Why invest?

Why invest?

Given the current turmoil in financial markets many people are asking themselves why would anyone want to arrange investments? 

It is fair to say that no one likes the thought of losing money and yet people still invest money when they know that potentially they could end up doing just that – losing their hard earned money. So why do they do it?

The simple answer is that over the long term any money you have invested in a balanced spread of investments will perform better than monies you leave on deposit. Crucially, over the rest of your life the only way to ensure that the purchasing power of your money exceeds the rate of inflation by a meaningful amount is through asset backed ‘real’ investments.

When investment values are volatile, as they are at the moment, it is easy to forget why you invested the money in the first place, so ask yourself some questions:

Do I have a proper balanced spread of investments across different asset classes?

Has my attitude to risk changed, for example, do I hold any high-risk investments that I made as a bit of a ‘punt’ that I am no longer happy with?

Do I need any money in excess of my current deposit based savings for planned expenditure over the next five years or so?

To illustrate the points made in this document I would like to consider most peoples first major investment – the home that they live in. 

Your home

Where will residential property prices be in a year’s time? A lot of experts think that they will be 10 - 15% below where they are now and that prices will still have further to fall at that point. 

If you agree with this, would you sell your property now and try to buy it back, or a similar property in one or two years time when you feel the market is at the bottom? 

Whilst some have tried to do this, they are in the minority. The major reason most people own their house is to make it their home, not as an investment. However, it is true that more and more people are viewing their home as an investment in the sense that at some point they will downsize to release some equity for their retirement. 

Considering the issue solely from an investment perspective, if you did sell your house, you would need to pay rent to live somewhere else, which would possibly use all of the interest you could generate from the sale proceeds. 

Surprisingly this is not always a low risk strategy. For example, if this situation continued over a long period of time your capital would actually lose purchasing power, as there would be no protection from inflation. Provided house prices carried on falling or stayed the same, this would not be a problem, but if house prices rose unexpectedly, or you delayed in buying a property, the purchasing power of the cash you hold could be reduced. Also, the costs of selling the property and buying it (or another one) back are significant (for example, the costs include; stamp duty, legal costs, moving costs, Estate Agency costs etc.)

However, the real problem is in timing your entry back into the property market. Many believed that house prices were too high back in 2000 - 2002 and that they would fall. However, whilst they were ‘waiting’ for prices to fall, they watched in horror as prices doubled and in some cases trebled over the next few years.

Calling the top of the property market was something that the experts tried to do repeatedly from around 2002 onwards, however, few recognised the real turning point. The same will be true regarding the bottom of the current fall in house prices. In the last ‘upturn’, price falls and the ‘doldrums’ soon turned into people clamouring for the same property and gazumping. In reality trying to ‘time’ the top and bottom of markets is virtually impossible and more experts get it wrong than get it right.

Consider also that the current market is not an ideal place to try and sell your home. People are making vastly reduced offers to sellers thinking that they must be ‘desperate’. 

So from an investment perspective only, ask yourself would now be the best time to sell your property? 

The answer to that question is all to do with the key to successful investing – timescale. Ask yourself?

Are property prices going to fall over the next year or two? Probably, but: 

Are you going to own property for the rest of your life? 

If you are going to own property for the rest of your life and you are not forced to sell at a time when the markets have fallen and there are few purchasers, who are able to offer much lower amounts than possibly a realistic value, then you will be better off than someone who is in a hurry to sell. (Of course, if you can sell a property you own now for a reasonable price, perhaps due to unique property features, then this is a different proposition.) 

Fundamentally, if you intend to own property for the long term, believing that over the rest of your lives the value of your property will increase and provide you with a better investment return than putting your money in a bank and using the interest to pay rent, then any short term fluctuations in your property’s value would be of little concern to you.  

You might be wondering what this has got to do with investments that you might hold in stocks and shares. Well, although some of the basics are different, a lot of the principles are the same and I will detail these below. 

However, before we leave the topic of your home, it is important to point out that holding one valuable residential property does NOT constitute a balanced spread of risk. Not only can you be affected by what happens to the property market in general, you can also be affected by local events unique to your property, such as an undesirable business being able to operate near you, reducing the value of your house, when perhaps property prices in general are increasing.

For many people the returns on their property investments have been spectacular, but these have been with a relatively high level of risk, even if it did not feel like it. 

