DIY Investor Magazine
/
March 2016
27
EGGS & BASKETS.
Diversification, the idea that spreading your investment
between different investments and asset classes can
boost your returns has been around for many years, but
is as valid today as it ever was. Often described as a
‘free lunch’, you can boost your returns and reduce your
risk by diversifying.
Spreading your investment between assets classes
(equities, bonds, property, and cash) leads to a
lower risk for a given return (or, alternatively, more
return for a given risk). The same goes for spreading
investments within asset classes between, say, different
geographies (e.g. UK and Overseas) or sectors (e.g.
energy, financial and retail company shares). The
important thing to remember that different assets will
perform differently over time so to keep you portfolio
well diversified you need to rebalance (sell the assets
that have risen, and top up the ones that have fallen).
Index funds are an excellent way to achieve this
diversification at very low cost – they hold a very broad
mix of bonds or shares. And rebalance very efficiently.
Though you still need to make sure that the asset mix is
also rebalanced.
COST IS A RISK?
One of the biggest risks that long term investors face is
cost. Every pound that is taken from your investment in
costs or charges is lost forever. And so is the return on
that pound …each and every year in future. It is one of
the biggest unseen risks facing people drawing income
from their pension funds too (but that is an article in its
own right).
Unfortunately the investment industry is not always as
good at showing the full costs as it might be.
Always look for the Total Expense Ratio (TER) of a fund,
rather than just the Annual Management Charge (AMC).
Also check out the Portfolio Turnover Rate (PTR) to see
how often the manager is trading the stocks and shares
inside a fund - and thus how much extra cost drag
from transaction costs the manager is generating by
chopping and changing.
Another good reason for choosing index funds is that
they trade far less often – so have lower running costs
as well as lower expenses. It is just like cars – ones that
are more efficient cost less to run!
Morningstar in the US conducted some analysis in 2010
to identify the best historic predictors of performance.
The results are remarkably clear:
‘In every time period and every data point tested, low
cost funds beat high costs funds.
Expense ratios are strong predictors of performance. In
every asset class over every time period, the cheapest
quintile (cheapest fifth) produced higher total returns
than the most expensive quintile (most expensive fifth)’
Choosing low cost index funds gives you a head start
when building your portfolio.
The same goes for the cost of any wrappers (ISA or
pension) that you select. Make sure you know the initial
costs, the running costs, the switch or trading cost and
any other charges.
