Nearly half of UK households say that they would struggle to cope if their monthly outgoings rose by £99. We look at how you can create some financial 'breathing space' to help you out if you lose your job or become ill.
How to create a quick and easy investment portfolio
Image: Wang xizeng - AP
Historically, over any 18-year period, shares have outperformed cash, earning interest 99% of the time, according to the most recent edition of the well-respected Barclays Equity-Gilt Study.
However, those attractive figures can be somewhat misleading. Three excellent researchers - professors Dimson, Marsh and Staunton of London Business School - have conducted probably the most comprehensive and rigorous research on investment returns looking back over more than 100 years. They have found that, historically, stock markets have not always been able to keep up with inflation over long periods.
Although your shares and share income may have gone up over 20 years, they might still be worth less than the cash we originally invested, because the price of goods has gone up even more and money has become devalued.
When looking at the stock markets of 16 countries, the researchers found that inflation had got the better of seven of them over 20 years more than 10% of the time. Four more stock markets lost to inflation more than 20% of the time. When you add on trading costs and commission, the situation is even worse.
However, there is a simple way to invest that reduces this risk. It requires very little time and knowledge, just a little bit of a cool head. And it will mean that you will outperform the vast majority of investors and fund managers and reduces your chances of losing money outright.
It begins with instant diversity
Half of the method may be familiar to anyone who regularly reads the MSN Money pages. I am talking about so-called passive investments. Passive investments merely buy pieces of all of the companies in an index, such as the FTSE 100 or the S&P 500, and track that index.
With passive investments you get instant diversity and lower risk. If you invested in a FTSE 100 tracker last year, BP's share price fall of 40% would have been reduced to a loss of a few per cent in your overall portfolio, as it was just one of many shares you owned. You can expect passive funds to soundly beat the vast majority of fund managers and private investors, because their typical high costs eat so aggressively into investor rewards.
Generally, the best way to choose a passive fund is by looking for the lowest charges and at the fund's tracking error, which shows how much the fund's performance deviates from that of the index it is supposed to be tracking.
Reducing risk further
The London Business School researchers also look at another way to decrease the risk of losing money in shares. If you take a basket of eight countries, rather than investing in just one, the risk of underperforming inflation over 20 years is roughly halved. Even better, this is based on conservative estimates, namely that stock markets in the future will do a lot worse than they have in the past.
Investing in other countries does create a currency risk in the short term, as you'll be investing in local currencies that may move against you. However, the three researchers have found that, over the long term, investing in assets denominated in other currencies has tended to balance out, which pretty much eliminates that risk from overseas share investing.
A little choosiness helps
You can further reduce risk by buying cheaper indices. When London is bubbling over, there is probably a market somewhere where the shares are being overlooked.
There is unfortunately no single, free data source that will tell you how cheap world stock markets are. However, with a bit of searching you can usually find data on many countries. The historical price-to-earnings ratio (PE), the standard measure of prices, is easiest to find.
There is also a reasonable proxy. One type of passive investment is called an exchange traded fund (ETF). Some websites that quote share and ETF prices also estimate PE values. If you call up an ETF for, say, the S&P 500, you can take the PE as a proxy for the stock market itself.
Refining your technique
Pound-cost averaging will reduce risk further. This means paying the same amount monthly into your investment rather than putting in lump sums. Hence, you buy fewer shares when the prices are higher but more when prices are lower.
Once a year, you could look again to see which markets are the cheapest and start dripping your new money into those. However, don't move your existing holdings each year, because the trading costs are likely to more than destroy any extra gains from buying a cheaper market. Once it's there, keep it there.
Look at buying a mix of developed and emerging markets but do not underestimate the cost of corruption. Countries and markets with higher corruption tend to do worse overall. It pays to do a little reading on this before investing in a new country. Keep such investments to a minimum, if at all.
Generally, a lower PE is better, but some stock markets with low PEs have a history of staying low. We have no idea if that will continue but it would make sense to not track too many indices such as this. Do some background research before investing.
The PE measure is far from perfect. While I expect using it will boost your returns overall, you might want to do some extra research into its weaknesses, and into the pros and cons of other measures of price, such as CAPE and Tobin's Q.
Watch out for bubbles
Typically investors go for the countries that are said to be growing fastest, but the three London Business School researchers did an impressive study showing that those countries have underperformed on average. This is because investors tend to pile in, creating a bubble greater than the growth-rate justifies.
There are many passive funds tracking commodities, dividends and ethical investments. Stick with plain geographical share indices for simplicity and don't go for so-called leveraged funds or funds that are supposed to make you money when stock markets fall. These are very risky.
Many passive funds do not actually buy the shares, but buy something called 'options' on them instead. This is likely to be more risky, so if you have a choice between 'full replication' and 'synthetic replication', choose full.
Caution rather than exuberance is likely to serve you better, and the less activity you make the better you are likely to do.
Do not take on a more advanced strategy or succumb to the temptation to trade frequently unless you have huge amounts of time to analyse shares. A more intelligent decision for many of us is to be passive and focus on improving our career prospects.
You might want to diversify out of shares, but I think your basket of eight stock markets gives you enough cheap diversification across many countries and hundreds of companies.
What's more, your risk of losing money is even greater if you stay in cash, gold or bonds for long periods. However, I'm not against a bit of asset allocation if it prevents you from panic selling during the times when your share portfolio crashes (which it inevitably will).
Passive funds come in two forms: index trackers and ETFs. You can invest in both through many pensions and share ISAs, as well as through normal broker accounts. For some pension choices see my article on finding the best pension.
Remember, there are no guarantees. As Dimson wrote: "While a country has only one past, there are many possible futures."
But what is for sure is that we will always need goods and services, and businesses to provide them, and we will always strive to grow, making businesses perhaps the lowest-risk long-term investment.
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