New Sunday Times Feature - Diary of a Private Investor

That's very clever Colm!

Joking aside, it's really not that long ago that the fruits of your offsprings' direct labour was the only retirement plan available to the vast, vast majority of people. In a sense, part ownership of any business is just a claim on the future profits of that enterprise so maybe things haven't really changed that much.

My take-away from this thread is that there is no "one true way" to achieving an acceptable level of financial security in retirement and there are equally valid ways of constructing an appropriate portfolio depending on a very wide range of individual circumstances and emotional dispositions.

Ah, who am I fooling?

I think your approach to investing is totally bonkers!

I am struggling with two words being used freely here. Risk and Diversification.

Risk. We are told that over the long term equities provide good returns. If we accept that assumption, what is risk. Of course there will be short term falls in equity values but unless one caught by a personal cash requirement and is a forced seller, why is this considered a risk. (I understand that there is a technical definition of risk in terms of quarterly volatility, but I don't think that is how the term is generally used, nor can I see any connection with the general usage).

Diversification. If an investor believes in an efficient market then it would not matter what shares she buys, they are all priced appropriately by the market. An investor should seek to buy the whole market as different shares representing different risk/reward profiles would give better returns than any single share. It seems to me that this is what BB is trying to approximate when he talks about buying 10 shares.

But this discussion is all about stock picking. Thinking that you can identify Share A that will perform better than all other shares. Then why buy share B which will perform less well than Share A. I can understand that a stock picker would reluctantly buy more than one share to protect against unforeseeable bad news for Share A, but not that she would actually seek diversification as an end in itself.

Well one risk is that the higher expected returns of equities over less volatile investments might not be realised over an investor's time horizon. Long term government bonds outperformed local stock market returns on a cumulative basis for almost 50 years in each of Germany, Italy and Japan and we recently experienced a 30-year period where long term US Treasuries outperformed the S&P 500.

Absolutely agree that choosing to hold a small number of stocks from the thousands of investable, publicly traded equities across the globe is stock picking. I've no problem with that if your objective is to outperform the broader market but otherwise I don't see the logic of holding such a concentrated portfolio.

Brendan Burgess said:

So they should be 100% in equities. Of course there is a risk that they will outlive their fund. But the risk is much higher if they put the money on deposit or in bonds.

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Actually, that's not true - at least historically, using US data.

There have been 60 complete rolling thirty-year periods between 1926 and 2014. Making inflation adjusted withdrawals at a rate of 4% from a 100% stock portfolio (S&P500) over any of those 30-year periods had a portfolio success rate of only 93%, whereas making withdrawals at the same rate over any of the same 30-year periods from a portfolio of 50% stocks and 50% intermediate US government bonds had a 100% success rate. That ignores investment costs and taxes.

While stocks have invariably outperformed bonds over 30-year investment periods, the risk of receiving low, or negative, returns early in a period when withdrawals are made from a portfolio of investments has a significant impact on the success of a given portfolio.

The takeaway? The historical data suggests that a 65-year old retiree shouldn't be 100% in equities.

Wollie said:

I would like to understand how those figures were derived.

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Hi Wollie

Here’s the underlying study (which has subsequently been updated with data through 2014) - http://www.retailinvestor.org/pdf/Bengen1.pdf

You are quite right that the study assumes drawdowns are made on an annual basis (on the last day of each year) and the Ibbotson data employed in the study assumes that all income (interest and dividends) is continuously reinvested. The study also assumes continual rebalancing (maintaining a consistent allocation between stocks and bonds) and that there are no investment costs or taxes.

Thanks to everyone who posted comments on my Sunday Times column of 17 January. I got so much value from your comments that I'm repeating the exercise with yesterday's column. I look forward to your reaction.
Colm

Diary of a Private Investor Colm Fagan Sunday Times, February 7, 2016

The purpose of this column is to demystify the world of stocks and shares by recounting one person’s adventures in this world. It does not purport to give advice.

