One of the most consistent findings of behavioural finance research is that most of us think about our property, pension and investments as distinct areas of concern, instead of seeing them as facets of a bigger picture.
One of the most consistent findings of behavioural finance research is that most of us think about our property, pension and investments as distinct areas of concern, instead of seeing them as facets of a bigger picture. The result of such narrow-mindedness is higher stress levels and, often, sub-optimal decision-making.
The great bear market is a case in point. From 2001-2003 the stock market fell by roughly 50 per cent, since when it has bounced back fairly strongly.
Yet for anyone who held a well-balanced portfolio of assets, including some cash, a slug of bonds and a big chunk of property, the three-year bear market should not have been a cause for anxiety, especially if they took advantage of the blatant overvaluation of shares in 1999-2000 to lighten their equity holdings in favour of other asset classes.
On an aggregate basis, anyone in such a position should still be better off than they were before. The gains on their cash, bonds and property have balanced their losses on equities. This is as finance theory tells us it should be. A well-diversified portfolio with several different types of asset in it can be expected to withstand most periods of market disruption in any single asset class. For those who look regularly at their overall asset allocation, there is almost invariably a more "efficient" portfolio of assets than the one they hold at the moment.
What the theorists mean is that for any given level of risk you can usually find a mix of assets that offers you a higher rate of return than the one you have. This insight is simply a function of the common sense fact that mixing assets with very different risk and return characteristics must produce a more stable, less volatile outcome when combined in one portfolio.
The real tragedy of some recent financial scandals is not just that hapless investors were persuaded to put their money into unsuitable products such as precipice bonds, but that they were persuaded to commit such a large part of their overall wealth to such dangerous products. In a well-managed portfolio, no single type of investment should become a life-threatening proportion of the total.
The corollary of all this is that it threatens to make investment rather dull. The investor with an efficient, balanced portfolio sleeps easily at night, but is never going to achieve the returns that could have been had by investing in the best performing asset class of the day.
Quite how boring this all can be can be illustrated by looking at the performance of the private investor benchmarks produced jointly by FTSE and the Association of Private Client and Investment Managers. These indices provide a measure of the performance achieved by a representative sample of three different types of asset mix, for which the shorthand labels are income, growth and balanced.
This can be used as a reality check to see how your own financial progress compares to the market's performance. The current weightings are: income - 50 per cent UK equities, 5 per cent international equities, 40 per cent bonds, and 5 per cent cash; growth - 60 per cent, 25 per cent, 10 per cent and 5 per cent respectively; and balanced - 55 per cent, 20 per cent, 20 per cent and 5 per cent.
The year-by-year performance of the different types of fund are shown in the table. One series shows the changes in capital value of the benchmark indices. The second shows the total return, ie assuming that income is reinvested. The final column shows the cumulative change over the period the series has been running, which is since January 1998. The six and a half year period therefore includes the last phase of the great bull market in shares, the subsequent bear market and the recent faltering recovery.
This has been an exciting period for financial markets, and this is reflected in the year-by-year changes in the value of the indices. But the most striking feature is how dull the overall performance has been. The compound annual rates of return over the period, work out at 2.3 per cent for the growth fund index, 2.5 per cent for the balanced fund and 3.1 per cent for the income fund. The cumulative total returns are 17 per cent, 19 per cent and 24 per cent.
The other interesting feature is the relative difference overall styles have made to investors' returns. The growth fund index has been more volatile, rising to a higher peak in mid-2000, and falling to a lower low in March 2003 than either of the other two. At the lowest point last year, the balanced fund total return index was 8.7 per cent below its starting value in January 1998, whereas the growth fund index was 13.5 per cent lower. The income fund index never fell below its starting point. It also has the highest total return over the whole period. In part this merely reflects the composition of the indices and its much higher weighting in bonds.
These figures exclude direct ownership of property, which will have boosted most people's overall wealth considerably, but it would be interesting to know how people's financial assets have compared overall with these figures. A bit more diversification would have improved performance.
The professionals seem to agree that we could be in for a lengthy period when investment returns remain relatively low, which suggests that the search for more exciting alternatives will not diminish, with - alas - predictable consequences. For most people, one suspects, it is better to be dull than damaged.Reuse content