Buy losers, sell winners

Vanilla finance has a few very simple rules. They have been shown to work pretty well in the past. But they do have some big implications. 

Remember, the vanilla investor has to pick a mix containing both exciting [eg shares] and dependable investments [gilts]. Boring or bouncy? Whatever lets you sleep easy at night. 

Say you pick a 50:50 mix [the balanced portfolio]. When it gets out of line you will need to rebalance - maybe every couple of years. This will mean selling the asset that has outperformed, and buying more of the underperforming one. You sell winners and buy losers. 

Now buying into a losing share can be a recipe for disaster - because it could go to zero. (Actually this is true of winning shares too, its why we skip holding individual shares  in vanilla investing).  But buying into an asset class is not as dangerous.  The world global equity markets, taken as a whole, are not likely to hit zero [though there are no guarantees].

Let's look at what happened to Siobhan. She's saving £3000 a year into an ISA and had savings of £30,000, split 50:50 between gilts and shares. Held in a FTSE100 tracker and a medium-term gilts etf.

Siobhan has watched her shares drop 40% in value, her  savings are down to £24,000. To rebalance, she should now sell £3000 of her gilts and buy shares. This is tough. She has just watched two-years worth of hard saving disappear in the market falls. It feels like throwing good money after bad. 

So what did Siobhan do? Well if she just obeyed the rules, that would be that. But in the real world very few people do stick with a simple set of proven rules. Otherwise we'd all be vanilla investors.

First off , the 50:50 split turned out to be too scarey for Siobhan; 40:60  might have suited her better. Note that a portfolio should be tailored  to 'suit' your personality and circumstances more than market conditions. But Siobhan is enough of a vanilla investor to realise that buying when the market is low is better than selling. So she resists the temptation to give up on shares completely and sell out. She is saving for the long term, she is not going to change her strategy every time the market drops.

She still can't bear to sell any of her £15,000 of gilts though, which have been rock steady and such a comfort. So she compromises. She decides to channel all her dividends, interest and futures savings into the 'shares' side of her portfolio. She figures it will take her about 18 months for her monthly savings to push her current £9000 of shares back up to £15,000.

In fact the market rebounded. Within a year and [with the new money she was putting in] her shares were back and more - to  £17,000. Time to sell some shares  to rebalance ? No - selling £1000 worth to put into gilts is not economic, because of broker's commission and admin charges. Siobhan continues the strategy that suits her - any 'new' money [monthly savings, interest, dividends] she will now channel into the gilts side.

The rules on when to rebalance

'Every couple of years' sounds a bit vague, but in tests  its been shown to work ok. In theory rebalancing should happen when the portfolio gets out of balance. That's another simple statement with big implications: there is no timescale. Taken literally you could rebalance every day [big funds do this] or, if you wait for a major imbalance to occur years could go by before action was needed.

As a simple rule - if you have to top up a holding by 25% or more then do it.  If your 50:50 split slips to 40:60 then it is time to rebalance. In Siobhan's case suppose her portfolio grows to £40,000, of which £16,000 is in gilts. She should sell £4000 shares and invest in gilts to bring everything back into balance. That's a 25% increase in her gilts holding.

As ever - real life bends these rules a bit. Selling [especially shares] costs money - and should be avoided if possible. Instead, re-direct savings and interest flows. Don't forget, in the accumulation phase of your life [ie while you are working] you will be buying into asset classes over the long term. You will be buying more of everything. Selling is not normal.*

Finally, even the '25% top-up' rule should be ignored if you are only switching small amounts of money - say at the beginning of your savings career.  Steve has £3500 in shares, his plan says he should  have £2500. Is it worth selling £1000 of shares? In practice - no.

How much  is the minimum then? 

How long is a piece of string? But since you ask, and you want something practical and simple, and because all our other rules seem to have a a 2 and a 5  in them how about: £2500. 