Investment portfolios

The decision to buy a house to live in is usually far easier than the decision to arrange an investment portfolio. Traditionally, people understand and feel comfortable with property and deposit accounts. Everyone is aware that stocks and shares can increase or fall in value in a relatively short period of time, so why do people buy them?

The easy answer is that over the long term stock market investments have delivered better returns than other asset classes, even property. But understanding why this has been the case is just as important. 

Businesses sell shares in their companies so that they have the capital they need to run their businesses effectively, possibly to finance expansion into new markets or product types. 

Why do investors buy shares in companies? They believe that if they provide the money the company needs to run their business, over time the company will improve their profits, pay out more income in the form of dividends and over time the share price of the company will increase. 

Fundamentally, the companies that form the stock market are linked to the real economy and if they consistently perform badly, over time peoples’ wages will be affected, which will affect what they can afford to spend on all items including property. That is why traditionally, property prices were usually closely linked to earnings, as this would restrict how much people could afford to pay for them. Many of you will remember the historical lending criteria of Banks and Building Societies, namely three times one person’s salary or two and a half times joint income. 

The reason that property prices have escalated beyond the usual multiple of earnings was explained by the very low interest rates available, the looser lending criteria and also ‘buy to let’ investors buying properties on an interest only basis, rather than a repayment basis, which meant that they could afford to pay more for a property and still have the interest payments met by the rent. 

In summary, if the companies that form the stock market do very badly for a long period of time, it will affect other investments. However, the Directors running the companies are experts in their field and have good people assisting them when they face problems ensuring that on balance they still grow their business over the short, medium and long term. Their success is shown by the fact that despite companies expanding, contracting and even going out of business, collectively over the long term, stock market investments have delivered better returns than other asset classes.

Why do you have, or would you want, an investment portfolio?

We said earlier that the major reason most people own their house is to make it into their home, not as an investment. However, there are sometimes dual reasons for buying a house, as we mentioned earlier, some intend to downsize in the future in order to release equity. Many people use their deposit accounts, to provide them with easy access to cash as well as good interest rates and will sometimes forgo the latter for the former.

Understanding WHY you have an investment portfolio is very important, as it will influence the decisions you make regarding it. Our clients fundamentally invest for one reason only. 

They believe that over the long term a balanced investment portfolio will provide them with income and capital growth in excess of that available from deposits and that over their lifetime the portfolio will keep pace with the inexorable rise of prices, or inflation.

Just as any fluctuations in your property’s price is of little concern if you intend to hold the property for the rest of your life, the same is true of a balanced investment portfolio.

Reducing risk in an investment portfolio

If you have any investments that are not held on deposit then there are some key points to remember. The most important of these is that it is important to diversify your investments. 

For example, a ‘buy to let’ investor with one property is vulnerable if he loses his tenant, as he no longer has an income. He is also vulnerable to local factors affecting his one property, as detailed earlier. ‘Buy to let’ investors with a reasonable number of properties in different geographical locations, with different types of properties, will have greatly reduced the risk profile of their portfolio. This also means that if the landlord loses one tenant, hopefully the income from the other properties will cover the void period. 

The same principles regarding diversification are true with an investment portfolio. It is also important to remember that at its most basic level you want two things from an investment – firstly income to compensate you for the risk of making the investment and secondly, hopefully some increase in the value of the investment. The core constituents of an investment portfolio are: 

Cash

Cash provides a known level of income, however, it does not provide any capital growth. It is crucial to have the right amount of money in cash. If you are forced to sell assets when they have fallen in value, you are crystallising what would otherwise be a ‘paper loss’. Holding an adequate emergency fund ensures that you are not forced into this situation. 

Cash is classed as low risk, as the value of the capital does not fluctuate. However, it is important not to hold too much cash, as over the long term this has traditionally failed to keep pace with inflation. The effects of inflation are often underestimated, for example, inflation of 4% a year will halve the buying power of money over 15 years. 

Only ‘real’ investments have historically beaten inflationary rises over the long term. It is also important to note that deposit accounts often do not work well for higher rate taxpayers. For example even if they can get 7% gross (and these rates are likely to only be around for the next year or two), this is only 4.2% net of higher rate tax, which is roughly the current rate of inflation i.e. the deposits are only keeping pace with inflation, there is no ‘real’ growth. 

