Plus good reads from around the Web.

A recent investor event I attended gave the usual insights into the average private investor’s mindset.

In 2011 I went to a monthly investing meet-up in a pub, where the talk was all of gold and oil miners. Literally nobody wanted to talk about anything else. It was one of the biggest contrarian signals I’ve ever encountered.

This time virtually everyone was debating how to prepare for the imminent stock market crash.

I’m not exaggerating – about the only people who weren’t preparing for a crash were those who believed such preparation was futile. On balance they still expected a crash, but they had a sort of passively-active mindset that steered them towards investing through the seemingly inevitable meltdown.

Is this just as big a contrarian signal as the one I saw in 2011? Does this universal pessimism mean we can be optimistic about future returns?

I’m not sure.

American splendour

While a five-year old and largely hated and ignored bull market doesn’t in itself point to an imminent plunge, higher share prices do mean inferior value and so lower returns in the future.

That’s just the way the maths works.

The US market still looks to me by far the most expensive. I’m very underweight there, and what I do own tends to be in the ‘beaten up’ category.

The always thought-provoking Meb Faber highlighted the relative expensiveness of US stocks this week in an article on home bias:

The U.S. is actually above the upper end of the range for expensive countries. […]

The U.S. was cheap relative to the rest of the world in the early 1980s, which also happened to be the start of the long bull market. [Whereas] the late 1990s saw the U.S. near the top of the range, which preceded the bear market that began in 2000.

Will the current overvaluation signal another bear or perhaps a time to shift more assets to foreign markets?

There was a similar point made by another US blog, A Wealth of Common Sense, which pointed out the average investor is greedy and fearful at exactly the wrong times:

A recent study from Harvard showed that in February of 2009 (during the crash), investors expected annual returns of only 3.9% a year going forward.

But in January of 2000 (during the tech bubble), expectations were for 14.3% annual returns.

Of course 2009 was a terrific buying opportunity while 2000 was not the time to be upping your expectations for future gains.

Perhaps those skittish investors I met are right to be cautious then – at least if they’re thinking of the US market?

Or are they set to be confounded again by this huge long melt-up that nobody has ever really celebrated?

To bail or not to bail

While I agree the US seems to be the most over-valued stock market index, that doesn’t mean it’s a reason to bail out of equities altogether.

Indeed The Wealth of Common Sense blogger seems to fall into this trap himself.

Wisely admitting how difficult market timing is – and addressing a US audience – he suggests that only the following three classes of investor should sell US stocks here:

1) Investors that have spending needs within the next few years (this has always been the case).

2) Investors that have seen their asset allocation to stocks drift much higher than their target portfolio weight (this has always been the case).

3) Investors that don’t have the willingness or ability to withstand periodic losses in exchange for longer-term gains (this has always been the case).

This is very solid advice, but I would suggest there’s also some home bias creeping in here, of the kind Meb Faber writes about.

That’s because there’s a fourth class of investor who might sell – an investor who is prepared to reduce his or her US exposure in favour of apparently cheaper overseas markets.

Cheap and expensive countries

Where might they be? The Meb Faber article has some pointers, and so did the Telegraph this week.

Its analysis looked at cyclically adjusted P/E (CAPE) ratios, price-to-book values, and dividend yields:

To be named “cheap”, markets had to be trading below their own historic valuation across all three measures.

Only a handful of stock markets managed to achieve this feat – Greece, China, Hong Kong, India, Japan, Russia and Turkey.

And the expensive? By its reckoning the US, followed rather oddly by Pakistan and Sri Lanka. (The UK is up there, too, judged by two of the measures – by CAPE we’ve still more room to run).

To conjecture wildly, I’d guess the US is so expensive because of the general fear that still persists in the financial world. Despite shares offering better value elsewhere, those with money feel more confident having it invested in America. The weight of this money may have bid up prices to excess.

In contrast, Pakistan and Sri Lanka may be the sort of expensive-looking markets that defy obvious analysis. Perhaps investors are correct to bid up these former backwaters because company profits there are going to explode?

Time will tell.

What to do if you must do something?

Valuing markets is something that looks easy to novices but is notoriously difficult, especially over the short to medium term.