As in - if you are buying and selling stuff over the long run - do it in decent-size chunks.  £1 is too little, £5000 is fine, and somewhere in the middle is the minimum you should aim for.

Yeah but why £2500 exactly?

It ain't exact, but its something you should be aware of. If  at 65 you look back over your savings career and your purchases have been in chunks of £500 rather than £5000, then commission and charges will add up. Seriously. If you aim to keep purchase costs under 1%, and you get charged £12.50 a trade, and stamp duty is 0.5% then the minimum size order turns out to be......

£2500

Yup

But what if there is no trading charge or stamp duty?

I remember some Irish based funds didn't pay stamp duty, and brokers offering special deals - effectively zero charges if you bought an Irish-based etf.  But you can't get round the spread.

Spread?

Even with zero charges if you buy something and sell it back immediately you will have lost money. Because of the difference between the buying and selling price. The spread. Vanilla investors resist making trades incessantly. Charges are one reason, the spread is another. The third is... oh, we'll save that for another time. 

Let indolence by your watchword.

*For pensioners [de-cumulators] 'buying'  to rebalance is not normal as you are taking money out of your portfolio to provide an income. Here adjustments are made by changing where these cash flows are coming from - taking more from gilts, or shares; and selling holdings over the long term. Rebalancing by 'buying' is the option you would look at last. Just as rebalancing by  'selling' is what you avoid as a saver. Remember to change your mindset when you retire.

OUCH!

Its the small print that carries the big news.

I am looking at a Hargreaves Lansdown sales letter that suggests I buy Artemis Strategic Assets fund. In small print is the bit about expenses.

Imagine it grows at 6% for ten years, with inflation at 3%. Unspectacular, boring even. But if you have just been hit by a 30% drop in share prices it could look quite attractive.

You give them your £1000. Now their calculations show that you might get back £1420 after ten years, after deducting £366 in expenses. Hmm. Your money has 'grown' by £788, and you get to keep £420 of it. They [the finance industry, not just HL] get the rest. This is terrible. And here's why - inflation.

After 10 years you need £1344 just to keep up with inflation. The 'growth' in your savings (in tomorrow's devalued pounds) is actually £447 - and they get to take £366 of it. Three quarters of the growth in your savings they take.

And finally it gets worse - you could invest your savings in government index linked bonds (say at 1%) then you end better off after ten years, with virtually no risk.

You have allowed someone else to take a bet with your money. They reap the rewards, you take the risk.

How do they (the industry) get away with it? HL are doing nothing illegal. They are not unusual in this. The 6% example is standard across the industry sales literature. The annual charge of 1.5% is also pretty standard (implying it costs £150 000 to run a £10million fund, but it takes £15million to run a billion pound one. Discuss).

The figures I have added in (1% real return for government bonds, and 3% for inflation) are not outrageous. Changing them changes the outcome - but then so would changing that stately 6% growth every year for ten years.

And that may be the answer. Year on year changes of 6% are rare; annual share price swing are much greater. Up 20%, down 25% and the ordinary punter (you and me) feels that within this context the odd 1.5% is neither here nor there.

Well it is.

By the time you work out your average net return over ten years, and then work out the return after inflation - and then you work our what you could have got completely safely with gilts - suddenly that 1.5% becomes a very big chunk of what is left. In many years its all of it.

And don't forget, you are being charge a premium on the assumption they can outperform the market (otherwise why not just hold the FTSE100). So even when the market massively outperforms gilts, they still haven't earned their money if they haven't outperformed the market.

How to fix this? How about if funds only charged if they outperformed the market,*  and only then on the portion of outperformance. If you have an active  fund manager (and I hope you don't by now) why not write and ask them whether you can switch charging regimes, and how much their fees would be. Let me know how you get on.

frequently unasked questions

When I do the calculations, ten years of index-linked is still a few quid behind the Artemis example; are you wrong?

Index linked money is todays pounds, you have to multiply by the inflation factor (here its 4/3) to turn it into tomorrow's money (£1 now has the same purchasing power as £1.33 in ten years time). Try it, and you really will wish you had stuck with gilts.

But at least with shares I stand a chance of making bundles

Yup. You'll win some, and you'll lose some. But win or lose the finance industry still gets your money.

It's a bit like estate agents - house prices may go up or down but...

Estate agents get their commission once when you buy/sell.... financial advisors go on getting it year after year. Even if you don't move or change your holdings at all for the rest of your life.

So I should buy individual shares to avoid the charges?

No - too risky. Buy collective investments like trackers and etfs

But they will still charge me won't they?

Yes. Maybe 0.5%, maybe less if you search hard enough.

But saving 1% a year... is that really worth it?

...sigh

*Even that is not a solution. Because they are smart, fund managers would then start making enormously risky bets with your capital. The winners would make them bundles, the losers they would never have got any commission on anyway. Under this system, the size of your loss would not impact on their fees.

How to fix a pension shortfall

Not saved enough for a decent pension? There are four ways to get round this. Save more, spend less, work longer.

That's only three.

No-one ever mentions the fourth.

Which is?

Die young.

I prefer the other alternatives.

Very well - lets go through them: save more.  This strategy has a bonus side effect. Suppose you want to retire on two-thirds of your salary. You increase  your savings as much as you can - say up to one-third of your salary. So when you finally retire on two-thirds your net spendable income doesn't go down at all. It might actually go up as you won't be paying national insurance.

Spending less has a big impact. Cut back by £4.50/day - every day for the rest of your life as a pensioner- and you can knock £50 000 off your required pensions saving.* Sure you will miss that coffee and croissant, or the odd liqueur, but how long would you have have had to work to save an extra £50 000?

Working longer. Not only will your savings keep going up, you will also get more for your money when you turn it into a pension.

Because?

Because by retiring late you have less long to ...

OK I get the picture.

*Who would have thought cutting out a large cappuccino and a cream doughnut would save you £50 000.  But divide by 25 and  the resulting £2000 a year then turns into £1600 a year after tax. £4.50/day. Pensions seem absurdly expensive, but the flip side is that the naturally frugal can retire years before the rest of us.

How to save a quarter of a million....

... because thats what a £10 000 a year pension will cost.

Who says?

Well if you use the rule of 25, then 25 x £10 000 is....

Yeah I saw that calculation, looked a bit flakey to me

OK, check out inflation-proofed pension quotes for this month and for a 65 year old woman £250 000 gets you...

Let me guess.

£10 000 a year.

And for a man?

For a 63 year old man - about £10 grand a year.

I can't live on £10 grand a year.

There's state pension on top of that.

True. I suppose my house will be worth a bit too.

Yes but don't forget - if you sell it and buy an annuity, you will also need to pay rent out of that £10 000.

So I can't have my house and eat it. I think I will live in it.

Fine - you will still have a quarter of a million in assets; you  won't have  much income, but you won't have rent to pay either. And do you get a pension from work?

I'm freelance

Oh

Look this has come as a bit of a shock - a quarter of a million! Nobody mentioned that to me. I have got £40k put away and I thought I was doing rather well. What's that worth?

About £5 a day. Before tax. How about your wife?

She's a deputy head teacher  - she will be retiring on £25 grand at 60 ... Hey - thats worth over half a million.

I'd stick with her then

The Rule of 25

The rule of 25 says that if you want an income of £10000 you need to save a quarter of a million.

What? That's too much, haven't  you got ...

A rule of 20

Yes that would be...

Or 15?

Better.

How about 12?

Then I would only need to save half as much. So which one is right?

All of them in a way.....  x25 is not a bad estimate, but if you can live on 2/3 of your income that gets you to x15

No it doesn't it gets you to 16.66

Ah, but you don't pay national insurance  at 10% anymore. So maybe you can make do with x15

And x12?