In the same category as cash, is debt and as most of our clients know, we advocate the payment of debt prior to investment in virtually all cases. Ensuring that they have paid down as much debt as possible will become more important to people as the economy continues to contract.

Fixed Interest investments

These can be split into:

A - Gilts or loans to the Government, where you receive a fixed interest rate and your capital back at the end of the term. 

The value is only guaranteed if you purchase the Gilt at or below the value it will be redeemed at and you hold the Gilt to maturity. If interest rates, or the outlook for inflation falls, it would probably be possible to sell the Gilt for a capital profit, as your Gilt pays a higher interest rate than a new Gilt would. 

However, if interest rates or the outlook for inflation rises and you sold the Gilt prior to maturity, you would probably make a capital loss, as your Gilt pays a lower interest rate than a new Gilt would.

B - Corporate Bonds, which work in the same way as Gilts, except that they are loans to companies. They pay a higher level of income than Gilts, as there is a risk that a company might default on the repayment of the loan or the interest payments. 

This means that the outlook for the economy, default rates and the individual companies who have issued the Corporate Bonds will affect their value, as well as the changes in interest rates and inflation detailed above for Gilts.

There appears to be value in some Corporate Bonds at the moment, as the difference between Gilt yields and Corporate Bonds have widened, although this is in return for a higher level of risk.

Equities

The safest type of equities are traditionally shares in companies with strong balance sheets, steady profits that pay good dividends and that have historically increased their dividends over time. There are currently very high yields available from some companies. Over the long term, as detailed earlier, Equities have performed very well, better than most other asset classes, although this is at the cost of higher fluctuations in capital value. 

Some companies are classed as ‘growth stocks’ in that they do not pay any, or only small dividends, but investors still purchase the shares, as they believe that the companies will increase their profits very quickly. 

The market has already anticipated a fall in the earnings and profits of companies on the stock market. The main issue at the moment is whether earnings and profits fall by more than the market is already anticipating. If the earnings and profits of companies do not fall by as much as the market is anticipating, then share prices could recover quite quickly. Conversely if profits fall by more than the market anticipates, share prices could fall further. The market is also likely to be sensitive to other key indicators going forward, such as unemployment figures.

A balanced Equity portfolio would usually have holdings outside of just the UK, including those in European, American and other international markets. 

The FTSE 100, which measures the price of the top 100 shares in the UK, stood at 3,400 in March 2003. During September it has fallen as low as 3,800, which is only 12% higher than five years earlier, which was deemed to be an excessive low point driven by the fear of the second gulf war. In the middle to last quarter of 2007 it was over 6,800, meaning that the market has fallen by over 40% from its recent highs.

Commercial property 

This is a broad asset class including offices, retail, industrial units, hotels etc. The income is received in the form of rent and as rents and the values of the underlying land increase, so do the values of the properties. 

This asset class has fallen in value quite heavily already, more so than residential property. The main negative aspect for commercial property values going forward is that if the economy falls into a deeper recession than originally anticipated, there could be an increase in empty properties and in the average time that they are left empty. Some feel that the credit crunch so far has helped to keep the value of properties higher, as no one has been able to source the monies to make offers to purchase properties and if this changes going forward and money is available again, prices could fall further as investors selling under distress accept lower prices. 

There are two main types of property funds, those that invest directly into properties and those that invest into property shares (REIT funds). 

Despite the bad press, property is still a good asset class to hold for the long term in that it provides diversification to a portfolio and is likely to be a stable asset class with returns in excess of those available from deposit accounts, although it will be more volatile than cash.

Alternative strategies

There are lots of alternative investments that people use to further diversify their portfolio. These include gold and other commodities, hedge funds, private equity and timber etc. Typically, alternative strategies would only form a small percentage of an overall portfolio, depending on the investor’s objectives and risk profile.

Commodities have performed particularly well over the last seven or eight years. Some believe that we are in a super cycle and due to the demand from emerging economies, such as India and China and the time it takes to increase mining capacity and produce more commodities, commodity prices still have a long way to rise. 

Others feel that any short-term increases in commodity prices will not last and the current prices are unsustainable, particularly given the current slowdown. 

The benefits of volatility in the markets

If stock markets and investments only ever increased in value, everyone would invest into them and they would spiral upwards in value until they reached ‘bubble’ proportions and were being sold for more than they were worth. 

