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The index investor’s road map for avoiding financial hazards

When money is at stake, the last place I want to be is lost without a clue about what I’m doing or where I’m going.

  • ‘Where I’m going’ collywobbles are eased by my index investing road map.

By following the checkpoints on the map, I won’t stray too far from the straight and narrow.

Checkpoint 1: Start with your financial goals

Paying off your mortgage, early retirement, buying a secret volcanic island base – you need to know what you’re investing for.

Having a target is powerful motivation juice. Knowing how big and far away the target is enables you to work out three essential parts of your plan:

  • How long you will need to invest.
  • How much risk you’d expect to take for that level of return.

To reduce the risk, you can increase your timescale or contributions.

Hazard avoided: Never getting there

Checkpoint 2: How much risk can you handle?

Shooting for higher potential rewards means taking on more risk. But if you spend sleepless nights worrying about your portfolio – or you panic and sell when the markets plunge – then you’re never going to enjoy the rewards.

The more cautious you are, the more conservative your investment mix should be.

If you’ve stared into the teeth of a bear market then you may already know how much risk you can handle.

If not, then one way to know yourself better is by taking a psychometric test.

Hazard avoided: Wealth-destroying panic

Checkpoint 3: Think long-term

If your goal is less than 10 years away then banking on equity returns could end in tears.

Analysis of 116 years’ worth of UK equity performance reveals that the chances of equities beating cash are vastly improved over longer timescales.

Holding period (years) Shares beat cash (% of times)
18 99
10 91
5 75
2 62

Source: Barclays Capital Equity Gilt Study 2015

Equities are a volatile asset class, liable to switchbacks in returns that look and feel like the Oblivion rollercoaster. But over longer periods, you’re more likely to capture the good years that help you ride out the bad ones.

Hazard avoided: Unrealistic expectations

Checkpoint 4: Harness the power of compounding

Compound interest is often described as magical because of its astounding ability to boost your returns. It’s the effect of interest earning interest

You can see the magic in action by playing with the Monevator compound interest calculator. Just hit ‘calculate’ and watch the green compound interest line soar above the blue line.

The trick is to magnify the compounding effect by retaining every scrap of return in your portfolio:

  • Don’t withdraw income until you hit your target.
  • Reinvest all your dividends and other interest payments.
  • Start investing NOW. The longer you invest, the more compounding helps.

Hazard avoided: Paying in more than you need

Checkpoint 5: Choose your asset allocation

Asset allocation is like dressing for all weathers. Whatever lies ahead – inflation, deflation, market crashes and bursting bubbles – your bets are spread wide enough to cope. (Well, as best as is possible).

You can split your portfolio between five main asset classes:

  • Cash – bank account savings
  • Equities – shares in companies, and funds of shares
  • Property – residential or commercial
  • Commodities – gold, oil, wheat and so on

Many commentators describe asset allocation as the most important investment decision you’ll make.

Your mix of assets heavily influences the level of risk and reward you can expect, and how your portfolio will react in different market conditions.

Hazard avoided: Taking too much or too little risk

Checkpoint 6: Slash costs like a maniac

Treat your costs like Norman Bates treats his motel guests. Slicing every fee to the bone adds juice to your returns, thanks to the power of compounding.

The costs you need to cut:

  • Trading costs – Trade as little as possible and choose cheap, online brokers with low admin and inactivity fees and regular investment services.
  • Taxes – ISA and pension allowances are your friends.

Hazard avoided: Chucking money away

Checkpoint 7: Rebalancing reduces worry

A portfolio can mutate into a risk-hungry monster.

Picture a portfolio that starts off split 50:50 between equity and bonds.

In year one, equity rises by 10% and bonds fall by 10%.

The portfolio is now 55% equity and 45% bonds.

If the trend continues, your portfolio will become far more equity-biased than you originally intended, and so more exposed to risk.

Rebalancing enables you to reset your portfolio’s asset allocation to control your risk exposure. You occasionally sell some of the outperforming assets and spend the cash liberated on buying more of the underperforming ones.

Happily, this means you’re buying low and selling high, too.

Hazard avoided: Risk creep

Checkpoint 8: The unexpected joy of drip-feeding

Making regular contributions to your portfolio has a bonus effect. Thanks to a technique called pound cost averaging, drip-feeding can provide long-term benefits when the markets fall.

