Good reads from around the Web.

I really liked this extended metaphor of the stock market as a forest, from Nate at Oddball Stocks:

I want you to think of the market as a forest.  A healthy forest is filled with a variety of trees and plants.  There are tall trees, short trees, pine trees, oaks, maples, beeches, bushes, grasses, weeds, as well as numerous other plants.  A forest doesn’t grow all at once, it starts with a few grasses and slowly evolves into something mature.  Markets are similar, they don’t develop at once, they grow into maturity.

In a forest not all saplings grow into towering trees.  Many saplings thrive for a while only to be deprived of enough sunlight or good soil before perishing.  Sometimes a sapling falls victim to a grazing deer, or other destructive animal.  Likewise there are more smaller companies in the market and not all of them will grow large.  Some are small trees won’t ever grow tall.  Some fall victim to a predator, or are crowded out of the market place.

Given the right conditions, the right soil, and the right seeds a tree can grow large.  A tree doesn’t grow all at once, it takes decades.  As a tree journeys from a sapling to a stalwart many things can happen destroying its progress.  A tree might drop hundreds or thousands of seeds of which only a few become full fledged trees.  Even less seeds become giant trees.  A giant tree needs perfect conditions to crest above the other trees.  Once it obtains a certain size it’s own size becomes a strength.  A larger tree can steal sunshine and nutrients from the rest of the forest.  Size becomes a strength for a while.

Trees don’t grow to the sky, eventually all trees, even the giant sequoias face an untimely end.  Large trees are more susceptible to violent wind storms, they aren’t as flexible as smaller trees.  If the soil or environment changes large trees they have trouble recovering.  Large trees are also targets for lumberjacks whose wood is more valuable.

The market as a forest – or an ecosystem – is hardly a new metaphor, but Nate puts it really well.

Still, metaphors shouldn’t be entirely mixed up with reality.

As an active investor you are usually trying to either smaller trees that will grow faster than those around them, or else big trees that mistakenly seem small to other lumberjacks. A real forest has few such optical illusions, while attempts fence in promising saplings are doomed to legal and possibly biological failure.

Perhaps passive investors fair better with the metaphor? Like an owner of forestry assets or even a tribe of hunter gatherers, they get to benefit from all the riches the forest provides, whether the fast growth from seeds, the cool shade of the giants, or the fruit that falls from the more productive trees (as dividends).

Again though the metaphor founders slightly. Running a forest for profit is not cheap, which is why forestry funds tends to have high fees. Yet passive investors prize low costs above all but an accurate index.

I’m really nitpicking to extend the discussion though – I think elegant metaphors are useful, whether you’re a new investor or an old hand in danger of losing the wood for the trees (boom boom!)

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It’s pretty straightforward to convert your cash ISA into a stocks and shares ISA. Any amount of dosh tucked inside a cash ISA can be rerouted to the stocks and shares version.

As well as continuing to benefit from tax-free growth of interest, a shares ISA enables you to enjoy the giddy pleasures of:

• No tax on dividend income.

• No capital gains tax.

• No tax return tedium.

To switch out of your cash ISA you must fill in an ISA transfer form for the provider of your stocks and shares ISA.

It’s normally a short form that you download from your new provider’s website (look out for words like “transfer” or “switch your ISA to us”). Some providers may require you to open an account first.

Note, there isn’t a special form for converting cash ISAs. It’ll be the same form that’s used for moving stocks and shares ISAs.

You’d think the actual cash transfer would be as quick as the click of a mouse but oh no, this is investing we’re talking about. It’s as if the cash has to make several rural bus journeys to reach its new home – a good few weeks can pass before your cash ISA money pops up in your new share ISA account, ready to invest.

Choosing a stocks and shares ISA

Stocks and shares ISAs are hosted by online brokers (often known as platforms). These outfits buy funds, shares, bonds and other investments on your behalf, and keep them safe from the taxman in your ISA.

Of course the bank or building society that holds your cash ISA may also offer a shares ISA, too, but the chances are you can find a better deal elsewhere.

