slightly happier, while a big fall would jeopardise your dreams thus causing much misery. If you're lucky enough to be on this position, think about reducing equity exposure and increasing exposure to cash or specific bonds (not bond funds, as these can suffer short-term falls too).
Wallis Simpson famously said that "you can never be too rich or too thin". She was wrong. You can be too rich. If you've got more money than is sufficient to meet all your objectives, it might be a sign that you've saved too much or taken too much risk.
Remember - you can cash in your chips.
If, on the other hand, you want to build wealth, then more equity exposure is needed. Our probability table, opposite, gives a rough idea of what sort of long-term returns, and distribution around them, to expect. If this offers insufficient returns for you, you have several options.
You could increase your equity exposure and hold fewer bonds. Or you could leverage up equity returns by holding higher-beta ones, such as emerging markets. (But not speculative stocks, as these tend to have idiosyncratic risk and so a portfolio of them might well diversify returns away.) These strategies, however, are risky. Other options are to save more, or work longer or harder, or just reduce your expectations.
The point here is that your wealth should be like a suit. It should fit you comfortably. If you have net financial wealth (including pension assets) of more than £282,500, you are in the richest quarter of people aged between 50 and 65.
If, despite this, you're worrying about money, it's a sign that something is wrong. That something might well be a mismatch between your portfolio and your objectives.
Action: have a target level of wealth in mind, and ask: how likely am I to achieve this, based upon prospective equity returns. If the answer's 'very likely', consider whether you're taking too much risk. If the answer's 'unlikely', consider taking more - or doing other things to narrow the gap between reality and aspiration.