Seemingly expensive markets can continue to deliver strong returns for many years, and even an eventual crash may not be enough to make up for the gains missed by those who bailed out too soon.

For passive investors, the best advice is to make sure you’re globally diversified, and then let your automatic rebalancing take the strain.

Passive investors don’t believe they’re smarter than the market, so they shouldn’t start now.

As for us active adventurers, my feeling is too many people are cautious in the UK for this to mark the top of the bull market, although of course anything can happen at any time to change that. Stock markets are inherently unpredictable!

But I do think with plenty of still-cheap countries around the world, it makes more sense for active investors to favour putting more money abroad instead of hugely dialing down their equity exposure altogether.

While I did take some money out of the market at the start of the year – someday I’ll need to buy that still-postponed property, and I was at well over 90% equity exposure by the end of 2013 – that’s mainly what I’ve been doing.

I haven’t had so much invested in emerging markets in my investing lifetime, for example, and it’s started to come good in the past few weeks. If anything I’m tempted to add more.

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Good reads from around the Web.

Now that he’s just three years from financial freedom, blogger R.I.T. is rethinking how much he can withdraw from his retirement portfolio.

This week he decided that for a UK investor, 3% looks much safer than the oft-quoted 4%:

Staying with only UK stocks and bonds in your portfolio and following the 4% Rule over a 30 year period would have resulted in you running out of assets 23.8% of the time.

To be 100% “safe” you have to drop to a safe withdrawal rate of 3.05%.

Switch to global stocks and bonds and the news isn’t much better. 100% “safety” and your safe withdrawal rate is still only 3.26%.

The comments following the article are also worth reading. There are some real-life stories from the frontline of early retirement, and more than one millionaire who doesn’t think a million is enough.

I tend to think a million is the bare minimum for me today, the way I intend to do it – which is to replace my drawn earnings from work with investment income and not to touch my capital. (The pot can mainly go to charity when I’m gone, to make me feel less terrible about a life obsessed with finance!)

But if you intend to run down your capital, then your numbers will be very different. A million may well be overkill, depending on your retirement age.

Let’s have a few opinions: What’s your number for a safe withdrawal rate, and what size pot do you need to get it?

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Though it might not always feel like it, you have one big advantage over City fund managers.

True, they have the training, best research, computers and analysts.

But they’re also judged daily by their bosses and their clients, and woe betide any manager who starts to lag their peers or the market. A mere 6-12 months behind the pack can be uncomfortable. Underperforming for a couple of years or more can be deadly.

A desire to keep their well-paid jobs and be seen to do something – plus an overdose of self-confidence – means some fund managers trade shares almost like gambling chips at Las Vegas in their pursuit of short-term profits.

These fund managers are smart, but the short-term is unpredictable and trading is expensive. Overall this tactic typically hurts their long-term returns.

Other managers avoid getting fired by covertly tracking the index, guaranteeing they don’t lag too much in any given year. The resultant returns are mediocre, yet these closet index funds still charge their investors high active management fees, instead of the rock bottom charges of a true tracker fund.

While this might seem less harmful than actively trading and doing worse than the index, even apparently modest fees add up over the years.

The tortoise that beats the hare

You’re playing a different game to City fund managers. Nobody is watching your month-to-month performance, except maybe yourself.

You can think long-term when it comes to your goals, and how to get there.

And with a longer time horizon, you can turn to the most powerful investing tool of all: Compound interest.

Compound interest is the interest earned on interest, over time.

Think of compound interest like a snowball set rolling from the top of a hill.

When it starts its journey, it may only be the size of a football. But as it rolls down the hill it accumulates more snow.

Soon it’s the size of a beach ball.

As the snowball gets bigger, the area onto which new snow can stick gets larger.

This means that halfway down the mountain and the size of a car, the snowball is adding a far greater volume of snow per revolution than it did at the top, even though the percentage rate of growth is unchanged.

It’s the same with compound interest.

Let’s say you invest £1,000 and you earn interest of 10% a year:

Year	Capital	Interest earned at 10%	New total
1	£1,000	£100	£1,100
2	£1,100	£110	£1,210
3	£1,210	£121	£1,331

Note: The 10% rate was chosen simply for easy maths!

