This is one of a series of blog posts covering the principles that underpin the work we do with clients. If you find yourself sat alongside one of our financial planners at some point (and we hope that you do), chances are, they’ll be referring to these principles. This blog is about investing. The tricky business of risk and reward. We’ll stick to the fundamentals and look at how we do things at Abacus. Because the one thing you need more of in such a complicated field, is transparency.

First let’s deal with a few definitions. To ‘invest’ is to commit assets (capital) in the hope of generating a return over time. Those assets can be committed to the shares of companies, collective funds (baskets of company shares), bonds (debt), physical assets (property, art and so on) and each type of investment vehicle displays certain characteristics. This is important and we’ll revisit this concept.

While the terms ‘investing’ and ‘saving’ are typically used interchangeably, there is a difference. In contrast to investing, saving is to set aside funds for purchases and emergencies. There should be a lower risk associated with saving and you should have free access to your savings. Investing is a longer-term activity; saving is shorter term. This is especially important in the offshore market, where some investments accept regular contributions and are labelled as savings. The penalties to get access to your ‘savings’ are often severe and demonstrate how important it is to understand what you’re putting your hard-earned money into.

And then there’s gambling. It can be difficult to distinguish between investing and gambling but the timeline can help here. Gambling is short-term in nature, but it’s very different to saving. With gambling, you take a position (in a currency, stock, derivative etc) in the hope that the odds are in your favour and you’ll make a significant return. It’s short-term, but high risk. Why? Well if you look at the data, gamblers generally experience a negative average return in the long run. The house always wins. We don’t want that to be true, so we assign greater truth to the story of the guy that did win and ignore all the others that lost. The trick is to understand whether an opportunity is an investment, savings or a gamble, and to avoid the latter, unless it’s for fun.

Investment principles are high-level rules that one might follow when engaging in this activity. We’ve reduced years of collective investment experience, to a focus on four principles: Timely, Diversified, Frugal and Disciplined.

Timely – the power of compound interest is unquestionable. The concept of earning money on both your investment and the return you’ve previously made. It drives exponential investment returns. The more time you have to compound, the greater the effect, so to benefit you need to start early, reinvest your returns and stay the course.

Diversified – don’t put all your eggs in one basket. Spread your investments to help manage risk and drive returns. Why? Well, as mentioned earlier, asset classes have specific characteristics. This is known as correlation. Events frequently have an impact at the country or asset class level and this can both drive returns and help you manage risk.

Frugal – charges and taxes put a drag on investment performance. Price is what you pay and value is what you get. The higher the costs, the less money there is invested and consequently, the lower the return. So limit costs to maximise returns. While taxes are always visible, charges can sometimes be obscured, so it’s vital to understand who makes money from your money, as it has a significant impact on your returns.

Disciplined – we humans are driven by emotion. We might like to think of ourselves as rational but we rarely behave that way. Change is a constant and events frequently cause the value of investments to move in a volatile way. Aim for reasonable behaviour over rational, as you can live with it for a longer period, which is essential to the creation of returns. Time in the market, always beats timing the market. Reacting to volatility and selling investments is the road to ruin. It’s impossible to judge the right time to sell, or the right time to buy back in, so set your plan and stay disciplined.

So what does all that mean? How does it work? When we’re working with you, our first objective is to determine who you are and what your goals are. This allows us to allocate assets to investments and a portion of your income to savings. Then we need to explore your attitude to risk and capacity for loss. This is different for every individual and is often psychological in nature. Some advisers get clients to fill out a form but we prefer to go further, discussing this subject in detail and using examples to reach a shared understanding. It’s vital as your attitude to risk determines your asset allocation and it can also provide an indication of how you will behave in the face of volatility.

Once we’ve completed an initial assessment, we can look at different types of collective investment (baskets of company shares) and build a diversified portfolio that’s matched to both your attitude to risk and your goals. These investments typically sit on what’s called a Platform, which handles custody of your money, any trading and all the associated administration. Once we’ve built you a portfolio, we then cross-check this to any legacy assets you might have. These are historic investments that can’t be moved for whatever reason. This is done to ensure your over asset allocation is aligned to risk and goals. Bringing everything back to risk and reward.

We then keep an eye on your investments for you, highlight any situation where we feel a change might be prudent and review the asset allocation of your portfolio periodically. As the value of the various investments you have fluctuate (and they will fluctuate), your asset allocation changes. Rebalancing is the process of checking this situation and making changes to your portfolio, to realign it. This helps manage risk and reward on an ongoing basis. 

And that’s about it. As you approach a major milestone (like retirement for instance), we revisit your entire financial plan and portfolio and make changes, so you can start drawing income from your accumulated assets. There’s a whole science to this, but we don’t need to go into that now. If you’ve read this far, you’ve had quite enough for one day.

By Con Lillis – CEO, MBA