To my mind, one of the great ironies of financial planning is that a litigious culture, historic mis-selling, poor regulation, fearful professional indemnity insurers, better qualified advisers and RDR has meant that the cost of advising anyone has increased. Already this year our regulatory costs have increased by more than 10% (yet inflation is 0%). This will result in the continued rise of DIY investing (do-it-yourself).
I have tended to take the view that most people need to have a budget, a target, a savings habit and only when they have £50,000+ do decisions get complicated enough for me to get involved. Its not always the case, but largely. So it is alarming how poor most people are at investing – and by poor I mean really bad.
An academic study from 2012 “Just Unlucky?” by Meyer, Stammsschulte, Kaesler, Loos and Hackethal at Goethe University in Frankfurt, into the success or otherwise of online investors (who generally think of themselves as well-informed) concluded that 89% of them lost an average of 7.5% a year. Let me repeat that 89% achieved -7.5% a year! Those that performed better were basically no better, exhibiting the same performance metric as luck. The research is based on German investors.. a nation that is historically characterised as shrewed, efficient, conservative and risk averse.
91% of DIY investors fail – big time.
Why? It would seem a significant element is holding the wrong asset classes and not well diversified globally. There is also a high degree of fear and greed at play, selling at the bottom and buying at the top. I can only imagine that some were following the tips from journalists and media commentators “best buys”. If dealing costs are factored in (and this was DIY investors using online dealing accounts, which presumably they thought were low cost) returns were 1% worse at -8.5% and achieved by 91% of investors.
Part of my job is helping people reduce their mistakes. We cannot be perfect, but we do apply sensible disciplines to remove a lot of errors. We call this advisers alpha – adding returns by good advice. Other research (of American investors) by Dalbar suggests that most investors underperform the market by 4-6% a year. But this latest research suggests it is far worse than that. Yet from next week, the new pension freedoms will mean that more people will take it upon themselves to go DIY with their pension. I don’t imagine that it will be a favourable outcome. This does not bode well for those using “discount” online investments, who eventually become so disenchanted with markets that they try less mainstream investments – which invariably blow up in their face and due to a peculiar twist, advisers such as myself pick up the bill… which to makes the cost of advice higher… and so the cycle repeats.
Should I Buy A House?
I recently asked for questions and so I’m going to tackle those that I get. So I’m starting with someone at the very beginning of their financial life asking if they should buy a house.
A house is an asset, it is also a home, but frankly whether you rent or buy, a home is something you create. In Britain, we laud home ownership as a goal to strive for, most of the world doesn’t and most of Europe rent.
The short answer is that you have control over where you live. If I may make the wild assumption that by the time you retire any mortgage is repaid, this means that you aren’t still paying rent or facing the regular prospect of renewing your rental agreement or moving. You can, within local bureacrat (sorry… I mean Authority) rules do what you like to your own home. You cannot knock through walls, convert a loft if you don’t own the property.
The Upside of Renting
You aren’t tied to a building, you don’t have to pay for upkeep or repairs. You have no mortgage, so no liability.
The Upside of Buying
You are “tied” but could sell – the issue is timing (no buyers?). Having an asset means other finances are easier – Banks think you are a lower risk, because you are a homeowner. Credit (which means debt) is easier to obtain.
Property prices rise and fall, but generally rise over the long term. It is as the TV pundits suggest, all about location, location, location.. which means where do people want to live? If you own the property you could rent (let) it, if you need to live away from it. However, this needs approval if you have a mortgage and you should never misrepresent the truth to a lender, that is asking for trouble.
Buying a home is a long-term commitment right?
Well yes it is… but one could argue that renting is a longer-term committment. Do you intend to rent for life? the cost of renting will also rise over time (with inflation). Renting is generally about afforability, in retirement, this means having a good pension or source of income to pay the rent… for the rest of your life.
Property prices have risen enormously. The real issue is “are properties overpriced?” the honest answer is – of course they are. The entire system is built on vested interests. Lenders need to lend, (Governments need lenders to lend), Estate Agents need to sell, Surveyors need to survey and so on… the prices have been pushed up because homeowners want to make a profit on their home when they sell and move on – to larger or smaller valued homes. The system isn’t particularly good or fair, but it is the one we have today and I dont see much likelihood of it changing.
