Our investment philosophy in detail

Rothmere Wilson,  Hitchin

Recent times have been the most challenging economic environment in living memory.

Many investors have suffered heavy losses and found their investment risk was greater than they realised.

Our clients continued to make money throughout the financial crisis, as the yearly performance of our main recommended funds show:

Year 2004 2005 2006 2007 2008 2009 2010 2011 Ave
Cautious portfolio 9% 20% -2% 6% 15% 0% 8% 0% 7%
Balanced portfolio 23% 30% 3% 11% 7% 5% 10% 2% 11%


(Data from Finex. Past performance is not necessarily a guide to the future. The value of investments can fall as well as rise, so you may not get back the amount invested.)

Was this down to luck? No, it was a bit of science and the application of common sense.

Top down management rather than bottom up

Top down investment starts with looking at economic conditions at a strategic level, deciding the correct asset allocation, then selecting the best individual investments (or managers) within each sector. Different types of assets suit different stages in the economic cycle:

cycle chart

Bottom up investors will make tactical decisions based on shorter term considerations. For example, buying shares ahead of an announcement that could be favourable and then selling to take a profit. This kind of market timing struggles for two reasons: transaction costs and the inherent unpredictability of short term price movements.

“According the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one night stands a ‘romantic’.” (Warren Buffett)

In order to work, more bets need to be right than wrong. Although experts should be able to do this, many studies have shown it is not possible to be consistent. Investors like Warren Buffett, who have consistently beaten the market, have done so by holding better investments rather than market timing.

Asset allocation

In short, asset allocation aims to maximise the investment return for a given level of risk, or reduce the risk needed to achieve a given level of return, by allocating capital to different asset classes. The proportions depend on economic conditions, as discussed previously and change over time.

Correlation

To gain any benefit from spreading investments across different assets, they should not react in similar ways to events (correlated), but be out of step (uncorrelated), as shown below:

table 2

We see many investors who have been advised to diversify, but across one asset class, such as equities. This can be a real problem if there is a belief that risk has been reduced more than it actually has.

The science bit

Harry Markowitz, an American economist, started it all in 1952 by showing investors could trade risk for return if they spread capital across uncorrelated assets, as shown below:

table c3

The vertical axis shows the level of return and the horizontal one the level of risk. Point ‘A’ shows a portfolio made up of one asset, say government debt (gilts) and point ‘D’ is 100% in another asset class, say shares, with much higher potential returns and risk. If gilts and shares are perfectly correlated, varying the proportions in each asset would produce the straight line ‘AD’.

However, as they are uncorrelated, the actual return and risk are shown by the curved line. At point ‘B’ (for example 90% gilts, 10% shares) the return is improved slightly, but the risk (or volatility) has actually fallen. At point ‘C’ (for example 80% gilts, 20% shares), the risk is the same as point ‘A’, but the return is significantly higher.

The essential point is adding what seems to be a riskier asset class, can actually achieve a reduction in the volatility of the overall portfolio. Adding more asset classes shifts the line to the left, reducing the risk for the same return, or improving the return for the same level of risk.

Volatility

Volatility is a way of measuring how much the price of an asset moves up and down. It is often used to express the “riskiness” of an investment.

When you are starting out to build you wealth, most people will not have large lump sums to invest and save by regular monthly payments. Volatility can work in your favour in these circumstances, through something called pound cost averaging. To illustrate this there are two investors shown below. One has £1,000 to invest as a lump sum, whilst the other has £100 a month to invest for 10 months:

Units bought

Month
Asset price (£)
Lump sum
Monthly
1
4
250
25
2
4
-
25
3
5
-
20
4
4
-
25
5
3
-
33
6
2
-
50
7
3
-
33
8
4
-
25
9
5
-
20
10
4
-
25
 
Total  
250 (£1,000)
281 (£1,124)

In this example the regular monthly investor has more units and therefore more profit than the lump sum investor. By buying on the dips in the price of the asset, the average cost of units was lower, so volatility has worked in favour of the regular investor. However, for those investors wanting to use their investment to provide a regular income, such as those in or approaching retirement, the reverse is true.

Imagine that the regular monthly investor illustrated is now taking an income of £100 a month from a previously built up investment portfolio. Now the 281 units have been cashed in and the volatility has cost the investor more than simply taking a lump sum out at the start. This is why having low volatility in investment portfolios is a vital consideration for people in these circumstances.

How we apply asset allocation theory

You may have seen statements that asset allocation accounts for over 90% of portfolio returns. This is not correct as the 1986 study this comment is based on actually said asset allocation explained over 90% of the “variance” in quarterly returns. Many financial planners who practice asset allocation use index tracker funds, or exchange traded funds (ETF’s), to gain low cost exposure to each asset class, believing the underlying investments are unimportant. This is known as passive investing.

However, the same study showed asset allocation was much less important in improving 10 year returns, so the specific investments within each asset class do matter and this is common sense. Consequently, we use trusted investment managers to select holdings. This is known as active investing. We believe this is an important contributor to long term returns and is borne out by evidence shown earlier.

Asset allocation is a way to control the risk and make sure your wealth grows surely and steadily. By avoiding major setbacks, your investments are better placed to grow in the good times and you will be wealthier (and less stressed!) in the long term, compared to not using asset allocation.


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Contact us

Address:
35 Bridge Street
Hitchin
Hertfordshire
SG5 2DF


Tel: 01462 441100
Fax: 01462 441121
E-mail: info@rothmerewilson.co.uk