If you are one of the lucky people who have money to invest, what are the ins and out of starting a portfolio? For the first time investor and even for experienced investors the choices out there can be confusing, and with the marketplace growing ever more complex seemingly on a daily basis it is a daunting task for the average person.
The best piece of advice is to find someone who knows what they are doing, namely an investment professional. The first thing they should look at is what I would describe as the Discovery Process. What on earth is the Discovery Process, you might ask yourself? Well, it’s not some new age therapy. It is the process of determining your return expectations and risk profile. The investment adviser will also need to get some idea of how involved you wish to be in managing your assets. You will need to decide whether you want hands-off (discretionary) investing, where the decisions are largely left to the investment manager or an advisory relationship, where you make the ultimate decisions with guidance and support from the adviser, or even a combination of the two. You should also be thinking about your investment time horizon (or when do you want to start spending the money?) as well as any special requirements such as a need for income or estate planning.
Do not take this process lightly as it sets the scene for your investment strategy. Offer as much information as possible, relevant to the decisions you are taking on your investment plan. It is often at this point that unrealistic return or risk expectations are flushed out.
With the Discovery Process completed, you should then look at your investment strategy and the choice of investment product. Much of this depends on your investing style and that of the firm you are working with. Remember if the products and services they are offering don’t appeal to you, you can go elsewhere.
One option is passive investing, something that has grown in popularity over the past decade because it is both easy to explain and, at least on the surface, a low-cost strategy. Typically you would buy a product that closely tracks a particular market, most commonly an equity market index such as the S&P 500. This is known as an index tracker. The cost of doing this can be very low, with expense ratios in some cases as low as 0.10% a year.
The catch is that while passive investing gives you full participation in the upside, you also wind up participating in the downside. This is a painful lesson that many small investors have learnt over the past two years. If you consider that the S&P 500 lost close to 60% of its value in just 18 months from October 2007 to March 2009 you can see that the scope to lose money with this strategy is considerable. One solution to this problem would be to try and time the market using an index tracker. However, there are great risks in getting this wrong are and it is probably something best left to the experts.
Speaking of experts, we should turn our attention to active investing, firstly through using a single investment manager. Here, we are talking about investment managers who think that they can beat the market through a myriad of different strategies. These might include stock picking, country selection or market timing in the case of equities, or maybe decisions on interest rates or the creditworthiness of the chosen companies in the case of fixed income. You will probably find that your investment adviser recommends particular managers and often the focus is on in-house funds. It is certainly worth treading carefully here. It is rare to find a single investment manager who can excel across all asset classes, so if you find that the same manager is being recommended for both equities and fixed income, it’s probably time to start asking your adviser some tough questions. Even within an asset class, it is unusual (although not unheard of) for the same manager to be able to consistently deliver outperformance both when the market is going up and down over an extended period of time.
The third approach
The third approach is active investing using multiple managers. Here, a team is employed that picks what they believe are the best funds in each asset class, often putting significant resources and expertise into manager selection. Because of the additional costs that are involved in this process, it really only makes sense where there is decent potential for the best managers (top quartile in investment-speak) to outperform the average (median) fund. This certainly tends to be the case for equities, as the chart accompanying this article demonstrates. However, it makes less sense for an asset class such as fixed income, where the best managers achieve much more modest outperformance versus the average.
Aside from the potential to gain access to top-performing investment managers who are often not typically available to private investors, there are other advantages to multi-manager investing. We mentioned earlier that there is a risk of your investments sinking along with the market. Multi-manager can help mitigate this risk – the adviser can combine funds with different investment styles and that behave differently depending on economic conditions. This can create an investment strategy with the potential to outperform across the entire market cycle. Another significant benefit lies in the ongoing monitoring of individual managers – unlike the passive or single-manager approach, the investor will have access to an expert team assessing the investment manager and, if necessary, replacing them.
The three commonly-used approaches to investing each have their pros and cons but to find what suits you , the starting point should always be to consult an investment professional.