A major difference between a cash ISA and a stocks and shares ISA is that with a shares ISA you’ll be charged a platform fee by your broker for its services. Think of it as renting storage space for your investments.

While all stocks and shares ISAs are the same – they’re effectively just a tax-repelling wrapper around your selected investments – choosing the right broker is important because costs between brokers vary hugely. An expensive option can claim a heavy toll on your returns over the years.

If you’re transferring less than £30,000 and your total share ISA investment pot will remain below that level for a few years to come, then look for a broker that levies its charges as a percentage fee.

For example, if your share ISA investments are worth £5,000 and your broker charges 0.25% a year then you’ll pay a platform fee of £12.50 for your ISA.

If your investments are worth £50,000 then you’ll pay £125 per year.

Above the £30,000 threshold you are increasingly better off with a flat fee broker.

For example if your broker charges a flat platform fee of £80 per year then that is what you pay. It doesn’t matter if your investments held with the broker add up to £5,000 or £50,000.

£80 may not sound like a devastating lop off £5,000 but it works out to a 1.6% cut. With a £5,000 share ISA portfolio, an £80 fee slices a whopping 32% from the 5% average real return that UK equities have historically earned.

You can ill-afford to give up growth in your funds to high charges, especially as there are plenty more fee monsters ready to devour your money.

Today’s favourites

Our broker comparison table will help you find a good stocks and shares ISA deal. Our current top picks are:

• Percentage fee: Charles Stanley Direct or Cavendish Online.

• Flat fee: iWeb or Interactive Investor.

If you intend to invest less than £1,000 at a time on a regular basis then look for a broker that doesn’t charge dealing fees on funds or has a cut-price, regular investment scheme. Check out Charles Stanley Direct or Interactive Investor.

If you’re going to invest a lump sum and you won’t buy or sell more than a couple of times a year then iWeb is nigh on impossible to beat.

Choosing an investment for your new shares ISA

We believe in passive investing strategies here at Monevator.

Passive investing is a low cost investment strategy that is easy to understand, simple to maintain and recommended by one of the greatest investors of all time – Warren Buffet (among others).

If you have a low tolerance for faffing around with investments then take a look at the Vanguard LifeStrategy funds. These all-in-one passive investing products provide instant access to a globally diversified portfolio in a single fund, for a dirt-cheap fee. Life doesn’t get any simpler for reluctant investors.

Still, even with such a simple one-shot fund, investing without knowledge is like wandering through the Amazon jungle in your best clubbing gear – asking for trouble.

Take the time to find out more about a suitable asset allocation and read a good book about investing. This will give you more confidence to stick to your plan for the long-term.

Fine detail

• You can only open one stocks and shares ISA and one cash ISA every financial year (that’s April 6 – April 5) but you can switch any of your ISAs from one provider to another as often as you like without compromising your current allowance.

• Whatever you do, don’t withdraw money from your cash ISA to put it in the stocks and share ISA yourself. That’s a major blunder because once you withdraw money from an ISA, it loses the protection of the wrapper. Moving it into a new shares ISA will then count as part your annual allowance. Always use a transfer form. Funds that are properly transferred never leave ISA protection, and do not count as new money from your annual allowance.

• If you convert a current-year cash ISA into a stocks and shares ISA then you can open yet another cash ISA in the same year and fill it with the remainder of your allowance. It’s as if the old cash ISA never existed! Effectively it’s re-designated as a stocks and shares ISA once you transfer.

• You must switch your current ISA whole, but previous year’s ISAs can be split apart. So if you only want to dip your toe into share investing, you can decide exactly how much you want to transfer from yesteryear cash ISAs into the stocks and shares variety.

NISA to see you

Until July 1 you can’t put more than £5,940 in a cash ISA or more than £11,880 in a stocks and shares ISA, or more than £5,940 in your stocks and shares ISA if you’ve maxed out your cash ISA as well.

But from July 1 the New ISA (NISA) comes into play and the annual ISA allowance jacks up to £15,000 per year.

