Why it's time to overhaul your financial future

This article was published in the April issue of Master Investor Magazine

Master Investor

In my second article for Master Investor readers I want to raise some questions that hopefully will help improve your long-term real returns and planning.  Unless of course Financial Independence doesn’t float your boat.  And if it doesn’t why are you bothering to invest at all?

Many years ago when we used to talk to one another instead of staring at smartphones there were adverts on coal fired Scottish Television featuring Rikki Fulton, star of cult comedy series “Scotch and Wry” and “Rev I. M. Jolly.”  One ad featured him as an old chap in a bunnet wandering into a Painter and Decorator’s shop.  When asked by the shop assistant if she could help he’d say “I’m looking for a tin of paint please.”  When she asked “what colour?” he replied “Any colour.”

Another ad saw him in a Travel Agent’s enquiring about a holiday and when asked where he wanted to go he’d say “Anywhere will do.”  Imagine that.  I can’t recall what was being advertised, but the message stuck with me over all these years.  How can you advise people who don’t know what they want?

Take investing for example.  Despite having been in the financial advice business for 44 years, it still amazes me that so many invest in a haphazard manner.  For a few years now I’ve been asked by a couple of “money mags” to comment on reader investment portfolios.  Typically they’d written in laying out some concerns about how they invest, or seeking comments on what they have.  Or perhaps simply requesting a fresh eye, usually on the back of unsatisfactory returns or maybe they’re facing a change in their circumstances such as imminent retirement.

Remarkably, and without exception, no matter the age of investor or their circumstances, the portfolio was a dog’s dinner.  Far too many holdings, from overweight in one stock to having almost zilch, in say, a top performing fund.  No obvious strategy (a nice way of saying they’re all over the place), too much trading, short term thinking, looking for a quick fortune or obvious signs of herding, and typically with a “watch list” which included funds or stocks that had outperformed their investments over the previous three or five years.  But still being watched.  Doh!

Oh, did I forget a widespread obsession with costs rather than added value?  I respond by asking the obvious.  “What are you trying to achieve?  What’s your long term goal?  Why aren’t you taking tax into account?  Why do you think you’re better at investing than the best fund managers? Why do you have so many itsy bitsy holdings?  What attracted you to these investments in the first place?”  And so on.

Fail to plan:  plan to fail

We have used the same approach here for over 30 years since a couple of clients asked me a stupidly simple question.  Every year I’d sat down with them and we’d work out how much they could invest to build up long term wealth.  One year although they admitted to being delighted with their returns, they said they had no idea if they were on track to achieve the financial independence they were hoping for.  How could we fix that?

Financial Independence means different things to different people, but in their case the goal was to be able to just walk away from their family business leaving it to their son.  But they wanted to keep the same standard of living in real terms from their after-tax investment returns.

We agreed a net income goal, taking account of inflation, sensible returns, and timeframe, then tweaked the tax planning and revisited their master plan twice a year.  Given investors are pressured to take short term emotional (i.e. bad) decisions they need an “Emotional Blocker” to stay on track.  I find a good adviser helps.  Even I have one.  (Yes, really).

When new clients come to us, typically by referral, they tend already to have a jumble of savings plans and investment “products.”  Fortunately IFAs are required by law to complete full fact finds on income, assets, attitude to risk, and objectives.  And we ask other simple questions.  “What are you trying to achieve?  Why do you have this investment?  What attracted you to it?  What will happen to all this when you die?  Do you have a will?  Is your pension plan written in trust?  Why do you have so much in cash?  Why are you paying so much tax?  Does financial independence appeal to you, or not?”

Instead of chasing one media tip or “great opportunity” after another and ending up with a shapeless mess after only a few years, why not begin with a detailed goal in mind, and then a plan.  Work out in real terms how much you want to have amassed and by when.  When doing so, do remember what Professor Parkinson said about Tax Planning.  It’s crucial as part of the plan.

Parkinson said (over 30 years ago) the UK tax system is designed to tax income when you’re living and capital when you die. So all you need to do is reverse them.  Create only capital when you live, only income when you die and BINGO…no tax.  (Then he moved to Jersey and on to the Isle of Man.  Maybe he couldn’t find a good adviser).

