Debate has raged on amongst academics, professional investors, and the general public as to the most profitable method of wealth creation. Karl Ahlstedt, Founder of The Horizon Institute and Guest Lecturer at the University of Wales, explores the various options.
From bonds and real estate, to stocks and exotics, the options are both numerous and daunting for the uninitiated investor looking to profit in the long term.
Timeframes matter; there is no specific optimal type of asset for every time horizon, with the significant departure occurring between short-term (typically less than 5 years) and long-term (typically more than 5 years) investment.
Investors that need to access their investment capital in under 5 years tend to be locked into investments that are low risk and highly secure – at the cost of abysmal returns. In the UK today (July 2018), the typical return on cash savings accounts across the high-street remain at near record lows of 0.3% per year. With inflation likely to be above 2% according to the ONS, the purchasing power (or more simply, the worth) of the invested capital falls by as much as 1.7% per year- essentially a 1.7% annual loss, hardly an inspiring incentive for those looking to secure a stable financial future.
Prior to the 2008/09 financial crisis, the savings rate of easy access bank savings was as much as 5%, and consequently interest rates fell- making borrowing cheaper, and saving less rewarding. This led to investors taking greater risks to fight off inflation and protect capital growth. This is where the financial markets entered the scene for even the most ordinary of people.
The stock market since inception has returned an average of 7% per year in capital growth, and even the worlds worst investor would, on average, only have to wait 13 years to recover any losses, based on investing lump sums prior to each financial crisis.
There’s more to consider. Actively managed funds, such as those from hedge-funds, bring with them substantial management fees. This is often a 1-5% management fee, and a 20% performance fee. Given returns of 7% averaged out, the real returns to investors would generally be between 2% and 5% per year. Generally enough to stave off the effects of inflation, but again it is hardly inspiring for those planning long term financial security.
Yet, the world is changing – the cost of transaction fees continues to decrease, and we are seeing the first zero-fee brokerages opening across North America (Robinhood) and Europe (Freetrade). While this allows individuals to trade at minimal costs, the financial markets are hardly a place for the inexperienced. The majority of uninformed investors would be advised to avoid building a “positive selection portfolio”, to use the jargon of the industry
This is where an individual investor identifies, analyses and executes trades to build a portfolio of stocks. The investor is responsible for exposure, risk, financial analysis, and technical analysis to execute trades at the right time. Traditionally, professionals who perform these duties have a quantitative background with degrees in mathematics, physics, economics and finance.
These professionals construct and use complex financial models, back-testing and analysis which is often beyond the scope of individual investors. This is part of the problem: many of the worlds brightest minds are involved in buying and selling equity securities, and competing with that expertise and resources it often a futile approach.
Instead, for most ordinary investors a more passive approach is often best. Index funds track the list of companies that make up the index, e.g. the FTSE100 contains the top 100 British companies by market capitalisation (how much the company is worth).
Therefore, investing in a FTSE100 mutual fund provides exposure to the index as a whole. Remember the 7% annual returns we mentioned earlier? This is where that number came from, it is the average amount per year the collection of stocks (the index) has increased since inception across the developed world. There are a few caveats here, but generally it holds up well enough to be considered an accurate assessment.
To conclude, a word of caution – since the last financial crisis (and the drop in central bank lending rates), stock markets have become one of the only bastions left for investors seeking 5%+ returns. This has led to substantial demand for stocks and shares which has pushed many financial markets across the globe to record highs. Very simply, higher demand = higher prices.
I would specifically point out that the S&P now has a CAPE (cyclically adjusted price earnings) ratio similar to that of the great depression, and while its unlikely another great depression is around the corner, the S&P is almost universally accepted as being expensive now when compared to historic levels.
Decided the passive approach isn’t for you? Want to learn how to build a stock portfolio the same way as they do on Wall Street? Learn more about active investing at The Horizon Institutes blog.
Disclaimers:
The author is in no way affiliated with the brokerages mentioned above.