With NISAs, your money can be held in any combination of cash or investments.

• You can transfer cash into stocks and shares.

• Or move stocks and shares into cash.

• Or hold both assets in the same ISA if the provider allows it.

Final thoughts

Private investors often think of their cash ISAs as separate from their other investing activity, but this doesn’t make much sense. Emergency funds aside, if you stay in cash for a lengthy period then count this against the fixed income portion of your asset allocation.

Beware that brokers currently pay a next-to-nothing rate of interest on cash holdings, if you’re lucky. This may eventually change in the new NISA era, but we’re not holding our breath for any imminent generosity from brokers.

Also beware that brokers like to chuck a handful of marbles beneath the toes of consumer mobility by charging transfer fees to let you leave. £25 per holding in your ISA is common.

Finally, it’s worth knowing that the compensation limit for stocks and shares is £50,000 if your broker fails, not £85,000 as with cash.

Sadly, there’s a lot to think about when transferring a cash ISA to a stocks and shares ISA. But the truth is that if you’re sick of earning pitiful rates of interest on your money in the bank, there’s no reward without risk and a bit of effort.

Take it steady,

The Accumulator

Former hedge fund manager Lars Kroijer now advocates passive index investing as the best approach for mainstream savers. As well as his occasional contributions to Monevator, you can read his book, Investing Demystified.

Surveying their portfolio in the aftermath of the 2008/9 financial crisis left many investors feeling aghast. Some lost far more money than they thought possible.

Often they did so while their house and other assets also plummeted in value.

Their gut reaction may have been to sell out of their equity exposure near the bottom of the crash, only to miss out on the great rally that followed.

“The old story of retail investors abandoning their plans at the first sign of trouble,” lamented the financial planners.

But I don’t think it is that simple.

A good financial plan is a great start

If you’re a regular Monevator reader, you’re probably ahead of the game when it comes to investing.

You likely have a well-thought out financial plan, based upon:

• An assessment of your likely earnings and subsequent needs in retirement.

• A diversified portfolio that’s appropriate for your risk tolerance.

• A sensible guesstimate of your likely returns.

• A focus on cheap passive funds and cost-efficient brokers.

• Regular monthly savings to make it all happen.

Does that sound like you? Congratulations, you are genuinely doing very well.

But unfortunately that’s not the end of it.

No plan survives contact with the enemy

When we take charge of our investments, it’s up to us to keep an eye on our portfolio and our financial plan, and to adapt them to changing circumstances as well as the passage of time.

Big moves in the market might change our outlook, for instance.

Imagine a scenario where the stock market moves up 50% in a year. We would be remiss if we didn’t somehow take our improved financial situation into account in our forward planning. Our now-higher asset base might mean we can reach our financial goals with far lower risk, which could prompt a shift in our portfolio towards safer assets.

And it’s not just the market that changes. Our personal circumstances change too, and that in turn can impact our plans.

You’re promoted or fired, receive an inheritance, get divorced, your car is stolen without insurance, your tax circumstances change, you have a child – it all makes a difference.

How often you review your portfolio in the light of these changing circumstances is up to you.

Personally I think it’s worth doing so at a minimum yearly, as well as on an ad hoc basis when there’s a lot of turbulence in the financial markets or in your personal life.

Since you should plan to rebalance your portfolio periodically anyway, that is as good a time as any to review its composition in the light of these changing factors.

Reacting to disaster

The most important thing is to act in a controlled manner, and to try to anticipate how you’ll respond to different situations.

In other words: Don’t panic!

This can be easier said than done. When crashes like 2008 happen, there is a natural tendency for everyone to have a view on the markets. Financial news dominates the headlines and is a topic of conversation at the office, gym, mealtimes, in your home, and everywhere else.

When everyone is talking about it, how can you not have a view?

But the point is that as passive investors we recognise that we do not have any special insight or ‘edge’ when it comes to knowing what will happen after a crash, no more than at any other time. That’s why we’ve chosen to follow the index-tracking path. (Of course, we believe the evidence is that the vast majority of other people have no such insight, either!)

