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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.

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 [4], early retirement, buying a secret volcanic island base – you need to know what you’re investing for [5].

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:

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 [8]. 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 [9] 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 [10].

Hazard avoided: Wealth-destroying panic

Checkpoint 3: Think long-term [11]

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 [12] 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 [13], 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 [14] 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 [15]. 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:

Hazard avoided: Paying in more than you need

Checkpoint 5: Choose your asset allocation

Asset allocation [17] is like dressing for all weathers [18]. 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:

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:

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 [23] 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 [24] 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 [25].

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:

It’s human nature. We’re a bundle of impulses [26] waiting to run amok.

Be prepared. Whatever happens:

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 [27]!

Take it steady,

The Accumulator