If you have been saving  20% of your income, then you won't need the full x15, x12 will do.

Ah....where does x20 come in?

Thats how the government values pensions in payment. If you have a £5000 pension that counts as equivalent to £100 000 in value.

So what should I use?

Better go x25 for safety

But that means to get a pension of £10000 I will need to save..

That's right, a quarter of a million.

The big 4: how? where? what? when?

 You can't hope to know the answers without first figuring out the questions. And  even with plain vanilla personal finance there are four of them.  How? Where? What? When?

How much shall I save?  You need to save at least  slice of your income, preferably a chunk. A sliver isn't enough. [ A chunk is 2 slices, a slice is two slivers].  A slice is 8.33%. 

Its a piece of cake. A twelfth. A month's salary. Two months is good, three months great. Perhaps not coincidentally the new style UK  personal pension schemes will kick in at 8%. And the old style pensions rules used to limit tax relief to 15% of your income. Again that's saving around  1-2 months salary every year. 

Where shall I stash my savings? This isn't a what to buy? question. That comes next. This is about which tax regime? should my savings grow in. The three most popular are ISAs, pensions, and your home. Each has special tax concessions. 

ISAs have no further tax to pay, and a very flexible. Buying your own home isn't flexible, but there is no income tax [on the rent you save] and no capital gains tax. The pensions tax regime offers a tax free lump sum [25% of pension value] and tax deferment. On the downside it is the least flexibile. You can't access any cash until you are at least 55  [or 65 for men's state pension], and even then you can't get your hands on all of it.  

So you could stash all your savings in an ISA, or use it to pay off your mortgage early, and have very little to do with the pensions  tax regime even though you think of yourself a saving for your 'pension' [as in 'my house is my pension']. Governments like the pensions  (tax)  route because it limits you to when you can spend it [see the last question, below]. And the finance industry like it 'cos they can charge you fees. Of course home owning isn't a fee-free zone - as anyone switching mortgages can testify.

What to buy?  Is the traditional big question. The industry is ready with the answer: 'Buy our unit trusts, endowments , emerging markets funds....' by which they really mean 'pay our fees'. For vanilla investors this question is about your asset allocation. How much in boring assets [gilts and cash] and how much in bouncy  [shares and  commercial property].

When to cash in?  Even within the state scheme you can opt to delay your pension. Those with money-purchase pension schemes also have an additional question. Do I take an income (also known as drawdown) from my personal pension fund, while leaving it invested - or do I buy an annuity with it. Or can I do both?

Thats the questions - what are the answers?

It depends.

How much?

Lets look at what Robert  on £36 000 a year does..

Robert decides he can save £4500  a year  [an eighth - a month and a half's worth, not bad]. Over  35 years thats £250000 - [if the real interest rate after inflation is 2.5%, ie he ends up with  £250 000 in todays money].

Where?

Robert decides to pile it all into paying off his mortgage early. He manages this by his mid40s, and switches his savings into an ISA. There was a five year period when he did both - because he was worried his ISA allowance might not be big enough to cover all the savings he wanted to make in his fifties. He was hoping he would hit the 40% tax band, when he would have started saving into a pensions  wrapper because of the tax relief. But he never quite earned enough. And the standard tax relief wasn't enough to tempt him.

What to buy?

Robert just splits his fund equally between index linked gilts and shares [the FTSE 100] . He finds an etf [like a tracker] for each area. He only has two holdings. Its not ideal. He has no overseas holding. And gilt funds are not the same as gilts [the latter are redeemed - gilt funds aren't]; but compared to many of his friends he has done ok. Most of his money went to pay off the mortgage. His friends still have a mortgage - and a big hole in the value of their shares holding

When to take your pension?

Because Robert's money is in his ISA he can take the money out any time....  He doesn't have to wait until he is 55 - or be pushed into buying an annuity before he is 75. We'll come back to this later when we look at someone who has  saved/trapped all his money in a pension scheme.