In the first year you earn £100 in interest. But after just three years, you’re earning £121 a year.

That’s 20% more added to your savings in year three than in year one – all without contributing any extra money beyond that initial £1,000.

• After ten years you’d be adding £259 a year.

• After 20 years you’d be adding £672 a year.

A few more years again and you’d be earning as much in interest in a year from your savings pot as you first invested ¹.

All without putting in an extra penny!

Compound interest and long term saving

Let’s consider two investors: Captain Sensible and Captain Blithe.

From the age of 25, Captain Sensible invests £2,000 per year in an ISA for 10 years until he is 35. At 35 he stops and never puts another penny in.

Captain Sensible then leaves his nest egg untouched to grow until he hits 65.

Let’s say Captain Sensible earns an annual return of 8% from age 25. When he looks at his account 30 years later, he has amassed £314,870.

In contrast, his cousin, Captain Blithe, spends all his money between the ages of 25 to 35. Only when he hits 35 does Blithe start tucking away £2,000 per year in his ISA. However he keeps this up for the next 30 years until he reaches 65.

Captain Blithe earns an average annual return of 8% on his money, too. But he ends up with just £244,691.

 To recap…

•  Captain Sensible invested a total of £20,000.

•  Captain Blithe invested a total of £60,000.

… yet early-starting Captain Sensible’s pile is worth 28% more than late-starting Captain Blithe’s – even though Sensible only invested a third as much money as Blithe!

That’s the glory of compound interest.

Returning to returns

What’s that I hear you say?

“Good luck getting 8% a year in interest for 20 years!”

Quite right. Nobody is going to guarantee you that rate of return for two decades.

This is where the blended asset allocation that we saw in Lesson Four comes in.

UK equities have returned on average 8-10% a year ². Smaller companies, unloved shares, and emerging markets have generally done even better.

However all equities are volatile.

Young investors saving a lot of money every year might choose to ride out the volatility by investing 100% in equities for a shot at the very best returns. But they are taking a risk – and there are no rewards without real risks.

Older investors have less time to benefit from compounding as well as fewer years in which to add new money to the markets.

So as we age, it makes sense to increase our weighting of less risky assets, in case the stock market crashes in the years before we retire and we need the money.

The ideal long-term portfolio will therefore contain a lot of volatile assets like shares early on in its life, but a greater proportion of safer assets like cash and bonds in the later years, when we have less time to recover from stock market crashes.

The enemies of compound interest

Viewed through a prism of 30 years of compounded returns, short-term results gained from one month to the next – or even one year to the next – fade away.

What’s important is that we maximise our returns for the level of risk we’re prepared to take.

If you genuinely can trade shares better than the market, or you can profitably time the shift of your money between one asset class and the other, then trying to ‘play the markets’ will boost your returns.

But most people can’t, or at least not consistently. They will effectively buy expensive and sell cheap, cutting their returns.

What’s more, all this activity reduces your returns in other ways.

Dealing isn’t free, and there are other trading costs, too. If you use a fund manager, she might charge you 1.5% a year. All these costs reduce your returns.

Remember that due to compound interest, small changes in the rate of return make a big difference to your final payout.

For example:

• £10,000 compounded at 8% for 30 years is around £100,000.

•  The same amount compounded at 6% is less than £58,000.

Knowing about compound interest doesn’t just tell you why you should own at least some shares with the hope of earning 8-10% on average a year, over multiple decades – even though your share allocation will lurch up and down in value compared to the cash you save in a bank account.

Compound interest also shows you why you really need to keep costs and taxes low, in order to avoid sapping those returns and ending up with much less than you might have expected.

Our compound interest calculator enables you to quickly visualise the impact of compounding the returns on your investments.

Key takeaways

• A sound investment strategy aims to secure a good annual return over the long-term, not pick the best thing to own in the next month.

• Compounding a decent annual return every year can grow your wealth like a rolling snowball gathers ever more snow.

•  Keeping costs low will make a big difference in the long-term.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you and you’ll never miss a lesson! Why not tell a friend to help them get started?

1. I am ignoring the impact of inflation here, which would reduce the worth of that money in real terms.[↩]
2. Without adjusting for inflation. The exact average return figure varies depending on who is counting and over what time period.[↩]