Good reads from around the Web.

I wrote a big introductory musing article about the state of the world as usual this morning, but it’s so long that I’ve decided to save it for a future post in its own right.

It was riffing on this post by David Schwartz in the Financial Times about high yield shares (that’s a search result – click the article near the top).

So you can go read that to get prepped up. 🙂

Look on the bright side – less homework for you before you get to dive into this week’s links!

[continue reading…]

The 5:2 fasting diet is all the rage. And as a fan of the occasional bout of nil by mouth, I’m not surprised.

Sensible fasting can throw the reset switch on conditions such as Hungry Hippo-itus, whereby a cheeky slice of cake in January has become a daily muffin ritual by May.

Fasting also delivers results quick, which is great provided you don’t let it become an eating disorder. If you want to stay slim and sexy on the cheap, you should try it.

What the 5:2 diet does is turn fasting into a routine for long-term weight loss.

According to the BBC documentary that popularized intermittent fasting, if you limit yourself to 500 to 600 calories for two days a week, you can eat whatever you like for the rest of the time and still lose weight.

Early scientific research suggests it might also be good for your immune system, your blood sugar levels – even your brain.

We’ll see about that, but books on the diet are already topping the bestseller lists, and more and more people at dinner parties are stuffing themselves with cake while telling me between mouthfuls that they only had a salad the night before.

I haven’t noticed many thinner people when squeezing onto London tubes, but I live in hope.

Lessons from the 5:2 diet

I think there are three main reasons why the 5:2 diet has struck a chord:

• You don’t have to go without anything you like.

• You don’t have to think about what you’re doing all the time.

• It can quickly deliver results.

It’s a very pragmatic diet. In an ideal world, none of us would put on an extra kilo or eat cheesecake. In reality we do, and the 5:2 diet offers a way of dealing with it.

Are there any lessons for us as investors?

You and I both know the best approach to investing is careful budgeting and saving into passive index products for 30 to 40 years – all within tax shelters such as ISAs and pensions.

But we also know most people don’t save enough, that they buy active funds and trade stocks, and that CNBC exists and so do the temptations of Apple products and foreign holidays.

So within that mindset – that is, making an imperfect world a little better – here’s how the strengths of the 5:2 diet might be applied by investors – or would-be investors – who stray from the path.

You don’t have to go without anything you like

5:2 investing would acknowledge a few truths about human beings and money.

These include the big one that we like spending money now, rather doing without to spend it in the future – whether because of the time value of money, or because we struggle to envisage our future selves.

A quick and dirty 5:2 style response might be these two rules:

1) You must automatically transfer a fixed amount of your salary into your long-term savings each month.

2) You must never go into debt.

Why is this helpful? Because it automates your long-term saving, and enables you to spend what’s left over however you like.

Let’s say you’re 30-years old and you bring home £3,000 a month. If you set up a direct debit to transfer £500 a month from your account into an ISA or pension, you could do what you like with the remaining £2,500.

An iPad? A weekend break to Amsterdam? No guilt trips, just so long as you follow rule one AND you don’t break rule two, and never go into debt. Just let the after-savings money accumulate in your current account, and spend it as you see fit.

5:2 diet and active investing

Here’s another truth. Many people prefer to invest in managed funds or to buy their own stocks, rather than purely passive invest – even some who know better.

Personally, I’m a sucker for a portfolio of shares, and even I buy the odd investment trust on a discount.

So what might 5:2 investing have to say about this?

Well, perhaps you could divide your savings pot into sevenths. You could run 5/7ths of it passively, and maybe put 2/7ths in active funds (I wouldn’t!) or individual shares (I do).

Better yet, you could divide your monthly contributions into sevenths, and pipe the larger portion to your passive strategies, and the rest to your stock picking account. This way you won’t subsidize bad stock picks with your growing pot of passive money.

I believe most people will do better investing entirely in passive index funds, but equally I admit investing would never have captured my imagination – let alone got me blogging – if I only bought index funds.

If you’re like me, this might put a limit on your dark side.

You don’t have to think about what you’re doing all the time

While I am sufficiently obsessed with investing to devote as much as 50% of my net income to funding new investments – and half my free time to writing this blog, and you’re obsessed enough to read it – more people are in the opposite camp.

Most people come to investing as eagerly as Dracula goes to the dentist.

A constant fear of mine is that Monevator makes investing much more complicated than it needs to be for the average person to get far superior results.

The average person isn’t in slightly too-expensive index funds, or paying too much capital gains tax.

No, the average person is bewildered or ignorant, isn’t saving anything much at all, puts most of any money they do save into expensive managed funds, and never opens a stocks and share ISA.

For them, super simple is best.

I wrote some years ago that a new investor might simply split their savings between a UK tracker fund and a cash deposit account. A straight 50/50 division.

I don’t suggest they worry about bonds or other asset classes until they’ve done this for a few years and got used to the savings habit – and to the stock market wobbling.

It’s what I tell my friends to do when they ask for advice.1

Of course, I also point them to our posts on diversified ETF portfolios, but few read them. But if I can just get them automatically investing every month into a tracker fund, while buffering the volatility with cash, I know I’ve helped.

We can re-run that two-step automatic savings strategy here, too.

I’m naturally frugal, but I’ve never done a full-on budget in my life. Automatically saving every month means you don’t need to.

It can quickly deliver results

People applaud the 5:2 diet because they see the weight come off quickly.

When you go without food twice a week, you create a calorie deficit. You also temper down your appetite and shrink your stomach, so you don’t pig out as much as you might expect on the other five days.

This is in contrast to worthy plans where you eat only whole grains for 12 months, or ditch carbohydrates for only meat and vegetables, or ignore dieting altogether in favour of cycling naked sipping cold water at 6am in the morning.

All hard work, whereas the 5:2 diet is relatively easy and delivers results quick.

Sadly, there’s not many ways that this part of the 5:2 model can be safely moved to investing – at least not when it comes to returns.

Nearly anything you do to try to get results quickly from your investments is likely to cause more harm than good, whether it’s day trading, spreadbetting, or chasing hot funds.

I’d make one exception, though, and that’s if you have a company pension that offers matching employer contributions. Here you can get results overnight.

A matching contribution is like getting an instant 100% return on your money! You invest £500 and your employer matches it. You’ve doubled your money at a stroke. The only other place you can do that is Las Vegas.

Such pensions are a no-brainer, and if your company offers one, bite its arm off.

More 5:2 style approaches to wealth

Aside from good returns, there are two other crucial pieces to getting richer:

• Make more money.

• Spend less than you earn.

Boosting your income is an under-covered topic in personal finance circles, especially here in the UK. Perhaps it’s because we find talking about our salaries vulgar, or maybe investing for the long-term just attracts a more Spartan crowd.

I for one now believe I’ve made life harder for myself by not pursuing a higher income back in my 20s and early 30s.

I did okay income wise – I was hardly a beach bum – but given what I’ve achieved with my portfolio on what I did earn, I can’t help wondering where I’d be if I’d socked away another £10,000 to £20,000 a year for a decade or so.

Whether it’s by boosting your salary or creating a new side income, getting more money through the door can only help you reach financial freedom sooner – provided you save it of course.

And that brings us to spending less than you earn. (Here UK financial bloggers are definitely on message).

Unlike trying to make an extra 10% from your investments, cutting what you spend by 10% will quickly boost your bottom line in a safe way.

Better still, the first cuts are the hardest. Just as a 5:2 dieter doesn’t fear the fast days once they’ve become routine, you will find more ways to reduce your expenditure once you’ve got rid of the big items like excessive shoe buying or a new car habit.

If you’re in debt, then getting out of debt will deliver the biggest bang for your buck of all. Trying to get richer while paying someone else interest on your debt is like trying to lose weight by eating all the ice cream in the freezer first.

Take radical action – remember that all non-mortgage debt is an emergency!

Not an excuse to binge on bad investments

As I said at the start, I’m not suggesting running some of your money actively or using just a UK tracker fund instead of a global portfolio or keeping 50% of your savings in cash is the optimal route to wealth.

Far from it! But this isn’t an article about perfection.

In an ideal world, nobody would have a beer belly or flabby thighs. We would all eat well and exercise. The 5:2 diet exists because we don’t.

Similarly, these 5:2 investing ideas might help some people get on the right track. Blending your own smoothies or running a marathon can come later.

One caveat. There is some evidence that the 5:2 diet might actually be even better for us than normal eating, because the fast days may activate our bodies’ repair mechanisms. It could be we’re built to go without, and we literally have it too good.

The jury is still out on that. In contrast it’s pretty unequivocal about investing.

Yes, some active investors will beat the market. Yes, you’d have done better if you’d invested all your money with Antony Bolton or Warren Buffett.

But your chances of beating the market or finding the next Bolton or Buffett are very small – and anyway you don’t need to do so in order to achieve your financial aims.

There’s no suggestion here that anything but regular – dare I say boring – investing into tracker funds is the optimal way to go.

And so there’s no point being a 5:2 investor with flaws if you can be a perfectly passive one.

Rats, there goes the investing bestseller!

1. (I have more recently tried sending some to Vanguard’s LifeStrategy funds, but it doesn’t work as well. We know it’s very simple, but they see it as complicated! [↩]

A friend of mine used to torment himself with visions of a suave bogeyman named Dex. The imaginary Dex was better looking, richer, and more virile in every respect. And he prevented my friend from forming meaningful relationships. Every attempt was self-sabotaged by the fear that somewhere out there lurked Dex, ready to steal his beloved away.

Yes, my mixed-up friend had trust issues. And so do I when it comes to fundamental indexing.

Fundamental indexing is the debonair Dex to good old passive investing in market cap funds.

It’s newer, glossier, cooler (flying under the beguiling ‘smart beta’ banner) and it has a smooth line in proprietary patter that promises good times ahead.

Come hither, Dex

I’m attracted to fundamental indexing because it offers the chance to capitalise on the value premium. That premium has been worth around 3.5% per year to UK investors over the last 50 years.

There are a few fundamental indexing options available in the UK. First Trust Advisors AlphaDEX (note the Dex!) ETFs are the latest sophisticates, but the main players are the Invesco Powershares FTSE RAFI ETFs.

So how do these smart beta trackers work?

Inside the mind of the Dex

The first thing to note is that fundamental ETFs do not follow a traditional market cap index.

In other words, if company A is ten times the size of company B by market value then it does not automatically get ten times the presence in a fundamental index. That style is out like corduroy slacks.

Traditional market cap indices struggle to defend themselves against the accusation that they bloat up on overvalued equities, mechanically shoveling in more of the hot stuff like a compulsive eater – especially when the market is frothy.

In contrast, fundamental indices are meant to break this impulse by choosing equities according to a different menu.

In the case of the FTSE RAFI ETFs, their index encompasses a broad universe of equities, just like a vanilla index tracker.

However the FTSE RAFI indices rank their constituent companies not by market cap, but by four valuation metrics:

• Sales
• Cash flow
• Dividends
• Book value

These company ‘fundamentals’ are well known health indicators that transmit information about the underlying state of the business.

They are also the source of the value premium, and fundamental indices are tilted in favour of equities that are cheap on those measures.

Also, because a RAFI index uses the average of the last five years’ worth of sales, cash flow and dividends for each company, its rankings are less influenced by short-term noise than a market cap index.

And that’s a good thing…

Who cares what the world thinks? As long as I have you, Dex

…but what if that noise turns out to be news? (Think what 3D printed guns might do to Smith & Wesson!)

Then the RAFI indices will be more slow to adapt to the new reality.

Every time a RAFI index rebalances (once a year) it’s mostly using historical data to determine its rankings – data that only partially reflects the troubles of a recently impaired firm. So whereas distressed firms automatically sink in a market cap index, they actually rebound back up a fundamental index.

Hence fundamental indices favour companies in trouble.

That’s absolutely fine if you believe the market generally over-reacts to bad news, and such companies are reputedly the source of some of the value premium. But we underestimate the wisdom of the market at our peril, and a strategy that doesn’t screen for distressed companies piles on the risk as well as the potential for greater returns.

Dex stripped

The risks of fundamental indexing are highlighted by a comparison of the Powershares FTSE RAFI 100 ETF (PSRU) against its market cap rival – the iShares FTSE 100 ETF (ISF).

The FTSE 100 suffers from diversification risk in the first place, but the fundamental version is even more concentrated:

• 52% of PSRU is devoted to its top 10 holdings versus 48% of ISF and 37% of Vanguard’s All-Share tracker.

• Over 10% of PSRU is in BP – its number one holding. Whereas ISF has just shy of 8% in its top-placed company, HSBC.

• 47% of PSRU is concentrated in the financial and energy sectors versus 38% of ISF.

PSRU’s loadings are the natural outcome of its value tilt – the source of its potential to beat the pants off the market, but also the source of its volatility.

Fundamental products are also typically more expensive than market cap trackers and PSRU is no exception. The Ongoing Charge Figure (OCF) is 0.5% versus 0.4% for ISF and a tiddly 0.1% for VUKE – Vanguard’s FTSE 100 ETF. And that doesn’t take into account costs that show up in tracking error.

Dex’s midnight runner

Riskier, darker, more intense, more money… how can you resist the RAFIsh charms of fundamental indexing?

Well, in this follow-up post, I explain why I have my doubts.

Take it steady,

The Accumulator