Volatility ‘shakes out’ the prices and ensures that they remain relatively realistic, although experience shows that the peaks tend to be driven by greed to higher levels than can be justified on a realistic valuation basis and the lows tend to be driven by fear to lower levels than can be justified.   

The important thing is not to finally decide to buy after a sustained period of growth, just when the assets are getting expensive and do not sell them once they have fallen and they are finally getting to ‘bargain’ levels. This requires you to have a proper investment strategy and to avoid letting that strategy being driven by market sentiment, which is easier said than done. 

The economy moves in cycles

Traditionally the market has moved through four different stages in each economic cycle, with different asset classes offering value at different stages. Please note that the below details regarding these ‘four stages of the cycle’ are generalisations. 

The phase we are currently in is one of stagflation, or high inflation and low or negative growth. Early in this phase Oil and Gas companies tend to do well and Utilities usually perform well throughout the period, as due to their intrinsic value they have a defensive nature. During this period it also helps to be overweight in cash.

The next phase is reflation where the rate of inflation starts to fall. Pharma and Staples stocks start to do well in this period, due to their defensive growth qualities. Traditionally financials would also recover in this period as well, however, it might be different this time, due to the extraordinary problems that they have had. During this period it also helps to be overweight in Fixed Interest Investments.

The next phase is recovery where the rate of growth starts to move above the average. Consumer Discretionary stocks, Telecoms, Tech and Basic materials start to do well in this period, due to their cyclical growth qualities. During this period you would want to be overweight in Equities generally.

The final phase is overheat where the rate of inflation rises. Industrials start to do well in this period, due to their cyclical value qualities and you would want to start to be overweight in Commodities and Oil and Gas. Then you are back to stagflation. 

The problem is knowing which phase you are in and how long and extreme each part of the cycle will be. Most experts agree we are in the stagflation phase and think that when interest rates are cut by the European and UK banks, property prices stabilise then there will probably be a fall in the price of commodities and we will be at the start of the next bull market. Timing this to perfection is only possible in very general terms and as stated earlier, more experts get this wrong than get it right.

Speculating versus investing

There is a key difference to investing money and speculating. We have already said that you invest because you believe that the company will use the money to expand their operation, improve profits and dividends, which will ultimately increase the share price. Speculators simply bet on what they think will happen in the short term. This can be the price of individual shares, the stock market in general, gold prices or commodities, the list is endless. 

Some people make a lot of money doing this and are successful and can quote plausible reasons for their bets, however many more get it wrong. We do not get involved in any aspect of speculation, we only advise on investments. If any of our clients wish to speculate, they should only do so with money they can afford to lose.

Should you sell your investment portfolio?

The answer to this question is based on your personal situation and as much thought should be given to any decision to sell, as was made to purchase initially. The points that will have the largest bearing on the answer are as follows:

Do you have sufficient cash to cover any planned capital expenditure and as an emergency fund for the next five years?

Do you have a balanced and diversified portfolio invested across the different asset classes described earlier? Has your attitude to risk changed since you first arranged the portfolio, or has the portfolio become unbalanced over time? 

If you sold holdings within your portfolio, what would you do with the money? Where would you invest it, would you be making a long-term change to your investment strategy or a short-term change, pending ‘seeing how things go’?

It is important to remember that investments are at their lowest value when the news about them is at their absolute worst and things appear to be really dire. If you wait until the news about the investments has improved, the market has usually recovered and if you are not careful you can end up paying more money for the same investments or buying high and selling low, the opposite strategy to sound investing. 

Although stocks and shares and most of the investment funds detailed earlier can be traded on a daily basis, there are generally ‘good times’ and ‘bad times’ to sell them. For example, at the moment there are some companies that are trading at very low valuations compared to the assets, property, plant machinery etc. that they own. 

Do most analysts believe some companies are trading below a ‘fair value’? Yes they do, they know that the businesses are financially sound and they will be able to grow their profits and dividends over the next few years and that in time the share price will be higher. However, they also know that the share price will be volatile in the short term. 

Currently people who are buying shares can purchase them at very attractive historic prices. This is no different to people buying property over the next few years, if they have cash they will be able to buy at attractive prices and people forced into selling might have to accept large reductions to previous valuations. If you are not a forced seller of equities and you are in it for the long term, fluctuations whilst not pleasant are a normal part of investment.