But despite the UK tax code being over 10 million words and 21,000 pages long these days – 12 times longer than the complete works of Shakespeare….  (Alas poor Taxpayer)… and 66 times the tax code of Hong Kong – the Parkinson “move” still works.  Earning more income and ignoring Parkinson’s advice doesn’t work very well.  Today the top 10% of UK income earners pay 60% of all income tax, up by 70% in forty years.  That doesn’t need to be the case.

So it stands to reason if you have a money goal it will be easier to reach it by concentrating first on minimising tax and pocketing extra through tax reliefs while they last.  And move income stocks into your tax friendly ISAs.  Fast.

It doesn’t pay to follow the herd

Next up go check out the Dalbar Survey findings (US investors but we’re just the same).  Dalbar reports on the short-  and long-term returns of equity, bond and deposit investors.  Cutting a long story short they find that private “active” investors consistently underperformed “buy and hold index” investors by between about 4% and 6% compound over the last 30 years.  And the gap is widening since the financial crisis.

Because of fees?  Nope. By far the biggest reason for performance drag the report finds, is investor behaviour.  Chasing the latest hot stock or fund.  Buying high then selling low.  Repeat that enough times and you’re broke.  As I’ve said for many years now our brains weren’t wired for such times.  A key feature is our “panic button” deep in the brain.  It’s there to save us from “danger” thousands of years ago.  Over time we learned the safest place was with the herd.  It worked back then – contrarians  got eaten.  Nowadays stubborn contrarians are the winners.

If you want to beat the herd you have to be different.  You have to buy low sell high. That means doing the opposite of simply tracking a Capital Weighted Index. Especially here in the UK.  So if you are tempted to pack in your “fun” portfolios don’t follow the herd or for the “you can’t beat a cheap index tracker” cult.

Think of it this way:  investing in a Capital Weighted Index is like driving along a road you’ve never been on before by looking only in the rear view mirror.

The 25-year average total return of the FTSE100 is 8% compound.  Now consider Invesco Perpetual High Income’s total return after all charges over the same period…12% per annum.  That’s only a 50% higher annual return, but thanks to the miracle of compound interest it outperformed the FTSE100 by threefold.  (source:  Lipper Stats).  Hold it in a pension plan as a 40% taxpayer and the outperformance jumps to almost five times greater.  Magic.  (Past performance is no guide to the future though).

I’m well aware Index Trackers and Absolute Return funds are attracting both the headlines and the net inflows, but do remember all the “surefire” investments over the last 100 years that attracted the herd.  This mania for passive funds looks increasingly like a bubble according to legendary US analyst Ned Davis, a man well worth listening to.

As to the latest wheeze, ETFs – basically cheap mini trackers – Vanguard’s John  Bogle says “An ETF is like handing an arsonist a match,”  while successful value investor Neil Woodford likened them to derivatives. “Toxic” is his description.  Beware.

Pick a winning team

Assuming you’ve agreed the goals and fixed your tax planning strategy, it’s time to try to bank positive returns by minimising the possibility of loss.  When it comes to portfolio composition, it’s useful to draw the analogy of a world-class football team.

Winning teams build their defence first – the best goalkeepers, commanding
centre-halfs, quick footed full backs, stiff midfield, and fleet footed strikers.  Clubs like Bayern Munich and Barcelona attract the best players, pay the best wages, and while they score goals for fun, they’re solid at the back.  World class defenders, just in case!

But more importantly they seek the best managers and coaches.  There aren’t that many about.  US investor Jim O’Shaughnessy says outstanding investment managers don’t grow on trees either.  And he reckons they need seven traits to consistently win.  They have a long term perspective, ignore headlines and media noise; they have a consistent process, are patient and persistent with a strong mental attitude; and finally they’re highly disciplined and stick to objective probabilities.

Sounds good to me.

Alan Steel
Alan Steel is chairman of Alan Steel Asset Management
Alan Steel Asset Management is regulated by the Financial Conduct Authority.

This article contains the personal views of Alan Steel and should not be construed as advice. Do check your individual circumstances with your advisers.