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Perfect timing

27 October 2014

Investors need to think long-term and build a diversified portfolio.

As different stocks swing in and out of favour, it’s important to know when to hold or sell. But investing should also be a long-term process with the ultimate aim of building a diversified portfolio.

At the turn of the century, technology stocks were all the rage; but for much of the following decade few investors would even consider buying them after the technology boom turned to bust. Banks replaced technology as investors’ favourites in the Noughties; we all know what happened to them after the financial crisis. Between the autumns of 2010 and 2011 the price of gold rose 40%¹, but within two years it was back where it started. Other assets, from property to commodities, bonds to hedge funds, have had similar periods when they have swung in and out of favour.

These fluctuations are also seen in the fund performance statistics from the Investment Management Association, with most sectors having their periods at the top and the bottom of the league tables as investor sentiment switches from one sector to another.

The holy grail of investment is to time these switches to perfection, buying into a sector or asset when it is at a low point and selling out when it reaches the peak. However, often it’s the opposite that is the case: it can be difficult to resist buying at the top just as the hype reaches a peak and then sell on the way down because the prices are falling.

Getting the timing wrong can make a big difference to returns. For example, an investor with a £100,000 portfolio who had stayed in the market for the 15 years up to the end of 2013 would have produced a cumulative return of more than £216,000, based on the performance of the UK stock market as a whole.

But if that investor had missed just ten of the best days in the stock market the return would have been just £118,658; miss 40 of the best days and the return would have fallen to £40,337².

Academic research supports the theory that investors are likely to be better off by ignoring market timing and, instead, taking a long-term view and adopting a buy-and hold strategy. Andrew Clare and Nick Motson at the Cass Business School looked at the patterns of buying and selling by retail investors between 1992 and 2009 and concluded that those who bought and sold on market fluctuations lagged behind those who stayed invested continuously by almost 1.2% each year. Although 1.2% a year does not sound like much, compounded it can make a large difference: over 20 years, the difference between the two portfolios would be more than 35%³.

Regular ‘churn’ from buying and selling also incurs charges, which can also depress returns compared to a buy and hold strategy.

Investing across a range of assets – property, equities, fixed interest, cash and commodities are among the main options available – can also help to smooth out the impact of market fluctuations. This is because different types of asset react differently to factors such as economic conditions, investor confidence and the global outlook.

In times of great uncertainty, for example, relatively secure assets, such as government bonds, are likely to outperform; when the economic outlook is improving and confidence is high, equities and other so-called ‘risk assets’ are likely to do better. A portfolio that includes a range of these assets can reduce volatility and help to achieve more consistent returns over the long term.

Even within asset classes, individual investments can behave differently and it is worth bearing in mind how different types behave in particular circumstances. For example, ‘growth’-style equities – those companies in markets that are expanding – will tend to do well in periods of economic recovery, when investors are feeling optimistic about the outlook. ‘Value’-style shares are companies which are under-rated or out of favour with investors and, so value investors believe, have long-term recovery potential. In the bond market, higher-risk corporate bonds can do better when growth is strong, while more secure government bonds are seen as a safe haven against turbulence. Spreading investments between these different styles within an asset class reduces the need to second-guess what economic conditions we will be facing over the medium term.

Of course, buy and hold does not mean buy and forget. You need to ensure that the portfolio still meets long-term investment goals. Among the areas to discuss with your adviser are: How have the goals of investment changed? Are there more new opportunities available to invest in? Will access to your savings be needed quickly?

Investment goals can change over time – someone starting out in their career may need a strategy that prioritises long-term growth, for example, while someone who has retired may want to focus more on the income generation of the assets. The review should also consider the balance of types of assets and styles, how they have performed and whether there have been any changes of managers or style.

Regular investing is another way of reducing the impact of volatility on portfolios. Drip-feeding your money into the market gives the potential to buy more units when share prices are falling so, when prices recover, investors will have more units with a higher value.

The key factor to remember is that investment should be a long-term process.

Instead of worrying about short-term market noise, it is important to think about the ultimate goals and to build a diversified portfolio, including a range of assets to help achieve these goals.

1 http://goldprice.org

2 Financial Express Analytics

3 www.cass.city.ac.uk

The value of an investment with St. James's Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.

 

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