Secrets of Success: Balancing the portfolio is a forgotten art

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The Independent Online

Although sales of individual savings accounts (ISAs) and funds in general have fallen off a cliff in the past couple of years, there are still benefits to be had from using the annual allowances, not least the freedom to avoid having to account to the Inland Revenue for all your investment income and capital gains.

Although sales of individual savings accounts (ISAs) and funds in general have fallen off a cliff in the past couple of years, there are still benefits to be had from using the annual allowances, not least the freedom to avoid having to account to the Inland Revenue for all your investment income and capital gains. Gordon Brown's decision to extend the ISA season until at least 2010 is therefore a welcome one.

As the PEP/ISA regime now dates back many years, for most investors the most important decision they face each year is not which new fund to buy, but whether - and if so, how - they adjust the balance of the portfolio they already hold within the tax-free wrappers.

It would be nice to think that most ISA holders regularly rebalance their portfolios each year so as to maintain a given asset allocation after the changes produced by the previous year's movement in market values. Somehow I doubt that this happens very much.

Certainly finding references to rebalancing in either the media or in fund literature is like looking for needles in a haystack. True, the sales figures for unit trusts, OEICs and investment trusts show that it is not gross sales that have fallen so sharply recently, but net sales - ie, after taking account of redemptions or sales of existing holdings.

Rather than rebalancing, investors are mostly liquidating chunks of existing holdings, either because of disillusionment with recent performance, or because of a desire to realise cash, repay borrowings or reduce their risk in a climate of rising interest rates.

This may explain the unfortunate paradox that retail investors continue, in aggregate, to do the opposite of what subsequent market performance suggests is their optimal approach. Thus, the biggest falls in sales of equity funds have taken place since the stock market started to recover two years ago, just as they peaked shortly before the bubble burst.

Sales of corporate bonds have meanwhile risen dramatically ahead of what almost certainly will be a long, painful shake-out in that increasingly high-risk arena. (Not only are interest rates rising, but yield differential between corporate and government bonds had, until 10 days ago, fallen to historically unsustainable levels).

Despite the best efforts of regulators and the financial press, many investors, in practice, still seem to be buying what has worked well in the recent past, and passing over what is most likely to work well in the most relevant future time frame they face.

For most of us, that relevant time frame can be measured as five to 10 years, or even longer, which implies that it is largely irrelevant which funds you think will do best in the next 12 to 24 months. Yet, as far as I can see, despite the FSA's sensible attempts to make fund advertisements more informative, this is still not the way that most funds are being marketed.

My guidelines for any last-minute ISA buyers this year are: (1) Look at your overall asset allocation first - is it still appropriate for your risk tolerance and investment objectives? (2) Avoid like the plague "structured products" (eg, investment bonds that pay out so much if X happens to the stock market, and some different amount if Y happens) - at best they are expensive insurance, at worst a potential recipe for disappointment or loss. (3) Think carefully before buying the best recent performers among funds, unless you have more sophisticated grounds for doing so than mere headline numbers.

Seeing how funds perform during different market cycles is important. Most funds have a distinctive style or approach that can be expected to do well in certain market conditions, and less well in others. It is worth asking your adviser, for example, to tell you how well your proposed new fund fared (a) between March 1995 and March 2000 (the bull market); (b) between March 2000 and March 2003 (the bear market); and (c) from March 2003 to March 2005 (the rally).

The results can be illuminating - many of the best performing funds of the past two years, for example, did very well in the final 12 months of the bull market, but underperformed badly before that, and again during the bear market phase. You also need to know whether the fund is biased towards small and midcap stocks, or has a value or growth approach, and how closely its performance tracks the stock market as a whole (if the answer to the last question is "closely", an index fund is likely to be a better bet).

Finally, I find it useful to look at the risk-adjusted returns of the fund in question and, if forced to choose between two funds, buy the one managed by someone with experience of several market cycles rather than a new kid on the block. (Having said that, the list of top-performing funds will always include several funds run by youngsters who haven't yet found out whether success is the result of luck or skill. Anyone who watches the big poker games on satellite TV, which pitch professionals against amateur poker players, will be familiar with the phenomenon).

As far as asset allocation is concerned, from a medium-term perspective (not necessarily the next 12 months), within equities the safest bet is to be overweight in commodities and natural resources, underweight in property and the financial sector, and mildly biased towards large cap stocks.

Among sectors, it won't be long before technology finally starts to revive, so I am looking to increase my exposure in that area. Corporate bonds are, however, a disaster waiting to happen at today's prices, so in my view they should be a reducing part of your portfolio.

jd@intelligent-investor.co.uk

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