It works because your regular contribution (say £100 per month) buys fewer shares when prices are high, and more shares when prices falls.

When prices rise again, all those cheap shares you picked up go up in price, too. This lowers the average price paid for all your shares.

Forget fretting about market peaks and troughs. Just keep contributing regularly, and stick to your long-term plan.

Hazard avoided: The temptation to try to time the market

Checkpoint 9: The enemy is in the mirror

Our brains are wired against us when it comes to investing:

  • Greed makes us want the hot asset class just as the bubble is about to burst.
  • Fear makes us panic and sell when the market falls, guaranteeing losses.

It’s human nature. We’re a bundle of impulses waiting to run amok.

Be prepared. Whatever happens:

  • Stick with the plan.
  • Ignore the ‘buy this, sell that’ noise.
  • Don’t chase performance.
  • Don’t obsessively check your portfolio.

Hazard avoided: Yourself

Safe journeying!

This was just a brief sketch of the index investing road ahead of you. For more on the detail, check out our passive investing HQ!

Take it steady,

The Accumulator

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{ 9 comments… add one }
  • 1 Amber tree June 23, 2015, 2:55 pm

    Good timing to read the article. It is point 8 that i needed to read again. I will keep investing each month according to the plan.
    I still have some work on point 9: don’t check your portfolio too often.

  • 2 Flybynight June 24, 2015, 1:47 pm

    Just rebalancing – so good timing for me too 🙂

    When it says “shares beat cash” in the table – does this mean cash or would this also include bonds? I have only equities and bonds – and have held only enough cash for things like an emergency fund and for short term items I know I need to buy like a car…should I be moving some out to cash as I get nearer to retirement?

  • 3 dearieme June 24, 2015, 3:29 pm

    “you need to know what you’re investing for.” We’re investing “just in case”. Just in case our final salary pension schemes fail, just in case of governmental financial collapse, just in case we both need “care”, just in case we have a grandchild with huge health problems, just in case ……..

  • 4 Dawn June 24, 2015, 10:16 pm

    I wish I could rewind 20 years as I had no idea what to do then, and what I would do is exactly as it says above.

  • 5 dean June 24, 2015, 10:45 pm

    Can I not rebalance by simply putting new money into what’s gone down and thus avoid selling shares at £10.00 a pop. And just buy what’s gone down at £1.50 on a regular investment scheme?

  • 6 The Investor June 25, 2015, 9:51 am

    @Amber Tree — We’re glad to help!

    @Flybynight — The table numbers are for cash only. The probability of beating bonds with equities during the past 114 years over the same holding periods as the table is:

    18 years — 87%
    10 years — 79%
    5 years — 73%
    2 years — 68%

    Remember these are probabilities, applied to past periods, so are only a guide not a prediction. Also “79% chance of beating” for example means there’s a 21% that shares will lag bonds over that period. I spell this obvious-sounding latter comment out because some people start calling assets “broken” and so forth when the returns don’t follow the most probable line, but there is *always* a spectrum of possible outcomes in investing. 🙂 The key is to balance risks and rewards across the spectrum as you see fit.

    @Dawn — I think nearly all of us would do something different 20 years ago, but then would we ever have learned? This information has always been around, we didn’t invent it here — but one has to journey a bit perhaps to see the wisdom of it. 🙂

    @dearieme — Indeed. My favourite way of thinking about risk starts with the fact that it is the possibility of more than one thing happening…

    @dean — Yep, it’s a great strategy while your new savings are significant relative to your total pot. Eventually (hopefully!) your stash will dwarf your new contributions, and relying on new savings could leave you over-exposed to one asset or another. See this article:

    http://monevator.com/rebalance-with-new-contributions-to-save-on-grief-and-cost/

    Remember though that on many platforms there are no dealing fees on index funds (*not* ETFs though) so rebalancing an index fund passive portfolio needn’t cost a penny.

  • 7 Flybynight June 26, 2015, 8:55 am

    @ The Investor – thank you for the numbers and the reminder that these are only a guide…having reflected on this article and others in the recent weeks I think I need to look at my risk exposure again…

  • 8 The Investor June 26, 2015, 10:07 am

    @Flybynight — You’re more than welcome!

  • 9 David November 17, 2015, 10:42 am

    It´s the first what newbies should read before they started to invest. Although it´s a good reminder for all investors at some moment when human’s nature begins to influence your decisions…
    When in doubt – read this article 🙂

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