Buying and Mortgages
Most people have to borrow money to buy. That means a long-term loan and one that you need to be able to afford. There are different ways to repay, but you have to repay the loan at some point. However inflation does help. Let me explain.. a property is £250,000, you have a £50,000 deposit and so need to borrow £200,000, which for the sake of example, will be reapid over 25 years. After 5 years how much is the property worth? the same? more? less?… and after 10,15 or 20 years? Well generally proprty will rise, let’s say by an average of 3% a year. Without doing anything to increase the value of the house, after 25 years the property is worth £523,444… the mortgage is repaid (because you agreed to repay it over 25 years). Your equity (what you really own) has increased from 20% to 100% over 25 years…. but if you rent, well you still own “nothing”.
Keep it Real
As an exmaple, if you can borrow £200,000 over 25 years at 4% interest, your repayments will be £1,067 a month. Making the huge assumption that rates don’t change (they can rise or fall, or you could fix) then your repayments will be falling in real terms due to inflation. Rent costs will almost certainly be rising, every year… let’s look at a possibility.
Mr Holmes earns £57,500 buys a property for £250,000 in 2015. He has to borrow £200,000 and begins paying £1,067 a month (£12,804 a year – about 22% of his income. His salary rises by 3% a year (lucky him! today… but not unreasonable looking back and I haven’t assumed promotions etc). After 10 years His income is £72,275 and he’s still paying £1,067 a month (now 18% of his income). His house is now worth more at £335,979… so he’s gained £85,979 since buying it. His mortgage is gradually reducing, it takes a while by £200,000 has reduced to about £142,000 – he’s cleared about £58,000 in 10 years. At the end of 20 years his mortgage is now only £56,500, his income is now £103,850 and his monthly payments are still £1,067 and about 12% of his income. Another 5 years and the mortgage is gone… no more payments. He’s done, but his home is still rising in value.
Mr Rentit earns the same amount and found a similar property to rent but it only cost him £700 a month to rent. He has the same job and earns £57,500 a year. Mr Rentit isn’t a fool, and he decides to save the £367 a month that his friend Mr Holmes is shelling out each month. He puts this into a tax free ISA which grows at 7% a year (he’s fairly adventurous). At the end of 10 years Mr Rentit’s rent has increased each year… but only by 3% the same as the price houses are rising by. So after 10 years he is paying £1434 a month – double what he started paying. But he has no mortgage, and his ISA is worth £64,259… ten years later he’s paying rent of £1,927 a month (still 22% of his income). His ISA is now worth £192,662 and he has no mortgage. However he’s now a little concerned that rent keeps going up and thinks that his ISA could probably buy a house – just like the one Mr Holme’s has. But that is now worth £451,000 and he only has £192,662. So if he wanted to buy he’d need a mortgage of £258,338.As it is he is facing a lifetime of rising rental costs…. so let’s hope his pension can cope.
To be fair, he had the same £50,000 deposit 20 years ago and it had been in his ISA it would be worth £393,117 and he would still need a mortgage of £57,883 and pretty much level-pegging. He might argue that Mr Holmes had 20 years of upkeep costs and home insurance – that boiler that was replaced.. twice! and so on. Yet Mr Rentit may also be forgetting those letting agent fees, the moving costs and the hassle that he spent trying to register with the local GP/dentist etc eaxh time he moved.
Now, my example is obviously flawed and full of linear assumptions about inflation and the largest being a 4% difference in ISA outperformance of inflation/property prices. None of this will become reality. We could make the numbers prove one case or another (with the wrong assumptions). The issue is one of having an asset or not.
My experience is that most would not be like Mr Rentit – they wouldn’t save the £367 a month and those that did probably were tempted to raid the pot, so would have less. Most investors panic in market crisis, so probably wouldn’t get a market return unless they had a decent adviser… Most homeowners do improve their home, making it more valuable – but there are certainly upkeep costs.
