The aim of savers should be to maximise the real returns on their savings - returns stripped of inflation.
If the nominal value of your savings has doubled and inflation has tripled, you are actually a lot worse off. Hence throughout this article I will be referring to real values and returns. All equity returns which I quote include reinvested dividends, net of basic rate tax.
There are three critical decisions which investors must make:
Firstly they must decide whether they are long-term or short-term investors. The shorter the investment term, the greater is the risk. The riskiest form of investing is day-trading and nearly all private investors who try this lose money. As most of us are on the planet for the long term and have to cater for long-term needs, we should be investing for the long term (10 years plus). There is no need to take unnecessary risks.
Secondly investors must choose the asset or assets in which to invest. For UK investors, assets denominated in foreign currency carry an additional element of risk ? exchange rate risk ? and so these will not be the focus of this article. As regards UK securitised assets, equities historically have provided the best long-term returns (20 years +) and are likely to form a significant proportion of long-term UK investment portfolios.
Consequently in this article I focus on long-term UK equity investment.
Investment management responsibility
Thirdly investors must decide who is going to manage their investments. Should they outsource this vital task to commercial third parties or should they manage their own investments? Savers who rely on commercial fund management suffer the double whammy of high costs and poor investment performance.
For long-term savers these twin evils can have a devastating effect on savings values:
a) High costs
First let?s look at costs. A typical actively-managed unit trust will levy a 5 per cent initial charge and then annual charges (explicit and non-explicit) of at least 1.8 per cent p.a..
Ignoring investment gains, over 45 years these charges will reduce a £1000 investment to just change £420. And any investment gains will also be savaged by these costs.
By contrast, one simple self-managed strategy which I describe in this article, has annual charges averaging just 0.3 per cent p.a. With these low costs, again ignoring investment gains, £874 of the original £1000 is retained after 45 years i.e. over double the amount from the unit trust.
b) Poor investment performance
Now let?s look at the long-term investment performance of commercial funds.
Must stack up: Looking for gains over the long-term is key
Sparkling short-term investment performance means nothing if it is reversed over the long-term. The longest period for which comparative fund performance is available is 10 years. Over the 10 years to the end of September 2011, the median performing UK large-cap equity fund produced an annual real return of just 0.6 per cent.
Why not choose instead a top-performing UK equity fund? The problem is that hardly any funds have long-term track records of consistent top performance and, of those few that do, there is no guarantee of top performance in the future.
Anthony Bolton, who used to manage the legendary Fidelity Special Situations Fund, has just had to apologise for the dire performance of the Fidelity China Special Situations investment Trust which he now manages. Furthermore, one of Bolton?s successors at the Special Situations Fund has just left because of poor investment performance.
Because of the high costs and poor performance of commercial funds, investors who are prepared to devote some time to managing their own investments are likely to reap large rewards.
The best approach for managing your own UK equity funds
The best approach on a long-term basis is to use a technique known as value investing ? buying shares when they are cheap and making profits when the prices increase.
This technique is the creed of the world?s most successful value investor, Warren Buffett. Value investors look for fundamental factors to indicate whether a share or index is cheap ? for example the dividend, dividend yield, the multiple of earnings to the dividend (dividend cover) and the prospects for earnings growth.
Value investing is the only systematic investment technique which has been proven through research to outperform the market over the long-term. You can find this evidence in, for example, 'Selecting Shares that Perform' (Koch and Gough). Value investing is for long-term investors, as it sometimes takes several years for value to be reflected in market price.
In my new book 'How to value shares and outperform the market' I describe a system for valuing the FTSE100 and a relatively low-risk strategy for investing in it when it is cheap, and switching the investment to cash when the price becomes dear. The strategy reduces risk compared with remaining passively invested in a FTSE100 tracker, as the fund will be invested in cash when the FTSE100 price is expensive and therefore most likely to fall.
From the start of the FTSE100 in 1984 to the end of 2010 this strategy has delivered a real return, net of costs, of 6.3 per cent p.a. Costs are kept low by investing in the FTSE100 via a low-cost FTSE100 exchange traded fund (ETF). There is no management fee for the time the fund is invested in cash (approximately half the time).
'The Little Book that Beats the Market' (Greenblatt) has a higher-risk, higher-return value investing system for running a share portfolio. The track record is very strong. My book also includes a high-risk, high-return strategy for investing in the FTSE100 as well as a system for valuing shares and running a share portfolio.
For long-term investors, even a small increase in annual return can produce a huge increase in the long-term value of their investments.
The best way of illustrating this point is to look at the extra return achieved by the self-managed FTSE100/Cash strategy over the 0.6 per cent return achieved by the median commercial UK large cap fund for the decade ending 30 September 2011. The real compound annual return of the FTSE100/cash fund for this period was 3.45 per cent - over 5 times as large as that of the median commercial fund. The extra 2.85 per cent annual return of this fund splits into 1.5 per cent extra due to lower fund management costs and 1.35 per cent extra due to better underlying investment performance. The burden of high fund management costs makes it is as difficult for commercial funds to outperform their benchmark index consistently as it is to win the marathon carrying a bag of cement.
A 2.85 per cent extra annual return may not sound large but it means that, after 45 years, a lump sum investment will be worth over three and a half times as much as if it had been entrusted to the median commercial fund. As for regular saving, a 20-year old self-managing investor who saves £2500 each year for a pension at age 65 will build up a pension pot of £270,000 through achieving the 3.45 per cent real return instead of £130,000 from the commercial fund return.
At pension age the traditional commercial route is to purchase an annuity with the accumulated pension pot. Because of the high management costs and the commission payable to intermediaries, the best-value single-life annuity for a 65-year old male in normal health currently delivers a negative real return of 2.6 per cent p.a.. Assuming, by the time the 20-year old reaches 65, the remaining life expectancy of a 65-year old male has increased to 25 years, this return would produce from the £130,000 pot a pension of just £3,600 p.a.
By contrast, if instead of buying a high-cost annuity, the investor self-managed his pot of £270,000 and enjoyed the same real annual return of 3.45 per cent, he would enjoy a pension of £16,300, four and a half times as much as through the commercial route ? a vast and life-changing difference. The last decade has seen low returns for UK equity investment. If real UK equity returns revert to their long-term level, the differences in personal wealth between managing your own investments and relying on commercial managers could be even greater.
Glenn Martin worked in financial institutions for 34 years. In 1994 he developed a system for calculating the intrinsic value of the FTSE 100 and of individual UK shares. He went on to develop software for the system, ShareMaestro, and now writes about investment.
His latest book, 'How to Value Shares and Outperform the Market' is out now.