Investment Logic & Strategy

Fundamental considerations

We all face a major conundrum when it comes to planning finances and investments.

That central dilemma is that we clearly know that we are going to meet the Grim Reaper one day but we simply do not know when that day will be. From a financial perspective this leads to three further complications:

• We don't know the effect that inflation will have from the present day until the time we are eventually called to eternity.
• We need to take into account of the concept of 'mortality drag'. This is an actuarial hypothesis which holds that the greater the age we actually achieve, the longer our life expectancy then becomes.
• We need to ensure that our funds are not substantially diminished by withdrawal (or over-drawdown) of income.

These factors have a fundamental bearing on our investment decisions and our approach to risk.

It is essential to maintain the real value of our wealth and the security and purchasing power of the income stream that flows from it, and in order to do that we have (to some extent) be prepared to accept exposure to risk.

It follows that is vital to build in to your investment portfolio a worthwhile level of exposure to asset classes that carry a degree of risk (controlled risk but risk nonetheless) but which will, over time, maintain financial integrity.

If one's income requirement is lower than 5% of one's capital then, in today's market climate, one could largely achieve that via Index Linked Gilts. For many investors, though, their gross income requirement is roughly equivalent to 10% of their capital base. One then has to include exposure to other asset classes and a higher level of risk in order to avoid the capital eventually reducing to zero.

Some investors prefer to take their income on an annual basis, as a lump sum once a year. This introduces a further degree of difficulty in that the much reduced capital sum remaining after income has been taken requires an even larger percentage investment return in order to regenerate the capital.

The major asset classes

The asset classes we would normally consider are:

• Fixed Interest securities, equities, commodities and property

Fixed Interest

These have the advantage of being low risk but, of course, the returns reflect that. In particular, we favour Index-Linked gilts, which have two intrinsic attractions:

• Because they are index-linked they keep pace with inflation
• Because they are underwritten by the British Government there is no risk of default

In today's market I could create a portfolio of Index-Linked gilts which would currently produce a return of 4.8% per annum.

Sadly, this would not (on its own) produce sufficient to cater for the income requirement of many investors and, if used in isolation or as a large proportion of their investment strategy, would simply see their capital reduce slowly to zero. Hardly an attractive proposition.

Commodities

The commodities markets are, in our view, very high risk and although one can produce commensurately high returns as a result, they are far too volatile and too risky for my taste. One can make very high short term gains but one can also, very quickly, lose eye-watering amounts of hard earned capital.

Many market commentators are presently extolling the virtues of gold and other precious metals. We see them as a highly speculative markets and prefer to concentrate elsewhere.

Property

We do not favour property as a factor in most investment portfolios simply because it is so illiquid. Asset classes are cyclical but the cycle of property values tends to be much longer than those typically of equity markets or commodities.

We would not want to be in a position of needing to encash at a point where the property market is in a prolonged period of decline.

One has exposure to the property market through one's own domestic housing arrangements and so we would not seek to include further exposure in an investment portfolio.

Equities

Over a period of time, equities have invariably produced higher returns than other asset classes and, very much so of course, over fixed interest securities.

Naturally that higher return comes at the cost of higher exposure to risk. An intrinsic feature of equity investments is volatility and one must therefore be prepared to accept occasional periods of downturn if one wants the potential long term advantages of equity investment.

We try to control risk and emphasize returns in this area either by reverting to cash during periods of negative sentiment or by concentrating on the best of the positive trending global equity markets at any given point in time and switching markets in line with ever-changing global conditions.

Summary

When it comes to investment there are many misconceptions and false impressions which all too easily can cloud one's judgement. Emotional responses to gains (too much too soon leading to a false expectation of future returns) or, more often, to losses (fear that they will get worse) can interfere with a true appreciation of the risk/reward ratio.

Often the root cause of discontent is based on (unrealistic) expectations overwhelming economic reality. Ideally one would like to be out of equity markets altogether in periods of negativity. However, this is not always possible, particularly when market movements are sudden, volatile and excessive. A paper loss only becomes an actual loss when it is crystallised. In those circumstances, if one is on the wrong side of the market then one simply has to keep one's nerve. Equity markets always bounce back, it simply becomes a matter of time.