Long-term investors rewarded by compound performance
An investor who puts money aside over the long term for a rainy day is far more likely to achieve their goals than someone looking to ‘play the market’ in search of a quick profit.
The longer you invest, the bigger the potential effect of compound performance on the original value of your investment. Many investors will be familiar with the term ‘compounding’ from owning cash savings accounts. The term refers to the process whereby interest on your money is added to the original principal amount and then, in turn, earns interest.
Over time, compounding can make a significant difference. Your investments can benefit from compounding in a similar way if you reinvest any income you receive, although you should remember that the value of stock market investments will fluctuate, causing prices to fall as well as rise, and you may not get back the original amount you invested.
Shares, bonds, property and cash react differently in varying conditions, and opting for more than one asset class can help to ensure your investments won’t all rise or fall in value at the same time. Holding a portfolio of investments as part of a collective investment scheme can help to diversify the perils associated with investing in individual assets and markets, as well as less visible hazards such as inflation risk – the possibility that the value of assets will be adversely affected by an increase in the rate of inflation.
Investing in vehicles such as unit trusts, investment trusts and OEICs can also remove a lot of the difficulty associated with managing a broad portfolio. Above all, investors should aim for a level of risk they are comfortable with which reflects their investment objectives.
Types of collective investment scheme
Unit trusts pull funds together under one umbrella and then manage them en masse. Investors pay into the unit trust, which then buys assets such as equities or bonds on their behalf.
The monetary value of these assets is divided by the number of units issued when the fund is created to give an initial unit value. This value then fluctuates as the underlying assets trade daily and investors put money in or take money out. As there is no limit to how many units can be created or redeemed on an ongoing basis, unit trusts are known as ‘open-ended funds’.
An investment trust works along the same principle of raising money from investors to buy assets that it manages on behalf of them all. The main difference is that the investment trust is created by selling a fixed number of shares at the outset. As no new shares are created, investment trusts are known as ‘closed-end funds’.
Open Ended Investment Companies (OEICs)
OEICs are a mixture of a unit trust and an investment trust. OEICs issue shares rather than units but have a different pricing structure to unit trusts. OEICs are based on a single price structure which means buyers and sellers receive the same price.
What is a diversified portfolio?
This is the practice of spreading your investments so your exposure to any one type of asset is limited. This helps to;
Diversified portfolios are usually made up of many components which may include;
It’s easy to find people with investing ideas—your hairdresser, your neighbour, or an “inside tip” from a someone “in the know”. But these kinds of well-meaning but not necessarily informed suggestions aren’t a replacement for a real investment strategy.
At Virtue Money we believe that setting and maintaining your strategic asset allocation are amongst the most important ingredients in your long-term investment success. No matter what your situation, this means creating an investment mix based on your goals, risk tolerance, financial situation and timeline and being diversified both among and within different types of stocks, bonds and other investments.
Your portfolio needs a regular check-up. You should check your asset allocation at least once a year or any time your financial circumstances change significantly—things like losing you job or getting a big bonus. This is also a good time to review your existing assets and risk strategy to see if it still meets your current situation and future plans.
The aim of diversification is not necessarily to improve performance—it won’t ensure gains or guarantee against losses. However, once you choose to target a level of risk based on your goals, time horizon and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.
To build a diversified portfolio, you have to look for assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction and to the same degree; and, ideally, assets whose returns typically move in opposite directions. This way, even if a bit of your portfolio is not performing so well, the rest of your portfolio is more likely to be growing, or at least performing better. This means that you can potentially offset some of the impact that a poorly performing asset class can have on an overall portfolio.
A diversified approach can help to manage risk, while maintaining exposure to market growth.
Importance of having a risk level you can live with
The value of a diversified portfolio usually reveals itself over time. Unfortunately, many people struggle to fully realise the benefits of their investment strategy because when markets are on the up, they tend to chase performance and purchase higher-risk investments. When there is a market downturn they do the opposite and look to move to lower-risk investment options. These are actions which can lead to missed opportunities.
It is important to understand that the decisions that you make about how to diversify, the time you choose to get into or out of the market, as well as fees you pay, or underperforming funds choose, can cause you to generate returns far lower than the overall market. Having a plan that includes appropriate asset allocation tailored to your attitude to risk and reviewing your portfolio on a regular basis can help you overcome (to a certain degree) the challenge of an uncertain market.
Successful investing involves making choices that meet your unique needs today and your financial goals for the future. Your personal circumstances will affect your decisions every step of the way. Whether you are saving for a home, retirement or your child’s education, here are six investing principles to consider:
It may seem very obvious but the longer you invest, the bigger the potential effect of compound performance on the original value of your investment. Many investors will be familiar with the term ‘compounding’ from owning cash savings accounts. The term refers to money multiplying itself by earning a return on the return. Over time, compounding can make a significant difference.
Your investments can also benefit from compounding in a similar way if you reinvest any income you receive. You should remember, however, that the value of stock market investments will fluctuate, causing prices to fall as well as rise and you may not get back the original amount you invested.
