Learn to be a Financial Hunter - Not the Hunted

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How To Easily Build, Manage and Run

a Successful Stocks & Shares ISA


This guide offers Stocks & Shares ISA investors a simple yet logical investment plan. It is designed for long term investing where a portfolio of securities is held for multiple years. By its very nature it's simple to follow and requires little research or month to month management.

The guide focuses on 3 main points -

  1. The importance of controlling and cutting costs,
  2. How to build an ISA investment portfolio of different asset classes, and
  3. How to run the investment portfolio over a multi-year period
This guide also assumes you know what a Stocks & Shares ISA is and how it can be used. If not, or you need a refresher. then please go to the LearnMoney ISA section.

Note, that although there are 2 different ISAs (Cash & Stocks) I'm going to be using the shortened term of ISA to always refer to a Stocks & Shares one.

A Stocks & Shares ISA should only be used as part of a long term investment plan
Many personal finance commentators view Cash ISAs as excellent products but are wary about Stocks & Shares ISAs for the following 2 reasons -
  1. Investments held within a Stocks & Shares ISA that in turn lose money cannot be used to offset capital gains tax obligations made on other investments held outside the ISA, and

  2. At the time of writing everyone has a Capital Gains Tax (CGT) tax-free yearly allowance of £10,100. So unless the value of the ISA is significant it's highly unlikely that most people will generate profits over the year anywhere near the tax-free £10,000 limit
Therefore the conclusion must be that unless you're looking at funding an ISA every year with at least £4,000, and preferably higher, you're probably better off investing in the markets outside an ISA wrapper because investing outside offers far more flexibility for smaller sums of money.
Think long term with ISAs
I would also strongly encourage most readers to start to think long term investing with an ISA. One way, which many savvy investors are doing, is to use an ISA to build up an investment pot which will help fund their pension/retirement.

The advantage to this strategy is flexibility -

  • A standard pension is by its very nature an inflexible financial product
  • Money gets paid in and then is locked up with no chance of tapping into it (or its income) before retirement age of 55
  • And even then you can only take 25% as a tax-free lump sum, the balance has to be used to buy an annuity

But invest all or part of your retirement savings into an ISA and it remains 100% flexible, allowing you to withdraw tax-free money at your will. Plus, you won't have to buy an annuity.

However, the flexibility that ISAs offer will only suit certain people. For example, if you're both financially organised and disciplined and use an ISA to help fund your pension then chances are you won't need or have to dip into the fund until you're actually retired.

But if you're financially ill disciplined, ie can't always trust yourself with 100% access to your savings, there's a good chance your ISA fund will be part or all depleted when you hit retirement. The money will have been used up over the years to help pay for a new car, a family holiday, or a new conservatory as just a few examples.

In such a situation I think it would be better to use a SIPP (or other pension vehicle). Then you can be guaranteed that any money saved over the years to help fund your retirement will do just that.

The Importance of Controlling and Cutting Costs
Unfortunately for us private investors the majority of well-paid people who work in finance base their success and high salaries not on their market expertise, rather on their skill in extracting a never-ending succession of high fees, charges and costs. A quote which perfectly sums this up -

The definition of capitalism:

'The passing around of your money from one entity to the next until there's nothing left....'

Anonymous

Costs, fees, and charges are often bad news for investors. Put simply, the more we're charged to both trade and manage our investments the less capital we have working for us.

But if that's bad news it gets worse when looking at the role that costs play over the longer term. It's all do with the power of compounding where profits are generated on profits to create what we know as the snowball effect -

  • The snowball gets larger and larger the further it rolls down the hill as more and more snow gets packed on to an ever bigger ball
  • The difference is often negligible to start with
  • But as time progresses the effect is always dramatic.

So when we're charged high commissions and management charges it's not so much a case of having less money invested today, it is rather the difference in value of our investments over a multi-year period if they had been reinvested and allowed to compound over several years.

The power of compounding is therefore a great friend, possibly the best, of the long term investor. The beauty about costs is we can 100% control them if we in turn take control of our investments away from the middlemen who tend to view us as profit centres rather than customers.

Why costs are usually so high (and often out of control)

The following are not pastimes the majority enjoy thinking about, researching, or working at -

  • Sorting out investments
  • General personal finance
  • Seeking out a competitive mortgage deal
  • Finding the best life insurance product or buying a pension

Unfortunately this widespread apathy means the banks, brokerage houses and fund management groups, in fact the majority of finance companies, have a head start in their business dealings with their customers.

This is because if many of their customers don't properly understand what they're buying (or even whether they actually need the products they're being encouraged to buy) they in turn won't know if they're being overcharged and generally being taken financially advantage of.

