Six rules every investor should remember

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SIR ELTON JOHN is planning a three-year farewell tour. This columnist only has a few weeks to go, before he moves on to a new one economist beat So it seems like a good idea to summarize some of the topics that have influenced this blog.

For starters, long-term investment. Here is a set of rules that every investor should remember.

  1. You can’t start too soon. Albert Einstein may not have said that compound interest is the eighth wonder of the world but it is a good motto to remember. Buttonwood started a pension plan for his daughters when they were three years old. We assume a return of 4% per annum. That means an amount doubles in 18 years, quadruples in 36 and increases eightfold in 54. If you look at it another way, say you have a fixed amount in mind for your retirement. If you start saving at 20, you only need to put in half as much money each month, as if you were starting at 30.
  2. Risk and reward are related, but don’t think that the latter is certain. In financial theory, academics such as Harry Markowitz and William Sharpe developed sophisticated explanations for the relationship between risk and return. This is where we get concepts like the capital asset pricing model (CAPM) or beta, the risk of a security relative to the market. But risk is measured in terms of short-term volatility. It is assumed that if you hold a risky asset long enough, you will eventually be rewarded. But this is not the case when you start from a high valuation – think of Japan in 1989 or the Nasdaq in 2000. Britain’s FTSE 100 index is barely higher than it was at the end of 1999. A nominal return could good to be earned from shares but the real return this century from UK equities was only 1.9%; real yield from bonds 3.2%. Risk is not about volatility, it’s about capital loss. That’s why investors should always have some money in cash or government bonds.
  3. Long-term returns are likely to be lower from here. Even if equities are not performing as badly as Japan since 1989, they are still likely to earn lower nominal returns than here. That’s just math. Short-term rates and long-term bond yields are low in nominal and real terms. The return on equities is a “risk premium” over and above these rates. There is no plausible reason why the risk level should be much higher today. The London Business School team of Dimson, Marsh and Staunton believe it is currently at 3.5%. Based on reversion to mean valuations, GMO predicts negative real returns for all equity markets except emerging markets (the same goes for bonds). US pension funds that think they are going to earn 7-8% are worrying themselves.
  4. Costs are equal to finance. Say you invest $100,000 for 20 years and hope to earn 4% per year. There are two products available; one with an annual fee of 0.25%, and the other with a fee of 1%. How much more will the latter cost you? It is disturbing to think that the answer is small; it is only a difference of 0.75%. But the answer is $30,000 (see this SEC photo). In fact, it is tempting to believe that the product with a higher cost will produce a higher yield. But you don’t know that; the only thing you know for sure is the costs. A recent FCA study showed that, after tax, “more expensive funds have produced worse returns for the investor.” You can’t rely on money that did well in the past to do well in the future.
  5. Multiply globally. Many statistics about long-term performance come from America, which was the main economic success story of the 20th century. But this is an example of permanence bias; back in 1900, people probably thought that Russia, or Argentina, would do as well or better. It’s a shame for Americans to think they don’t need to invest abroad; most of the tech giants are based in the US. But the Japanese may not have seen the need to invest outside their home market in the late 1980s, after their spectacular post-war performance. The US market is more than half of the MSCI World index. It won’t last. Diversification protects the investor against currency risk and political mistakes. Economic power is moving towards Asia (where it lived before 1500) and where more than half of the world’s population lives.
  6. But do not specialize too much. The fashion today is to create thousands of different funds, covering smaller slices of the market. Even ETFs have been investing in ETF providers. Unless you are an investment professional who has extensively researched the field, you don’t need this nonsense. Also be wary of new investments that simply claim to be unaffiliated. That might just mean they don’t rise in value when everything else does. The return from investing in equities is a share of profits; from bonds the risk-free rate and credit risk. It is not at all clear what the return should be from investing in volatility (not to mention cryptocurrencies). There may be no return from them at all. So why buy them?
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