Owning shares is not for the fainthearted. That was proved to me once again by recent gyrations in the share price of Renishaw, a British engineering company that is my largest individual investment, accounting for over 25% of my portfolio. In the past four months, the share price has fluctuated from a high of £20.50 (€27) to a low of £16, a difference of 28%. This volatility is despite the fact that there have been no price-sensitive developments of note for the company in the period, with the results for the half-year to December 31, 2015 confirming guidance given for the full year to June 30, 2016. God knows what would have happened to the price if the company had made a big announcement. This is the sort of volatility shareholders must live with.

Short-term price fluctuations don’t concern me unduly - what matters is the long-term. In the long-term, Renishaw has delivered. I bought my first shares in the company over 17 years ago at a dividend yield of slightly more than 2.5%. The dividend has grown by an average of more than 8.5% a year since. The dividend yield is once again slightly over 2.5%, which is close to the average for the entire period. This means an average return of more than 11% a year over the 17 years, comfortably beating inflation, which averaged 2% a year. Nice.

My target return for the future is inflation plus 6% a year. I will get this return if the dividend yield stays around 2.5% and dividends grow by an average of inflation plus 3.5% a year - 2.5% dividend plus 3.5% real growth in dividends equates to my target 6% real return. The company aims to pay around 50% of profits in dividends, and to reinvest the other half in the business, so the question becomes: will profits grow on average by the same 3.5% a year in real terms in future?

There are a number of drivers for Renishaw’s success. One is the strength of the commitment at the top. The joint founder and chairman, Dubliner Sir David McMurtry, owns more than a third of the company; his shares are worth approximately £460 million at the current price of £17.43 a share. It’s good to know that his interests are aligned with mine.

Another success driver is the company’s unswerving long-term focus on a set of core competencies, centred round metrology, the science of measurement. From this core competence, Renishaw has branched out, with an appropriate degree of caution, into specialised areas of healthcare and additive manufacturing, more colloquially known as 3-D printing.

The company eschews mergers and acquisitions, other than small bolt-on acquisitions aimed at enhancing its competencies in key areas. It prefers to grow organically. This is in tune with my own philosophy. I believe that organic growth is best, and that mergers and acquisitions generally fail to deliver long-term value for the acquiring company.

It also helps that the company’s strengths are in a specialised and obscure area of business, where there is likely to be less intense competition. It is said that, during the Californian gold rush, the only guaranteed winners were the merchants in the unglamorous business of selling picks and shovels - not the prospectors who used them. Renishaw is a modern-day equivalent of those merchants. Manufacturers of electronic consumer products, modern-day equivalents of the Californian prospectors, are among its biggest customers. Let them have their occasional bonanzas; I’m happy to stick with the company that generates a steady income.

The most important driver for Renishaw’s success to date, however, is the strength of its commitment to research and development (R&D). Year after year, through good times and bad, it invests around 15% of revenues in R&D. The chairman firmly believes that there is a strong correlation between the proportion of revenues invested in R&D and the rate of growth in profits. If he’s right, and I have no reason to doubt him, then my target return of inflation plus 6% per annum is safe.

Of course there are risks, lots of them: demand could fall, particularly in China; margins could be hit by competition; the supply chain could fail, causing the company to be unable to meet customer deliveries; R&D could be misdirected. My biggest concern is the need to ensure a successful transition of the management team to the next generation: the chairman and chief executive is 75; his deputy is 76; the finance director is 66. I love to see fellow senior citizens doing well, but we can have too much of a good thing. Nevertheless, I am confident that the board will be able to oversee a successful transition to a new management team when McMurtry and his colleagues at the top eventually decide to call it a day.

While I may reduce my holding slightly to keep my New Year’s resolution of reducing risk by diversifying my portfolio, I still believe that Renishaw will deliver the target long-term return.

Colm Fagan is an active private investor. He is a retired actuary and a non-executive director of a number of financial institutions.

Therefore with regard to the stock market the price the market places on a stock is most of the time wrong swinging from optimism to pessimism. At the moment the market is illiquid therefore if you sell you will probably not get the correct price for stocks you hold. But everyone is of the, opinion that stock markets will continue to fall so everyone seems to be selling in the hope that they can buy back in cheaper later. Even though by doing this they are already selling cheap.

