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 is not.
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 or Gambling?
- 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. The Fixed Sum Game, Average is Good
- 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 Managers, Selective Nurturing, Hype
- 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 Costs Matter?
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 fund. 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 fund underperforms the average stock. Therefore, if you are guessing, guess a stock.
- Funds 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 Turnover
- 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 Traded Funds.
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 portfolio.
- 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 is.
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.
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