This article was written by Karl Ahlstedt, Guest Lecturer in Finance at the University of Wales and Founder of The Horizon Institute.
From bonds and real estate, to stocks and exotics, the options are both numerous and daunting for the uninitiated investor looking to profit in the long term.
Timeframes matter; there is no specific optimal type of asset for every time horizon, with the significant departure occurring between short-term (typically less than 5 years) and long-term (typically more than 5 years) investment.
Investors that need to access their investment capital in under 5 years tend to be locked into investments that are low risk and highly secure – at the cost of abysmal returns. In the UK today (July 2018), the typical return on cash savings accounts across the high-street remain at near record lows of 0.3% per year. With inflation likely to be above 2% according to the ONS, the purchasing power (or more simply, the worth) of the invested capital falls by as much as 1.7% per year- essentially a 1.7% annual loss, hardly an inspiring incentive for those looking to secure a stable financial future.
Prior to the 2008/09 financial crisis, the savings rate of easy access bank savings was as much as 5%, and consequently interest rates fell- making borrowing cheaper, and saving less rewarding. This led to investors taking greater risks to fight off inflation and protect capital growth. This is where the financial markets entered the scene for even the most ordinary of people.
The stock market since inception has returned an average of 7% per year in capital growth, and even the worlds worst investor would, on average, only have to wait 13 years to recover any losses, based on investing lump sums prior to each financial crisis.
There’s more to consider. Actively managed funds, such as those from hedge-funds, bring with them substantial management fees. This is often a 1-5% management fee, and a 20% performance fee. Given returns of 7% averaged out, the real returns to investors would generally be between 2% and 5% per year. Generally enough to stave off the effects of inflation, but again it is hardly inspiring for those planning long term financial security.
Yet, the world is changing – the cost of transaction fees continues to decrease, and we are seeing the first zero-fee brokerages opening across North America (Robinhood) and Europe (Freetrade). While this allows individuals to trade at minimal costs, the financial markets are hardly a place for the inexperienced. The majority of uninformed investors would be advised to avoid building a “positive selection portfolio”, to use the jargon of the industry
This is where an individual investor identifies, analyses and executes trades to build a portfolio of stocks. The investor is responsible for exposure, risk, financial analysis, and technical analysis to execute trades at the right time. Traditionally, professionals who perform these duties have a quantitative background with degrees in mathematics, physics, economics and finance.
These professionals construct and use complex financial models, back-testing and analysis which is often beyond the scope of individual investors. This is part of the problem: many of the worlds brightest minds are involved in buying and selling equity securities, and competing with that expertise and resources it often a futile approach.
Instead, for most ordinary investors a more passive approach is often best. Index funds track the list of companies that make up the index, e.g. the FTSE100 contains the top 100 British companies by market capitalisation (how much the company is worth).
Therefore, investing in a FTSE100 mutual fund provides exposure to the index as a whole. Remember the 7% annual returns we mentioned earlier? This is where that number came from, it is the average amount per year the collection of stocks (the index) has increased since inception across the developed world. There are a few caveats here, but generally it holds up well enough to be considered an accurate assessment.
To conclude, a word of caution – since the last financial crisis (and the drop in central bank lending rates), stock markets have become one of the only bastions left for investors seeking 5%+ returns. This has led to substantial demand for stocks and shares which has pushed many financial markets across the globe to record highs. Very simply, higher demand = higher prices.
I would specifically point out that the S&P now has a CAPE (cyclically adjusted price earnings) ratio similar to that of the great depression, and while its unlikely another great depression is around the corner, the S&P is almost universally accepted as being expensive now when compared to historic levels.
Decided the passive approach isn’t for you? Want to learn how to build a stock portfolio the same way as they do on Wall Street? Learn more about active investing at The Horizon Institutes blog.
Disclaimers:
The author is in no way affiliated with the brokerages mentioned above.
This article was written by Karl Ahlstedt, Guest Lecturer in Finance at the University of Wales and Founder of The Horizon Institute.