So while it’s tempting to take a view on the market when everyone else is and when we are perhaps instinctively looking for a reason why we lost so much money, we shouldn’t be fooled into doing so.

Or at the least, we can have an opinion but we shouldn’t act upon it recklessly and so become market timers.

With the benefit of hindsight, many people say they felt the market would rebound after the lows of 2009. But just because there is great market turbulence – that does not mean that an investor is suddenly better able to predict market movements.

As passive investors, we don’t consider ourselves smarter than the average pound invested in the market. That’s why we buy the index, after all.

That average pound put the FTSE 100 at an index value of barely 3,500 in early March 2009. That was the consensus opinion of all the money invested in equities at that point in time.

The fact that four years later we saw the same index much higher and approaching its all-time peak does not mean that we should have or could have predicted as much in March 2009.

Beware of hindsight bias

When they look back at the 2008/9 crash – or at any of the many that preceded it – people often have a sense that was always going to be a bottom somewhere, and great profits for the investor who can find the bottom.

And clearly that has mainly been the case throughout the history of most Western markets.

If you had stayed the course or invested more at exactly the right point in March 2009 in the UK or July 1932 in the US, then yes, you would have made a lot of money.

But you did not know that then.

For all you knew at the time, March 2009 was just a precursor to an even worse decline in the market.

Besides in reality you were scared to death.

There is no guarantee that markets will bounce back after a decline (which reminds me of the funny trader witticism: “He who picks bottoms gets smelly fingers…”). Just ask investors who bought Russian equities in 1917!

But that does not mean there is nothing we can do about the propensity of stock markets to crash now and then.

Buffered by bonds

First of all, after bad declines it’s likely that the future riskiness of the market has gone up a lot. While that does not tell you about market direction, at least you can prepare yourself for the increased risk.

Those willing to bear the extra risk will probably earn commensurate higher expected returns – there is good academic evidence that the equity risk premium goes up with the risk of the market – but they have to be willing to accept that a lot of money can be lost, too.

We know that losses like those in 2008/9 do happen with some frequency. It’s at times like these that you will benefit from a more conservative allocation policy – a portfolio that includes allocations of government bonds and perhaps cash. They are derided as boring and low return or even ‘no-return’ when the stock markets are going up, but they earn their place during steep declines.

These boring assets buffer your portfolio’s value – and your nerves – and hopefully stop you selling your equities in desperation when things get rough.

Avoid having to make bad decisions

Whether your portfolio goes down a little or a lot, a market crash can make your financial plan look pretty sick.

And when that happens, there are no easy fixes.

Instead you are faced with several unpleasant alternatives:

• You can find a way to put more money into your savings.

• You can accept a lower income in retirement.

• You can retire later.

• You may decide to re-allocate between the minimal risk asset (that’s government bonds for UK investors) and equities, if the large fall in your net worth has impacted the risk you’re willing or feel able to take. (Obviously this is a re-allocation that’s best made when stock markets are up, not down…)

Over time the stock market may recover, and with luck you’ll be able to tweak your financial plan again. If you do so because your shares have soared, then the options will be much more pleasant this time around!

But you shouldn’t rely on a recovery in the short to medium-term to be confident about your financial future.

Like the Boy Scouts: Always be prepared

You might say it’s closing the stable door after the horse has bolted to reduce your risk exposure after a market crash, and that’s obviously to some extent true.

Though it sounds like annoying hindsight, investment allocations are really about trying to ensure you never find yourself in the position of making forced or panicky sales.

Stress test your retirement plan and try to have a sufficient buffer of safer assets to stop you selling equities at what might be the bottom of the markets.

Over the long run, the returns from equity markets are likely to far exceed government bond returns, but they will also be far more volatile and periodically lose you a lot of money.

Make sure your allocations allow for that, especially as you get closer to when you’ll need the money.

Lars Kroijer’s Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. Check it out now.