Last Updated September 4, 2014
Most of the academic research out there suggests that shares are the best investment vehicle. They have produced the biggest returns for a given amount of risk; so does this means it always makes sense to invest all your savings in the stock market?
When do you want your money back? That’s the key question. One of the fundamental features of stock market investing is that you never know how much your investment is going to be worth tomorrow, next week or next year.
It’s not like putting money into a savings account where, ignoring inflation, the value of your savings never goes down. It’s also not like investing money in government or corporate bonds. If you buy a Tesco bond yielding 5% then you are virtually certain to get that 5% a year until the original investment is repaid. This repayment is on a date that you know even before buying the bond and it’s typically a number of whole years, usually 1 to 5 years.
So in the case of a savings account or bonds everything is known before hand and there is no uncertainty, or at least not very much.
That’s not the case with shares. Most people know that share prices go up and down, with the FTSE 100 level being quoted on the news every day. That’s something that even now as an experienced investor, I can see no reason for. Why would a lay investor care what the footsie is doing on a day to day basis? And if you need to know what the footsie is doing then surely you have a better information source than the 9 O’clock news?
Anyway, shares go up and shares go down. That’s the nature of the beast. Unfortunately, these moves up and down are completely unpredictable on a day to day and even year to year basis.
Time, and lots of it
This means that if you are saving up for a new car next year, putting the money into shares is probably a bad idea. You might come out of it with a 50% gain which of course beats the daylights out of a 3% savings account. But then again you might have a 30 or 40% loss which won’t be good for your choice of wheels.
But what if you have a lump sum to invest and you want it back in 5 years time, perhaps for your 40th birthday? Somewhat intuitively, this does turn out to be a better idea. According to one of my favourite books, “The Intelligent Asset Allocator” by William Bernstein, a 5 year holding period will produce a positive return almost all of the time. This means the chance of you getting back less than you put in are small, but you still won’t have much idea of what you actually will get back. Generally you could expect something between 0% and 20% a year, but it’s still a big unknown.
So at what point does investing in shares begin to be obviously better than bonds, as the academics seem to say? I think there are two main scenarios:
Investing for a lump sum several decades in the future
This is typically your children’s education or a retirement annuity. The end date is way off in the future but at some point you’ll need to sell everything. If your time horizon is 20 years plus then you are virtually certain to make a positive return and probably something around 7-8% a year on average. That’s a rate that bonds can’t match.
The key to success here is to reduce the riskiness of the portfolio as you approach the end date. That’s because you don’t want to be in the position of being 100% in shares the year before your retirement, thinking you’re going to have a comfortable post-work life, only to be hit by a massive bear market which takes 50% out of your fund.
The general idea here is something called the Glide Path, which is basically a way of gliding the portfolio towards low risk holdings as the remaining holding period reduces.
There are many different interpretations but as a stock picker with a semi-fixed selling schedule (1 holding out of around 20 each month) then I could just choose to leave the cash generated by each sale in cash, rather than reinvesting it. So over the last 20 months I’d gradually move the portfolio to cash. This means being 100% in shares 20 months before the end date, which might be a bit much, so stretching this phase out over 40 months might be a less risky proposition.
In doing this you’ll have a nice smooth transition from 100% shares to 100% cash over the last few years, so they’ll be no need to panic if the market falls.
Investing for an income
If you don’t like annuities and already have enough money for your kid’s university fees, you may be investing purely for an income, i.e. you have zero intention of ever selling all of your holdings. This changes things in that your time horizon is effectively infinite which can change your investing world view in some useful ways.
First, since your never going to sell up, you don’t (or shouldn’t) care about the market value of your portfolio. If the value of your portfolio takes a 50% hit, it doesn’t matter. As long as the underlying companies are sound and the income they generate is sustainable, this is simply an opportunity to buy more of the same investments with an even better dividend yield. In theory this should save investors who follow this approach a lot of heartache. The size of the income is all that matters, even in the ‘build up’ phase.
Second, it may help you focus on the income rather than all the other worries about where the market is going. All you’d want in this case is the largest income possible, growing at the fastest possible rate. Once it reaches the same size as your current salary you could then choose whether to retire early or not.
On top of that, if you continue to invest in the same manner by focusing on high yield, high growth shares, instead of moving your funds into something ‘safe’ like bonds as many people do, then your income may well continue to grow faster than inflation. This can happen even if you’re drawing all of the dividends.
Shares are not for next year’s holiday
Shares are probably the best long term investment there is. They’re just not well suited to anything where you need your money back in less than 5 years, and 10 or 20 years would likely be better.
But if you have a long or infinite time horizon then high yield, high growth shares, or high quality, high value shares, may just tick every box going.