Spreading risk across a wide range of investments is an effective way to reduce your risk exposure and increase potential returns over the long term. Holding a mixture of different types of investments can help cushion your portfolio from downturns, as the value of some investments may go up while the value of others may go down. Shares, bonds, property and cash react differently in varying conditions, and opting for more than one asset class can help to ensure your investments won’t all rise or fall in value at the same time.
Holding a portfolio of investments with a low level of correlation can help to diversify the perils associated with investing in individual assets and markets, as well as less visible hazards such as inflation risk – the possibility that the value of assets will be adversely affected by an increase in the rate of inflation.
Geographical exposure and long-term investing are other ways of spreading risk. Above all, investors should aim for a level of risk they are comfortable with, which reflects their investment objectives.
While a well-constructed portfolio can produce a healthy return for investors, the opposite is also true. It is easy to incur permanent losses by putting money into an asset that behaves in an unexpected way. Investors should always set aside time to try and understand what it is they want to hold.
The type of investments you choose will also depend on whether you’re saving for long-term or short-term goals. For your long-term goals, you may want to consider long-term, growth-oriented investments. Your short-term goals call for investments that are more conservative and more accessible. For example, if you’re investing to save for a house deposit, you’ll want quick and easy access to your funds.
The mix of investments within your portfolio is also known as your portfolio’s asset allocation. A portfolio should typically hold a combination of savings, income and growth investments. History is no indication of how an investment might act in the future, and investors should always try to weigh the potential risks associated with a particular investment alongside the prospective rewards.
One consideration is to invest smaller amounts over time – also known as ‘pound-cost averaging’ – to benefit from lower average costs than infrequent purchases. For example, your money will buy more units or shares within a fund when prices are low, and fewer units or shares when prices are high. Provided the fund gains in value over the long term, you’ll have the opportunity to profit from your purchases during short-term price declines.
As we witnessed in 2008 following the collapse of US investment bank Lehman Brothers, unexpected or adverse news flow can have a significant effect on stockmarket performance. For example, during the Greek debt crisis, this presented broader opportunities in European stocks for investors willing to take on a certain level of risk.
Indeed, there have been times when highly cash-generative, defensive businesses capable of creating value in a range of market conditions have been subjected to the same negative sentiment that has driven down the price of stocks more sensitive to economic cycles and those that are poorer quality.
Inflation, taxation and charges (such as dealing, switching and ongoing charges) are three of the factors that can affect the real rate of return on your investment. There are certain options that can reduce costs, including the use of tax-efficient wrappers, namely Individual Savings Accounts (ISAs), private pension plans and employment ‘save as you earn’ schemes.
There are also inflation-protected instruments, such as index-linked bonds (interest-bearing loans where both the value of the loan and the interest payments are related to a specific price index – often the Retail Prices Index), National Savings investments or commercial property holdings, where rents can often be increased in line with the rate of inflation.
Taking risk with some of your money to achieve a sustainable retirement income
Sourcing a sustainable retirement income is essential, but you also have more options than ever before to help you find a solution. After you have made adequate provision for your essential needs, you may want to consider if you can afford to take any risk with some of your money to aim for better returns.
If you have been investing for a number of years, you’ll be familiar with the idea that ‘risk’ represents the chance for your investments to fall as well as a rise in value. In general, higher-risk investments have a higher potential return, whereas lower-risk investments usually give a lower return. This still applies in retirement, but a bigger risk is the danger of running out of money too soon.
Factors to consider
Longevity – Rising life expectancies are undoubtedly good news. However, they are putting significant strain on both the state and private pension provision. In 1925, when the State Pension age was set at 65, average life expectancy for men was only 56*. By 2012, it had risen to 79.5, but the state retirement age – for now at least – remains at 65. When you are planning your retirement income, it is essential to consider carefully the risk of outliving the money you set aside for retirement.
Inflation – As prices rise over time, the real value of your money can be eroded. When you are working, your income generally gets inflation protection through annual pay rises. When you retire, inflation becomes much more of a risk if your income is not rising. This is why you may wish to invest some of your money with the aim of growing your capital – and, therefore, your income.
Between December 1988 and December 2014, the cost of goods and services in the UK increased by 97.8%. This means £100 in savings in 1988 would almost have had to double – to £197.80 – to buy the same basket of goods and services in 2014*. To look at it a different way, your capital would have to grow by 2.5% a year, on average, just to keep pace with inflation.
Income – We all want to have the finances for a care-free retirement, but this is becoming increasingly hard to achieve. In recent years, pensioners have faced persistently low-interest rates and declining returns on assets traditionally used for retirement income, such as UK government bonds (also called ‘gilts’). The yields on UK government bonds are a key influence on annuity rates.
Risk and reward
It is important to keep enough cash available for short-term needs and to understand the potential risks involved in investing. While there are varying levels of income available across the different asset classes, assets that pay higher levels of income also have a higher risk of capital loss. Before you choose a particular income strategy, you need to be comfortable with the level of risk involved.
Source data: * Office for National Statistics
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