|If you have decided to invest in
equities, here's how to go about it.
You must first settle your asset
allocation policy with your adviser. That means deciding how
much of your free cash flow you are going to invest in equities
and how much in other assets - particularly cash. If you have arrived
at this page through the Advanced Investing module you will have
already done this.
You must diversify your equity holdings. If you
do not do this you are taking unrewarded risk. Rewarded risk - where
you get more return for taking more risk - is OK. Unrewarded risk
Pooled or not?
You must decide whether to obtain diversification by buying a large
number of individual stocks or a small number of pooled investments
(unit trusts, investment trusts or their more exotic cousins).
Obviously a pooled investment is more convenient.
Because you know nothing about stocks you may think that buying
a trust at least saves you from having to make a choice in an area
where you believe you are incompetent. We have a different view.
Beliefs and assumptions
Let's review what we know, with the links to
those pages that explain these points:
- Investing is a betting game. Nothing is certain.
You are trying to take bets which give you the best expected return
consistent with your tolerance for risk. Investing
- You don't know more than the market. You
don't know how to pick stocks.
- The market is dominated by professionals.
So the average market return is achieved by the average professional.
Fixed Sum Game, Average
- Some professionals are better than average
and some are worse than average. But there is no way of telling
which are which. Pick
on Performance?, Star
- The average pooled investment will underperform
the market. That is because the average pooled investment without
costs will perform in line with the market. The cost drag will
lead, on average, to underperformance. Do
We believe that individuals with small amounts of money, having
made the decision to invest in equities, should be much less frightened
of direct investment. Because:
- Stockbroking costs are now so low that it
is cheap to buy small quantities of shares.
- You learn nothing from owning a unit trust.
You learn a lot from owning real companies.
- Most people know one or two companies where they
have a genuine edge over the professional investor. Many fashion-conscious
housewives, for example, will have sold Marks & Spencer ahead
of the professionals on the way down and bought ahead of them
on the way up.
- There is no harm in picking a stock with
a pin (but stay within the FTSE350). The price of the stock already
reflects the consensus view of people who are much more knowledgeable
than you, so why prefer one stock rather than another? If the
company is known to be badly run with poor prospects, the price
will be suitably depressed. In fact
one study in the US showed that "bad" companies have
been more profitable for shareholders than "good" companies
(so long as you bought them when they were believed to be bad).
Average Is Good
- Endless studies have shown that the average trust
underperforms the average stock. Therefore, if you are guessing,
guess a stock.
- Trusts are boring. Isn't it more fun to put
money into a real business that you can read about and even experience
as a customer?
You may feel uncomfortable with
random stock picking. It seems irresponsible somehow. But you know
even less about picking unit
trusts or other pooled investments. So why elect to spend management
fees and operating costs just to make a different guess? Isn't that
even more irresponsible?
The only fixed cost of buying a stock is the brokerage fee - say
£10 per stock. (The other costs are variable - i.e it costs
as much to buy , say, £10,000 of shares in one company as
£500 in each of 20 companies). So buying 20 stocks costs £200,
and £200 again when you sell. If you put the same £10,000
into a good investment trust the costs will be 0.5% or £50
per year. So the investment trust is cheaper for small investments,
but not by much.
What you should do
If you accept these principles, you should do one of two things:
- Buy a diversified spread of individual stocks,
according to any decision rule that you care to devise. Random
picking from a FTSE350 stock sheet sorted into sectors (one stock
from each sector) is acceptable. But, for discipline, stay with
your chosen rule. For discipline.
If you want to try stockpicking it's harmless and, for many, fun.
But don't lose the benefits of diversification, which is very
easy to do because you will be swayed towards businesses you know.
Don't ever allow yourself to believe
you have skill.
Only sell stocks for tax purposes or because you need the money.
Why incur the costs of buying and selling just to replace one
random stock with another? Portfolio
Buy a small (up to 5 or
6) selection of widely diversified funds with the lowest possible
Total Expense Ratio (total costs as a percentage of funds under
management). You may chose either Investment Trusts or Unit
Trusts or Open Ended Investment Companies (OEICS) or Exchange
Sell for tax reasons or because you need the money. Also sell
if the fund does anything to suggest it is changing its character
(for example, it is taken over or changes its investment objectives).
- Do a mix of the two strategies,
making sure that no single stock is more than 5% of your total
- If your portfolio is too small to make individual
shares economic, and you really want to gain experience of direct
share investment, put more of your assets into cash (to reduce
your risk) and buy a few single stocks (which will put your risk
back up again). Be ready to lose all
your money in one stock, and feel comfortable with that.
What else you should do
To maintain your discipline, do not read the business news. Or,
if you do, treat it like an amusing soap opera. Which is what it
That's the end of Advanced Investing. You now
know all you need to know. If you want to go further, it can be
a fascinating subject. But we doubt if you'll do any better. The
number of people who believe they can is quite large. The number
of people even capable of measuring if their performance is better
than random is very small (it's a very difficult technical subject).
The number of people capable of performing consistently above average
is very, very small indeed.
Here are some sources to take you forward. Good