Capital markets work

Markets throughout the world have a long history of rewarding investors for the capital they supply. Companies compete with one another for investment capital, and millions of investors compete with one another to find the most attractive returns. This competition tends to drive prices to ‘fair’ value, making it difficult for investors to achieve greater returns without bearing greater risk. Markets don’t have to be right to be efficient. If markets systematically misprice stocks then it would surely be easy for skilled investors to reap the rewards? However, virtually every economist who has studied this question would disagree and can find no significant link between outperforming the market and continuing to do so with any persistency, other than that expected through chance alone; in simple terms, the very presence of so many skilled investors creates an environment where stock prices are the result of the consensus view of a stock’s value at that time. Capitalist economies thrive – not because markets fail but because they succeed.

Take risks worth taking

Academic and practical evidence points to an undeniable conclusion; returns are related to risk. Gains are rarely achieved without taking some chance, but not all risk-taking is rewarded. Developments in financial academics over the past 50 years have bought us a powerful understanding of the risks that are rewarded and those that are not, and can be summarised as follows:

• Stocks are riskier than bonds and have greater long-term returns. Bonds generally offer both a regular income and a fixed redemption date, whereas stocks offer no fixed entitlements.

• Relative performance among stocks is driven by two other dimensions: ‘small’ and ‘value’ company stocks outperform ‘large’ and ‘growth’ company stocks, as investors demand a price discount to reflect the greater underlying risk in small and value company stocks. The discounted prices provide greater upside as compensation for bearing the increased risk. Value and small capitalisation stocks therefore have a higher cost of capital, as they must pay higher rates of interest on their debt and offer a higher return to attract equity investors.

Structure is the strategy – Diversification is imperative

Successful investing means not only capturing risks that generate expected return but reducing risks that do not. Unrewarded and therefore avoidable risks include: holding too few securities, betting on countries or specific sectors of the market and following market timing predictions. Diversification is the antidote to all these avoidable risks, and in simple terms is no more than that old adage ‘don’t put all your eggs in one basket’. It negates the random fluctuations of individual stocks and positions your portfolio to capture the returns of broad economic forces.

No investor wishes to see the value of their portfolio fluctuate wildly, and the unique power of diversification is to reduce this portfolio value fluctuation without reducing the expected long-term return. In fact, diversification is so powerful that it is often described as the only ‘free lunch’ in the investment world, yet it is still common for investors to hold portfolios which are not truly diversified on an asset class basis, geographically or across sectors of the market.

Asset Allocation is paramount

Asset allocation is the process of deciding how much of your portfolio to invest in each of the main investment types, or asset classes - cash, bonds, equities and alternative asset classes such as property. You will often hear investment companies and advisers stating that over ninety percent of portfolio performance is determined by asset allocation, with the remaining ten percent attributable to stock selection and market timing. This notion stems from the 1980s and has been hotly contested by practitioners and academics ever since. However, no sane investor can deny that stock selection and market timing cannot be important determinants of return, it’s just that you cannot forecast or control the results of timing and selection. In simple terms, since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy because it is the only factor affecting your investment risk and return that you have complete control over.

Successful asset allocation exemplifies the importance of combining art and science in portfolio construction. Mechanistic computer programmes can produce naïve and sometimes disastrous conclusions, whereas intuitive or spontaneous decisions lack rigour and are unlikely to produce good long-term results. Marrying seasoned judgement with the science of economic analysis creates a powerful approach to allocating your assets.

Minimise unnecessary costs

Professional investment management comes at a price, but there are certain costs which can and should be minimised. Costs are an immediate performance drag on a portfolio and eat directly into the available capital market risk premium. Disclosed costs are only a small part of the issue; the investment industry is notorious for obfuscation, and an annual management fee of 1.5% can easily lead to total annual expenses of 3% or more for retail investors. Costs for investing in specialist sectors, such as small companies stocks, venture capital or emerging markets, are even higher and can even negate any available risk premium for these sectors.

The authoritative 2002 study ‘Triumph of the Optimists’ stated that the historical equity risk premium (the additional return generated by equities over a risk-free bond return) was 6.0% in the UK throughout the 20th century. If this premium were to continue in the future, and with a 3% per annum expense ratio, then over half of the return available from holding equities would be sacrificed to your investment manager – not an appealing prospect.