Read for example the personal finance sections of the newspapers and you'll always see plenty of horror stories regarding how much some people have been grossly overcharged and missold across a whole range of investment and personal finance products. But if only they'd done a little bit of internet research....

For an excellent example of how outrageous some charges are in the fund management world look no further than the notorious initial fee which is around 5%.

Invest £1,000 today into any one of thousands of funds and the fund management company will swipe £50 just for the privilege of letting you buy one of their products! Sadly, many people happily pay these charges as if nothing was wrong.

Start moving in and out of different funds over a number of years and the quote of 'passing your money around from one entity to the next - until there's nothing left' starts to ring true.

High costs aren't a problem if backed up by superior performance

Nobody should have a problem with paying high fees if the results back them up. But sadly for us retail investors it's odds on we're going to be receiving lacklustre performance if we invest in funds and unit trusts.

For example, and this is only one research report out of hundreds that show the gross under-performance of the fund management industry as a whole -

  • Just 1 in 34 (3%) fund managers outperformed the median each year for a 5 year period
  • Fees play a dominant role in the findings, because an initial investment of £7,000 grew to £13,500 without charges over a 10 year period, but with charges of 1.5% factored in the amount was £12,000 - a significant difference of 11%
  • A report commissioned by Virgin Money in February 2003 showed that over the past 20 years, 79 per cent of active funds failed to beat the benchmark FTSE All Share Index

Source: New Star Fund Management Group

There are 2 main reasons for industry wide underperformance
1: Charges & Fees

On paper it would seem the majority of Funds underperform the market because they invest in the wrong shares or get the overall market direction wrong. But this is not the case because the underperformance in part will always come from the charges and fees the funds levy.

If an average of 1.75% of your investment is deducted each year as a management fee then as small as that may seem it's an incredible disadvantage for the fund manager to overcome. It's as if the manager is running a race with a heavyweight handicap - he might be fast (good investor) but the extra weight is too much of a drag to overcome.

2: Portfolio Turnover

Portfolio turnover is a hushed up term in the fund management world and it's not good news for investors. It is defined by how much of a fund is bought and sold over the year, for example -

  • A fund's total assets are worth £100million
  • The fund manager buys and sells £50million of stock throughout the year
  • Portfolio turnover = 50%

The costs associated with portfolio turnover are made up of commissions + the bid/offer spread.

Commissions are never really that much of a problem, it's the bid-offer spread where the real damage is done especially when a funds usually trade in large blocks of shares so having an effect on price.

If a retail client sells £10,000 of BT stock that will never move the market because it's a very small trade. But if a fund sells £30 million of BT, an order of that size might move the market a small percentage, and these small percentages have a nasty habit of adding up over the course of a year.

Morningstar, an independent research company, published a study in June 1997 which showed the effects of this portfolio turnover -

  • Funds that had shown a portfolio turnover of less than 20% returned on average a 27% annual return
  • Funds with turnover rates of between 20% and 50% returned 23%
  • Funds with turnover rates of between 50% and 100% returned 21.8%
  • Funds with turnover rates of more than 100% returned 17.6%
Yes, the study is over 10 years old and commission costs will have contracted, nevertheless the point is still valid today - buying and selling stocks is a major drag on performance.

The news gets worse because according to Data provider Financial Express the average UK fund annual turnover rate has jumped from just over 40% in 1990 to 150% today! This means the holding period for a stock which used to be on average 2.5 years has now fallen to around 8 months.

So how much of a performance drag does portfolio turnover actually cost the average fund? Well, we're never going to get this information because it would be damaging to the fund management companies as a whole but I would suggest a minimum of 1% rising to about 3% of negative performance.

Conclusions

If you take charges and fees of 1.75% (average) and then add a minimum of 1% as the cost of portfolio turnover that obviously equates to paying away an average of 2.75% per year and that's a significant sum of money.

As I indicated above paying nearly 3% a year (or higher) wouldn't be bad if competitive results are delivered but with so many thousands of funds underperforming, in fact the vast majority, how can anyone be expected to always be positioned in the right funds? Yes, of course it's possible for the experienced stockmarket investor but it takes a lot of time and effort (both physical and mental) to be positioned in the right investments which deliver superior returns year after year.

One solution to cutting down on costs, so using the money saved to add to your investments, is to cut all the middlemen (fund managers and other advisers) out of the equation. And to do this you need to be looking at Exchange Traded Funds (ETFs) which are going to be the main investment vehicle of the ISA strategy.

I discuss ETFs in detail on the following pages.

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