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Financial Times - Ten golden rules of investment

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In theory, individual private investors have plenty of advantages compared to managers of big retail and pension funds. They don’t have to write quarterly reports to investors justifying their fees. They don’t have to worry about beating benchmarks all the time. And they’re not constrained by rules about liquidity or limits on portfolio constituents.

But many investors fail to capitalise fully on these advantages because they make basic mistakes, such as buying the wrong companies, trading too often and paying charges that are too high. My ten golden rules are designed to help investors avoid such pitfalls – I’ll be expanding on some of them in future columns.

1. If you don’t fully understand it, don’t invest

Reginald Mitchell, the designer of the iconic Spitfire fighter plane, once said: “If anybody ever tells you anything about an aeroplane which is so bloody complicated you can’t understand it, take it from me: it’s all balls.”

The same is true in investment. How many investors have bought, or rather been sold, “structured products” without truly understanding the risks involved? My personal favourite to illustrate this point is a fund launched in 2011 by Parkstone Asset Management called The Tracker UK Managed Alpha Fund. This described itself as a “securitised derivative, low-cost, actively managed, multi-asset, structured investment”. I wonder what it does.

I always think that if you can’t understand what an investment does, it is because you are not meant to understand. So don’t invest in it.

2. Don’t try to time the market

“Market timing” is investing somewhere near the bottom in market cycles and getting out somewhere near the top. It sounds obvious and simple, but in practice it works in reverse: money flows into funds and markets when they have gone up and comes out when they have gone down.

Stocks are a “Giffen good” for most investors – demand paradoxically rises as their price increases. Investors feel comforted by the presence of others investing or disinvesting alongside them, rather like lemmings heading towards a cliff edge together. We don’t enjoy the lonely feeling of the contrarian who invests when everyone else is selling and sells when everyone else is bullish.

Humans are hard-wired to be bad at market timing, so don’t try to do it.

3. Minimise fees

Fees paid to fund managers and advisers are a drag on investment performance. The average UK investor who invests via an adviser, uses a platform and then invests in mutual funds, incurs total charges of about 3 per cent each year. This is higher than the yield on equities and most government bonds. So all and more of the income from his or her investments is being consumed by fees.

4. Deal as infrequently as possible

Since we’re so bad at market timing, and fees eat into our returns, it logically follows that investors should deal as infrequently as possible. The same applies to fund managers. But the Financial Services Authority estimated that the average UK mutual fund manager turns over 80 per cent of his or her portfolio each year, and in so doing incurs an additional cost of about 1.0-1.4 per cent in commissions, bid/offer spreads and stamp duty. This lot is added to annual management fees and is yet another drag on your investment performance.

5. Don’t overdiversify

While portfolio diversification can improve your investment performance, it does have limits and is not without drawbacks. Research suggests that 90 per cent of diversification benefits can be obtained in most markets with a portfolio of just over 20 stocks. The more you diversify beyond that, the less you know about each investment.

6. Never invest just to avoid tax

Instruments like venture capital trusts, enterprise investment schemes and film finance projects are primarily vehicles to enable you to avoid or defer tax. Many investors who put money into them have no burning desire to invest in movies or solar panels. They are so blinded by the tax advantages that they tend to overlook the mammoth fees and the poor performance of the underlying investments. It’s often cheaper just to pay the tax.

7. Never invest in poor quality companies

A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ. You may think you should invest in these poor companies as they are going to improve because the management will change, or they will be taken over, or their results will pick up with the economic or business cycle. But each day you wait for such events, these companies destroy a little bit more value. Good companies do the opposite. With a good company, time is on your side.

8. Buy shares in a business which can be run by an idiot

Never buy shares in companies which require a genius or charismatic chief executive to make them work. Sooner or later that individual will no longer be there, and what then?

9. Don’t engage in “greater fool theory”

Only buy investments that you really want to own and at a price at which you are happy to own them. If you buy shares – or any other investment – with the sole intention of on-selling them, or if you overpay even for good companies, you are engaging in “greater fool theory”. The success of that strategy depends upon someone else being willing to play the same game.

10. If you don’t like what’s happening to your shares, switch off the screen

The price of the shares you buy may vary for reasons which have nothing to do with the fundamentals of the business. So movements in share prices are not necessarily a guide to whether your investment is good or bad. If you have chosen shares in good companies or a fund at reasonable prices, and you find gyrations in their prices unsettling, then simply stop looking at the share price.

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Terry Smith 

Financial Times