I disagree profoundly with Eamon Porter's advice that ARFs should be 100% in equities.

Only investors (ARF or otherwise) with a very strong risk tolerance should ever be 100% in equities. Even where the person has the risk appetite I believe such a strategy really only suits people with long time horizons and who are making regular contributions.

Because ARFs are depleting, even if only at 5%, volatility consistently erodes their value - the effect is the opposite of 'pound cost averaging'. They are therefore unsuited for a fully equity strategy even where the investor is very risk tolerant - which most people are not, young or old.

Colm Fagan said:

. I believe that organic growth is best, and that mergers and acquisitions generally fail to deliver long-term value for the acquiring company.

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Hi Colm Nice piece, I 100 pc agree.
I think they are driven by among other things
1 executive egos
2 pressure to be seen "to do something " by market.
plus many more- any other thoughts?
mtk

Monksfield said:

Because ARFs are depleting, even if only at 5%, volatility consistently erodes their value

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I’m struggling to understand what you mean by this statement. Does it relate purely to ARFs that are invested in a unitised fund, where units must be cashed in order to generate the mandated “income”, or does the statement also hold true for ARFs that hold direct investments? As per an earlier posting, my experience to date has been that liquidity in the fund, from a combination of dividends and “normal” turnover of investments, has been sufficient to generate the required “income”, without having to cash investments. In that situation, volatility has only a marginal impact.

For what it's worth, I'm 100% with Eamon Porter and Brendan on the value of a high equity content in an ARF.

I think Monksfield is talking about “sequence of returns” risk - the idea that, even if short-term volatility averages out into favorable long-term returns, a pensioner could still be in trouble if the sequence of those returns are unfavorable. In other words, long-term returns over, say, 30 years don’t matter if the returns are so bad in the early years of retirement that a pensioner runs out of money before the good returns finally show up.

The sequence of returns doesn’t matter when there are no withdrawals from a pension pot, even when there is extreme volatility. For example, a €100,000 pension pot that experiences (total, real) returns of -50% and +100% in successive years finishes with the same balance as a pension pot that has returns of +100% and -50% in those years.

However, if a pensioner has to withdraw €50,000 from the pot at the end of Year 1, the sequence of returns is very relevant. With the “good” sequence of returns, the pension pot grows 100% from €100,000 to €200,000 and easily funds the €50,000 withdrawal and, after the 50% drop in Year 2, the pension pot finishes with €75,000. By contrast, with the “bad” sequence of returns, the pension pot falls 50% to €50,000 in Year 1, the €50,000 withdrawal completely depletes the pension pot down to zero and the subsequent 100% return in Year 2 is now irrelevant.

That's obviously a rather extreme example but hopefully it illustrates the concept.

Thanks for the explanation, Sarenco. I understand the theoretical point, but it’s of little or no consequence in the real world of direct investing (at least insofar as I have experienced it) for the reasons outlined in my earlier posting, i.e. dividends and normal turnover of investments usually mean that shares don’t have to be sold to satisfy the legislative requirement to take an "income" of 5% or whatever.

It's not really a question of liquidity - by "return" I'm referring to the total return (income and capital gains/losses), less costs and inflation.

Here's a link to a short note by BlackRock showing the impact of the sequence of returns on three hypothetical portfolios over a 25 year period.



Obviously if an investor has sufficient assets/flexibility to only ever need to withdraw from the income generated by a portfolio in a given year then the sequence of returns is largely irrelevant.

Sarenco said:

Here's a link to a short note by BlackRock showing the impact of the sequence of returns on three hypothetical portfolios over a 25 year period.



Obviously if an investor has sufficient assets/flexibility to only ever need to withdraw from the income generated by a portfolio in a given year then the sequence of returns is largely irrelevant.

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+1
Steady withdrawals over long term can impact more More than expected if early returns are bad even if returns even out over time.

