On track: Why index investing is good for your ISA
Investing in an ISA is like any other long term activity – it needs a clear destination or purpose (to make sure you can monitor your progress), you need to understand the risks that might be faced along the way (and what you might need to do to reduce or in response to those risks) and it needs some determination to stay the distance.
Start with the end in Mind
In these tough economic times trying to save or invest for the future is becoming increasing difficult for many. But the importance of providing for your old or infirm age is arguably higher than ever. On average we are living longer so will need more resources – at a time when the quality of pensions offered by employers are reducing.
A clear plan of what resources are needed for later life is growing in importance.
Spending a little time to develop this plan is probably the most important stage in investing. Without a plan how will you know whether you are on track? This is an area where a good financial adviser can really help.
Any plan will of course need to understand the risks.
There are some obvious and less obvious risks that all investors face. Chief among them are inflation and volatility (the ups and downs). Another potential issue is cost – research shows that reducing the cost of your portfolios / funds is likely to lead to better returns.
Every investment has a different risk profile. Cash isn’t volatile but it is poor at beating inflation. Equities usually beat inflation in the long run but are more volatile in the short run.
Understanding your own risk profile is critical as it is the only way to build a portfolio that will meet your long term goals – you need to know:
- Your attitude to risk (your appetite if you like)
- Your need for risk (how much return (as risk and return are linked) do you need to meet your goals?)
- Your risk tolerance (can you afford short term losses in pursuit of longer term goals?)
Too many investors underestimate the impact of inflation. Many people aged 60 today will live well into their 80s and beyond. Your investment plan needs to take account of this.
Eggs and baskets
Diversification, the idea that spreading your investment between different investments and asset classes can boost your returns has been around for many years, but is as valid today as it ever was. Often described as a ‘free lunch’, you can boost your returns and reduce your risk by diversifying.
Spreading your investment between assets classes (equities, bonds, property, and cash) leads to a lower risk for a given return (or, alternatively, more return for a given risk).
The same goes for spreading investments within asset classes between, say, different geographies (e.g. UK and Overseas) or sectors (e.g. energy, financial and retail company shares).
The important thing to remember that different assets will perform differently over time so to keep you portfolio well diversified you need to rebalance (sell the assets that have risen, and top up the ones that have fallen).
Index funds are an excellent way to achieve this diversification at very low cost – they hold a very broad mix of bonds or shares. And rebalance very efficiently. Though you still need to make sure that the asset mix is also rebalanced.
Cost is a Risk?
One of the biggest risks that long term investors face is cost. Every pound that is taken from your investment in costs or charges is lost forever.
And so is the return on that pound …each and every year in future. It is one of the biggest unseen risks facing people drawing income from their pension funds too (but that is an article in its own right).
Always look for the Total Expense Ratio (TER) of a fund, rather than just the Annual Management Charge (AMC).
Also check out the Portfolio Turnover Rate (PTR) to see how often the manager is trading the stocks and shares inside a fund – and thus how much extra cost drag from transaction costs the manager is generating by chopping and changing.
Another good reason for choosing index funds is that they trade far less often – so have lower running costs as well as lower expenses. It is just like cars – ones that are more efficient cost less to run!
Morningstar in the US conducted some analysis in 2010 to identify the best historic predictors of performance. The results are remarkably clear:
‘In every time period and every data point tested, low cost funds beat high costs funds.
Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile (cheapest fifth) produced higher total returns than the most expensive quintile (most expensive fifth)’
Choosing low cost index funds gives you a head start when building your portfolio.
The same goes for the cost of any wrappers (ISA or pension) that you select. Make sure you know the initial costs, the running costs, the switch or trading cost and any other charges.
Long run Returns
Real assets (e.g. equities / property) usually outperform cash and bonds over the long run. The Barclays Equity Gilt study shows that in 9 of that of the last 11 ten year periods analysed 2004 – 2014, 1994 – 2004 etc. Equities beat bonds (but of course that means in 2 of them they didn’t!)
A key point is that asset allocation, how much you invest in bonds vs. equities for example, has been shown to be by far the biggest driver of long term returns and is far more important than which equity you are invested in. Using index funds to get access to a range of asset classes is a sound strategy.
Academic research into the performance track records of active funds bolsters the case for passive investing. An analysis of past performance figures concludes that, although some active fund managers appear to possess skill, the average active fund typically under performs the market.
Even the most skillful investors struggle to produce consistent out performance. And the time, effort and therefore cost that would be required to select these managers (in advance of any hoped for out performance) is probably greater than the extra return anyway!
Investing is not an art – it is a Science
Investing needs a clear long term objective based on understanding the risk and returns you are seeking. Then you need to use the key rules of investing to help you achieve your goals:
- Get the right mix of assets to meet your needs
- Rebalance (keep your asset mix on track by checking it as the environment changes)
- Mitigate the risks, where possible
Index or passive funds are an excellent low cost way to achieve broad diversification within an asset class at low cost. Combining index funds into a portfolio tailored to meet your needs – by using perhaps 10 or so index funds or simple ETFs – is a great way to invest for the long term. And stands more chance of making you, rather than the financial services industry rich!