How to reduce the risk of losing money on your pensions and investments

How to reduce the risk of losing money on your pensions and investments when stock markets fall.

Ok, I admit it’s not totally straight forward (dealing with investments rarely is) but the
main point is this:

At all times there is something that you can be invested in that is making money – the trick is to identify what that is in advance. Can you be certain?  Absolutely not – however, you can make very educated decisions.

Worst case, if you believe there is a high chance that you will probably lose money by staying invested in something (say the UK stock market) why would you continue to do so? Would you not have been better off in cash from early October 2008 until the end of February 2009?

The First rule of investing

As Warren Buffet explains to his investors every year, the key to superior investment returns is to lose less than the stock markets in bad years at the risk of lagging the market in good years. Using this philosophy, Buffett managed to outperform in both bull and bear markets. For Buffett, risk considerations always outweigh reward prospects.

Many people have heard that Buffet’s first rule of investing is “Don’t lose money.” That rule is important because losses have a disproportionate impact on compounded returns.

Simple returns are the returns that occur each day or month. Compound returns reflect the real life cumulative impact of gains and losses on prior returns and represent the kind of returns that you eventually receive.

If your investment is up +10% one year and down -10% the next, are you at breakeven over the two-year period? The result is 0% if we simply average the two years, yet in the real world you will actually be down by -1% on your account (on a cumulative basis). This occurs regardless of the order of the gain and loss periods.

To calculate this:

  1. Start with £100 and add a gain of 10 % in the first year. The end value is £110. If you now lose 10% of that in year 2 the value at the end of year 2 is £99. – so you lose £1.
  2. In reverse if you start with £100 and lose 10 % the value at the end of year 1 is £90. If you make 10 % in year 2 the value at the end is £99.

You still lose £1 either way. It actually takes an +11% gain to make up for a -10% loss.

Further, as your loss increases, it requires a greater percentage gain to restore your account to breakeven. For example, it takes a +25% gain to recover from a -20% loss and a +50% gain to recover from a -33% loss. Therefore, as discussed earlier, one key benefit to avoiding losses is that it only requires 30% of the upside in the market to achieve market returns.

What can be done?

Most advisers believe you cannot time the markets and say things like, “If you had missed out on the 10 best days in the markets over the last 5 years your investment would be worth 15% less.”  That’s fine, but what happens if you miss the 10 worst days? As markets tend to fall fast and rise slowly you may be much better off. I would also point out that if markets cannot be timed why do so many advisers place money with fund managers who do exactly that.

The graph below shows that there are sometimes long periods of time when the stockmarket just moves sideways and long term “buy and hold” investors would not have made any money over those entire periods. In fact with charges and inflation taken into account, they would actually have lost money in real terms. However even during those periods there were large (5% or more) monthly fluctuations in the value of any given stockmarket. We seek to use fund managers who capitalise on those shorter term changes to make money as markets go up and avoid losses as they drop.

Catching just 80% of most significant upwards moves and avoiding 80% of most significant downturns will  greatly enhance the value of your investments over the years.

100 year Dow Jones chart

100 year Dow Jones chart

Main points
Around 95% of most financial advisers will invest your money and leave it in the same funds for the long-term. (Some may advise you to change annually at a review meeting.)  We do not advise clients in the normal way.  Very simply, we proactivly manage your investments by checking on the markets trends on a quarterly basis.  We only have money invested in areas that we believe are going to make money over the next year – not years. We will of course obtain your permission before switching any investment funds on your behalf.

There is almost irrefutable evidence now to suggest that the next 10 years will not show significant stock market gains. Passive tracker funds will reflect this return. Sure, some years will make gains but over the long term 120 years of history suggest this is unlikely until stock market values drop significantly. Some measures have the stock market at the end of 2011 as 70% overvalued

So, by being highly proactive, rather than holding for the long-term, absolute return fund managers can achieve higher returns.  Like all types of active fund management the returns are a direct result of fund manager skill and so picking them carefully is paramount.

If you have any questions on financial investments, please call us on 01763 232326 or Email us.