The point about depleting funds and volatility is very, very basic. It concerns the mathematical interaction of market falls and rises on a fund which is depleting. A fund which is neither added to or suffers withdrawals gets the market return whatever the pattern of returns. In any pattern of returns which includes losses (as in, the real world) a depleting fund has a reduced amount to capture the next market lift. Take the actual quarterly or annual returns from any market you like and model the outcome for an invested value; then repeat it for one which is depleting - adding back the amount withdrawn, the outcome is always worse. The greater the amount being withdrawn, the bigger the loss of return. The sequence of returns can certainly exacerbate the problem.

The example quoted is based on the highly theoretical assumption of an investor having a single asset which doesn't pay a dividend, and which he/she cashes on a single date every year to provide an income. It bears no relationship to real-world investing, at least not to my experience of it. I had a quick look at my portfolio activity for last year. For every €100 worth of assets held at the start of year, I got a dividend income of €3 but generated further cash flow of €44 from share disposals, the vast bulk of which was reinvested to buy other shares. I understand that my turnover rate is actually below the average for professional investors.

It is obvious from these figures that the income requirement of €5 or whatever can be met without difficulty from normal cash flow within the fund, without ever having to consider forced sale of an asset when prices are depressed. It shows the ridiculousness of the theoretical construct from which the conclusion was derived. That is very, very basic.

Sorry, I shouldn't have added the final sentence to my previous comment, but I got the impression from a quick read of Monksfield’s post that he/she was talking down to me. I realise now that that probably wasn't the case.

Obviously, I’m well aware of the phenomenon of pound cost averaging, but I would like to see if the rule still holds true in the type of real-world situation I’m talking about. I realise that it would be difficult to model. My gut feeling is that it does not apply in the real world.

Ah the illusion of Dollar Cost Averaging. In the 1970's this was in the tool kit of every unit trust salesman. Made them sound very learned. It has long since been discredited by mainstream financial mathematics but still rears its head from time to time, these days mostly from life assurance salesmen.

The financial mathematical argument goes as follows. Let's say you have a simple model of the market. You expect it to grow by 5% per annum albeit with volatility. You are evaluating ex ante an investment scheme. Let's say the scheme is to invest 1 a year for 10 years. Well you expect the first 1 to earn 5% p.a. for 10 years. You expect the second to earn 5% for 9 years etc. Now we do not know at what price we will buy those units in year 2 etc. If the price is "high" we will buy less units and if the price is "low" we will by more units. DCA argues that this is a "beat the market" system in that the excess units bought on the low exceed the deficit units on the high. But ex ante and even at the point of investing in year 2 etc. our expected outcome is entirely unaffected by any supposed DCA "windfall", it remains 5% p.a.

The illusion arises from the following plausible illustration. The wiggles of a path from start to finish about a constant path tend to be geometrically symmetrical; the oft quoted example is the path that starts at $1 goes to $2 ($.5) in year 2 then to $.5 ($2)in year 3 and finishing back at $1. Yes indeed a basic mathematical inequality underpins the DCA assertion on these assumptions. But besides the fact that in reality this geometric symmetry is often not actually realised it still remains that this is a big "so what?". Put another way there is no such thing as an investment system/algorithm which of itself adds value. DCA argues that the very simple strategy of investing regular amounts adds such value.

I was certainly not talking Colm or anyone else down - just disagreeing profoundly with Eamon Porter and the 100% equity policy for ARFs. If you have a very strong risk appetite and enough in the ARF or outside it not to be concerned about running out of money, no problem - you will almost certainly maximise your return by going 100% equity. For the majority of people for whom the ARF is likely to have a huge bearing on their standard of living if they live long enough, the issues are very serious (and 100% equity is most unwise).

Colm seems to be losing sight of the underlying argument in referring to the income generated meeting withdrawals. The analysis does not differentiate between capital and income: income is part of the return. The fact is that if money is being taken out of a fund regularly, the pot of money is systematically deprived of return by the volatility of the returns it experiences.It is just how the mathematics works, not a philosophical argument.