Case Study #2
Richard, via e-mail (contact details supplied):
“Over the past few months I have been getting my finances in order and I am now debt free and ready to invest. I've no experience in this and I am worried that I do not have the knowledge to truly read the numbers and fine prints of financial products.
“I am keen to put money away in Real Estate Funds and Corporate Bonds. I am planning to use my Shares ISA to stock. Whilst I am very anxious to get started, I want to know I can do the sums for myself and understand my true return after whatever deductibles there are.
“What advice do you have for people wishing to learn these calculations or is it basic arithmetic? Are there IFA out there who will educate me?”
The Answer
Alan Dick, Certified Financial Planner with
Forty Two Wealth Management LLP:
"First of all, congratulations on getting your finances in order and becoming debt free. Your query raises a number of very important questions and shows that you have given the matter considerable thought so far and appear to be well placed to really start planning towards the financial future you desire.
"The first thing you need to do is start with the end in mind and work back from there to create a suitable plan that maximises your chances of achieving all that is important to you. Start by asking yourself what you really want your life to look like. Write down a list of land-mark goals to work towards. These should include target dates and amounts. The arithmetic behind converting these goals into real future values relies on a fairly simple formula for compound interest and discounted cashflows. While it is possible to do this yourself if you are fluent with spreadsheets it will probably be a better use of your time to find a good Certified Financial Planner to help you crunch the numbers.
"Once you know how much you need to accumulate, and in what time scale, you can start building a suitable investment portfolio. You mention that you are not sure that you really know how to read the numbers and fine print relating to financial products. This doesn’t surprise me as many financial products are often deliberately complex and confusing to investors. Even the reported returns from investment funds often paint a misleading picture due to various statistical anomalies such as “survivorship bias”. The level of fees charged by funds is also often much higher than investors believe they are paying. The good news is there is no reason to be worried, investing isn’t rocket science and a few simple guiding principles should keep you on the straight and narrow.
"The first rule is that diversification works! Instead of trying to select individual asset classes (such as Real Estate or Corporate Bonds) based on current market conditions simply build a broadly diversified portfolio consisting of multiple assets classes. In most cases, the four main asset classes of Cash, Fixed Interest (Bonds), Property (Real Estate) and Equity (Shares) should be enough to construct a portfolio with the desired risk and return characteristics. A good planner should be able to help you assess your own risk tolerance (your risk comfort zone) and, perhaps more importantly, your risk capacity (the amount of risk you need to take to have a reasonable chance of meeting your objectives). This is often a balancing act requiring a considerable amount of fine-tuning to arrive at an acceptable investment portfolio.
"Once you know the amount you need to invest in each of the main asset classes, you need to select suitable investment funds to implement your strategy. There are two approaches to consider, the first is active fund management where you select funds on the basis that they will outperform the market. The second approach is passive investment using low cost Index Tracker, Institutional Asset Class and Exchange Traded Funds (ETFs). The fees for these funds can be as low as one tenth of those for actively managed funds.
"Ignore claims of excellent past performance. There is a reason why the Financial Service Authority (FSA) and most other regulators around the world insist that investors are told “past performance is not a guide to the future”--it’s true! Investors would be well advised to keep it simple and pocket the gains from low costs by employing a well diversified passive strategy. Until recently, it was difficult to achieve a diversified portfolio using passive funds. Investors were limited to a simple FTSE 100 or S&P 500 tracker. However, it is now possible to invest in almost any asset class using a low cost passive fund.
"You mention that you are considering investing in real estate and corporate bond funds while using your Stocks and Shares ISA allowance for equities. This may not be the most tax efficient strategy. An ISA manager can reclaim the tax on interest from bond funds but is not able to reclaim the 10% tax on dividends from equities.
"You should take advice from a Certified Financial Planner to help you build a suitable strategy. However, the real benefit of working with a planner isn’t just the initial planning and implementation but the regular ongoing monitoring of progress towards your goals. When it comes to investing, we are our own worst enemies. Numerous studies show that we invariably harm our chances of success by making irrational emotional decisions. A planner can provide the impartial discipline needed to stick with the plan and help you measure your progress towards your goals."
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Disclaimer: The financial adviser was provided by the Institute of Financial Planning. Morningstar is not responsible for the selection of the financial adviser nor will it be liable in any way for any advice or information provided by the financial adviser.
