The investment beliefs that form the core of our wealth management programme are heavily influenced by the Nobel Prize Winning Research conducted by scholars such as Harry Markowitz and William Sharpe and the subsequent research by Eugene Fama (Nobel Lareate 2013) and Ken French that built on their work.
Our studies have lead us to the conclusion that the application of certain fundamental investment principles to the process of wealth management will result in a successful investment experience for our clients. And by ignoring the hype that emanates from the investment industry we can help clients avoid some common mistakes and ultimate disappointment.
Specifically we believe that achieving a successful investment experience for our clients depends on
- Adopting a passive approach and accepting the returns the market offers
- Avoiding forecasts and active management
- Concentrating on strategic asset allocation
- Avoiding unnecessary risk
- Being diligent in keeping costs to a minimum
- Staying invested throughout the downturns
For our core portfolios Cadogan Wilson uses a variety of index funds, including Dimensional (DFA) second generation index funds (sometimes referred to as smart beta funds), and Exchange Traded Funds. These Institutional grade asset class funds provide broad diversification and reliable asset class exposure at low cost. They add value by adopting a passive approach and thereby keep trading costs to a minimum. Dimensional funds are only available through a few independent advisors who have been given access to the funds by DFA following extensive training.
Speculating is not investing
Faced with the bewildering prospect of investing money investors naturally seek advice from financial professionals and in some cases obtain guidance from the financial press. They delegate the task of stock selection to these experts in the hope and belief that these smart people will be able to see into the future and pick winners. The mountain of marketing material produced by the industry does nothing to dispel this belief.
Not surprisingly the evidence indicates otherwise – foretelling the future is as yet an imprecise science and speculation is not investing. Two thirds of all UK fund managers fail to beat their own benchmark and those that do, fail to do so on a consistent basis. Given this information we have to ask ourselves why anyone would want to pay extra fees to achieve a result less than they could get virtually for free.
Equity Markets are efficient and throughout the world have a history of rewarding long term investors for the capital they supply. This market return is compensation for the risk they are taking and it is available to everyone who buys the market.
A picture of growth
Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
Take the risks that are worth taking
Gain is rarely accomplished without taking risk but not all risk-taking is rewarded. Successful investing means not only capturing risks that generate expected return but also avoiding risks that do not.
Often the movement up or down of markets as a whole will be the dominant influence on price changes, especially for equities. Market Risk cannot be avoided and investors are rewarded through investment returns for accepting exposure to it.
Non-Market Risk is firm-specific and unique to individual companies, their sector, or industry. The Nobel Prize winning academic William Sharpe concluded (and we concur) that investors who accept exposure to Non-Market Risk are not rewarded for the increased risks they take with their money.
Whilst shares (the Market) have higher expected returns than fixed interest, research conducted by Fama and French noticed that small company shares have higher expected returns than large company shares and lower-priced "value" shares have higher expected returns than higher-priced "growth" shares. This pattern was consistent throughout world equity markets as the following chart shows. Many economists believe small cap and value stocks outperform over the long term because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.
Size and value matter
Standard deviation measures the variation in return away from the mean. It is often used to indicate the level of risk. Generally the higher the figure the greater the risk.
Asset allocation is the key determinant of the success of any portfolio
Asset allocation is the process of deciding how much of your portfolio to invest in each of the main asset classes i.e. equities (Domestic and International), fixed interest, cash and property. In our programme we further sub divide the equity asset class between small cap and value shares.
Two factors will affect the asset allocation of your portfolio, namely your tolerance of risk and the required return. We take the trouble to understand in depth these two factors using the best technology available.
Research has shown that asset allocation decisions accounted for 94% of a portfolio’s performance as against other factors such as stock selection and market timing.
Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986.
Diversification reduces risk
Investors familiar with the saying “Don’t put all your eggs in one basket” will be able to accept this statement intuitively. Diversification washes away the random fortunes of individual shares and positions your portfolio to capture the returns of broad economic forces.
However the degree of diversification that can be achieved with direct equity investment is limited by the size of the portfolio and restrictions on international share trades which is why collective investment funds are so valuable to the investor. Collective funds allow an investor to spread his exposure over a wide variety of international markets and different sectors within those markets.
The benefits of diversification
Monthly data: 1980-2005, rebalanced monthly.
1Portfolio consists of 50% FTSE All Share Index and 50% MSCI World ex UK Index
For many UK investors, the FTSE All-Share Index represents the first equity asset class in a diversified portfolio. Although this index is diversified in UK companies, investors can benefit by adding further components. Take, for example, a portfolio that holds just UK shares, a portfolio that holds international shares (ex UK), and a portfolio that holds half of its assets in each region. The diversified portfolio has a lower standard deviation and fewer negative quarters.
This is the power of diversification: the whole is greater than the sum of its parts.
Timing the market doesn't work
“Buy Low, Sell High” is sound advice but the difficulty is knowing when the market is at its peak or low point. No-one rings a bell when it’s time to sell nor when it’s time to buy. The sellers worry that the market will rise after they have sold and the buyers worry that the market will drop after they have bought. Those outside the market worry they will miss the upturn. Price movements can be very rapid and missing the upturn can have disastrous results for a portfolio.
Cadogan Wilson’s investment strategy is based on the premise that you will have the discipline to stay invested. The portfolio we construct for you will provide the market return over the long term according to the different asset classes within it. Patience will be rewarded.
The following chart shows the affect on a portfolio’s return between January 1986 and December 2007 when a number of the best days during that period are missed.
Returns for UK One-month T-Bill and Long-Term Government Bonds over the whole period are included for comparison purposes.
Time reduces risk
The longer your investment timescale the less significant will be short-term volatility. We consider 5 years to be the minimum time scale for any equity based portfolio.
It follows that the earlier you start your financial planning the longer will be your investment timescale and the greater chance you will have of realising your financial goals. A feature of our wealth management programme is a detailed analysis of your present financial position and desired future lifestyle then modelling your portfolio to help you fulfil your goals.
Best/ Worst Return
Monthly: 02/1955 - 07/2008
|Annualized Average Return||1 Year||3 Years||5 Years||10 Years||15 Years||20 Years|
|FTSE All-Share Index
|Best Return (%)||151.41% (1/1975)||56.52% (1/1975)||36.06% (12/1974)||31.62% (1/1975)||27.71% (1/1975)||23.02% (12/1974)|
|Worst Return (%)||-55.84% (12/1973)||-26.21% (1/1972)||-10.58% (1/1970)||0.53% (12/1964)||1.25% (1/1960)||7.52% (2/1955)|
FTSE data published with the permission of FTSE.
This graph shows how the variation in returns diminishes as the time period over which the returns are measured lengthens.