The short answer is really – few people are “better off” by renting. In 40 years time (perhaps at or in retirement) Mr Holmes would still be having to pay rent of £3,480 a month…which means his pension would need to be able to provide this, Mr Holmes would not. So part of the answer is about discipline… and Mr Holmes, being a client, would have saved more of his income despite his mortgage costs, we would have advised him to high-speed repay his mortgage, freeing up income later to squirrel away… but that’s another story.
Keep it Real
If one were to believe the media, there are many reasons for none of us to sleep at night through anxiety of our impending doom. However, whilst I wouldn’t wish to trivialise any of them, few in practice will have much impact. However for investors, there is one enemy that will do more to damage a portfolio than many other threats. That is “inflation”. This is a topic that I regularly discuss with clients, particularly someone new to our approach.
Hold cash, but not too much
Many people mis-manage their wealth by holding too much in cash or not being bold enough with their investments. I say this as someone that believes that holding cash is a good thing – wise, as cash provides liquidity – or at least it should in the normal course of life, providing for emergency funds and planned and unplanned expenses. However cash generally provides a poor return and one that few people can really afford.
Inflation is, at its most simple, the rising cost of living. I was reminded of this yet again on Friday as I attended the London Philharmonic Orchestra screening of the David Lean 1945 film “Brief Encounter” at the Southbank Centre. Much has changed in society since 1945 (a mere 69 years ago) particularly the days of buying two cups of tea and a couple of buns for 7 pence. I do appreciate that this was pre-decimal, but you get the point. So if building a portfolio it is helpful to know how long the portfolio needs to last, the longer its duration, the more likely the negative impact of inflation. The regulator has attempted to alert investors to this problem, by making providers quote returns with allowance for inflation. Invariably this makes the numbers look somewhat depressingly low and even negative, prompting the obvious sensible question “why invest?”.
If you have our APP for i-phone, i-pad or Android, you can use it to review inflation in a specific year or over a particular timeframe. The calculator goes all the way back to 1949. I usually show investors the rate of inflation in their year of birth and then the average rate since then. Inflation has only really come “under control” since the early 1980’s as the longer-term rate remains within 2.7%-3.7% range. So for real growth to happen, investments must beat inflation, otherwise they are either simply keeping pace or falling behind. Of course investments will rise and fall in value so even in a conservative portfolio if inflation is 2% and returns are -3% over 12 months, then you are making considerable losses, over that time – however a longer-term perspective must be taken to have any practical use for investment assessment. In order to ensure the value of your pound increases, it must keep pace with inflation. To grow wealth beyond this, we are left with few choices, investment being the most obvious. A good investment experience, will provide returns above inflation, commensurate with the amount of risk associated with it (and how much risk you are prepared to take). As a result, returns that are above inflation are actually “real returns”. As a consequence, we model financial plans in “real numbers”. I believe that keeping it real is vital for any worthwhile assessment of a portfolio.
What is evidence based investing? in short it is the use of data and mathematical formula to prove a rationale for investing. The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can’t “win.” Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.
Successful investing, like many things, begins in the mind…
It is important that an investor has an investment philosophy, for this guides and shapes decisions. Even if the theory is one of random chance, this would require a consistent approach to implement it. The problem with investing is that it becomes an emotional experience – and it shouldn’t. When you see your portfolio rise or fall in value, you have a gut reaction, often this is not good for you. There is a temptation to believe that beating the market is due to additional skill or knowledge, a belief forcefully proposed by active fund managers, who make their living by beating the market – or trying to. The sad reality is that few of them do (really few) and when taking a long-term perspective it is very difficult indeed to pick those Managers that can consistently outperform. Most Fund Managers don’t hang around for long, many funds get closed and when you consider the charges they apply, few (and I really mean a few) actually outperform.
Would you prefer evidence or guesswork when planning for your future?
My role is to help investors achieve the market returns for the various assets into which they invest. The main point being that when investing your money, I do not see any advantage in putting it at additional risk. This is essentially what most investment managers have to do in order to beat the market. Economic theory has backed up and evidenced this approach over the long-term and you may have seen me recently tweet at Eugene Fama was awarded a Nobel prize for economics. His research and theory together with that of others has helped inform the research used and investment philosophy that we adopt for our clients. Here is a short video about his pioneering work.
|2006: The Devil Wears Prada -Frankel|
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