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.

• ‘What I’m doing’ worries are solved by index investing, a very simple strategy with a good track record.

• ‘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 money you need to put in (assuming a certain level of return).

• 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 109 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	92
5	74
2	67

Source: Barclays Capital Equity Gilt Study 2009

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.

• Squeeze your fees – they reduce your returns.

• 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 e.g. bank account savings
• Bonds e.g. government or corporate loans
• Equities e.g. shares in companies
• Property e.g. residential or commercial
• Commodities e.g. 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:

• Fund charges – Use simple index trackers and ETFs with low Total Expense Ratios (TERs) and no initial fees.

• Trading costs – Trade as little as possible and choose cheap, online brokers with zero 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 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 – we’ll look into the detail as we go.

Take it steady,

The Accumulator

Thanks for reading! Monevator is a simply spiffing blog about making, saving, and investing money. Please do check out some of the best articles or follow our posts via Facebook, Twitter, email or RSS.

Receive my articles for free in your inbox. Type your email and press submit: