Here we are at session number 41 , and we’re going to be talking about building an investment portfolio. We’ve talked about Platform Wrappers and Funds back in Session 11, we had an intro to the different asset classes in Session 10 and even had some hints from the master, Justin Urquhart Stewart way back in Session 6.

But I’ve been asked several times to do a session on putting together a portfolio from scratch, so this time, that’s what we’re going to be discussing. I’ve been looking forward to this one.

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Remember that after the main content I’ll be announcing the topic for the next session and letting you know who you can get in touch.

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But first…

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Introduction

Assuming you have paid off all your debt and got an emergency fund in place, you have built your foundation. You’re now ready to start building towards your financial future. This is an exciting time. You have a blank sheet of paper on which to lay out your blueprint for achieving your future goals and aspirations.

You have money available every month to begin investing. Or maybe you have been given, or inherited some money from a relative and need to find a home for it.

You need to know some important things before you start and then you need to know what to do to get going.

I’ll add a rider here: there are plenty of ways to skin a cat; lots of ways to put together an investment portfolio from scratch. This is what I would do if I was starting from scratch. You may disagree. Plenty of people brighter than me may disagree. But this is what I would do, and it’s my show, so that’s what you’ll get!

If you do have questions or comments, then leave them in the comments section [below] so we can begin a dialogue.

So, let's deal with everything you need to know about building a portfolio from scratch:

Everything you need to KNOW

1 – Asset Allocation is paramount

Your grandmother, and her grandmother before her would always say that you should never put your eggs in one basket. It’s basic common sense and applies to many different situations, and especially so when you’re committing money to your baskets.

When investing, the baskets are individual assets, asset classes, countries, fund houses and all sorts. That’s lots of baskets to be aware of.

Spreading the money around is the simplest and most obvious way to reduce the risk of any portfolio. If you invest across the whole world and, say, Italian markets have a bad day, maybe the Australian do OK and one offsets the other. You reduce risk by investing in things which do not correlate very well together.

Correlation is the degree to which two things behave like each other. So let’s say you have shares in an ice cream company and an umbrella company. If it’s going to be a long hot summer, shares in the ice cream company will do well, and the umbrella company shares, not so much. But if the forecast is for a summer of rain, then the opposite is true.

Now, if you have the same amount of money in each, and one goes up and the other down by the same amount, then you’re in a neutral position. But that’s no good, you’re investing to make money not preserve it.

Equal holdings might be a neutral position – we call that a strategic view. But you’re going to have an inkling of what the weather might do. You’ll watch the forecast and if it looks like it’s going to be dry, you might switch more of your money into ice cream shares. You’ll still hold some umbrella shares in case the forecast is wrong, to give you some protection if the ice cream shares drop. This is called a tactical view – a short term view.

Strategic = long term, neutral view

Tactical = short term, opportunist view.

Obviously, no-one has a strategic, long term view to make no money. Even your strategic asset allocation is designed to make you money over the long term, and a tactical view is designed to take advantage of short-term opportunities as they arise.

There have been many studies about the influence that Asset Allocation has on various aspects of the performance of a given portfolio. One famous study by Ibbotson, showed that Asset Allocation – how much you invest in what – contributed to 91% of the range of returns of any given portfolio.

In other words, choosing the right stocks, timing the investment right and other factors were irrelevant in determining how well or how poorly a portfolio did. Instead it was the Asset Allocation which was the biggest factor. Get it right and it’ll do the business of you. Get it wrong and you’re sunk.

You want to buy  lots of different asset classes in different geographical regions around the world which behave differently to each other. You want to invest in such a way that your Asset Allocation works for you and behaves as expected. It should reflect your ethical preferences and timescales. And your Asset Allocation should match your attitude towards, and tolerance for investment risk.

Which leads us nicely on to…

2 – Risk: Know your limits

No-one wants to lose money, but the old adage that you have to speculate to accumulate isn’t far wrong. You’ll never get rich by hoarding money under your mattress. Another word for speculation is risk-taking. Maybe that’s two words, but at least they’re hyphenated.

Investing is always a risk. You might buy shares and the company goes bust and you lose everything. Or you might buy the same shares, and the company has a bad year and the price of the shares goes down by 10%, so you have lost 10% of your money. Or those same shares might go up and you have gained.

Obviously everyone likes the idea of making money, but are you prepared for your invested money to go down? If so, by how much?

When are you going to start to panic? When the value of your money goes down by 5%? 10%? 25%? 50%?

But what if it goes down by 10% and then goes up by 50%?

These are huge questions and are easy, sometimes, to answer in the abstract, when there’s no real money on the table. But if granny has left you £10,000 and you invest it, and it becomes £8,000 are you going to be hearing granny’s voice from beyond the grave, panic and pull it all out?

There are other risks of course, not just risk of loss due to market fluctuations. I covered lots more about risk in session 16, so listen back to that for more detail.

Knowing your risk tolerance is really difficult if you’re a novice investor. It comes with experience mostly. It is also affected by the size of the possible risk relative to your total wealth. Someone with half a million might be prepared to lose £10,000. But if they only had £10,000 in the world, they probably wouldn’t risk it to the same degree.

There are online risk calculators from all sorts of sources which will try to pigeonhole into a risk profile, and these are fine as far as they go. But measuring a client’s tolerance for and attitude towards risk is one of the most important parts of an advises job, and even now after 15 years in the job, it’s an inexact science.

Give this some thought before you invest for the first time.

3 – Benchmarks are for losers

When I speak to clients, we often talk about the returns they are expecting. It’s an interesting conversation because most people have no idea, understandably.

If you’re buying an investment fund, the literature will talk about it’s performance relative to other funds in its sector – its peer funds. A fund that is in the top quartile is in the top 25% of funds, so better than at least three quarters of all the funds in its sector (A sector will be made up of funds that invest similarly).

A benchmark is a desired return. It can be expressed in absolute terms, for example 6% growth in the value of your money per year. Or it can be expressed relatively, so you might want to exceed the return of the FTSE All Share index by 3%.

Benchmarks give you something to measure the performance of your portfolio by.

Here’s my thesis: Benchmarks are for losers.

Here’s why: Most benchmarks are arbitrary. What is the point of measuring the performance of your portfolio against an index? Or what is the point of being in the top 25% of similar funds?

The only benchmark that matters is the return you need to achieve your goals. End of story. I’ve talked in other sessions about investing for a purpose. Maybe that purpose is to have enough to put your kids through university, or to get married or extend the house, or to retire. Ideally, you want to put a number on the amount of money you would like to have, and by when.

If you know:

A) your starting amount,

B) your end date,

C) how much you can put away along the way,

…then you can work out what return you need to get there. It’s pretty simple maths, even when you take inflation into account.

Take that figure and if it’s 10% a year, then it’s probably unrealistic. Or it might be possible but along the way you’re going to have a rocky ride. If you need 10% a year and you’re the kind of person who doesn’t like taking any risk, then it isn’t going to work out well.

I’ll say it again: the only benchmark that matters, the only target you need to set for your investments, is the rate of return you need to get where you want to be in the timescale you have.

You’ll need to give this some thought too. Hopefully I’m not freaking you out too much with all this thinking, but this is your hard-earned (or hard-inherited!) cash, and you want to get this right, right?!

4 – Costs are a killer

It might seem like stating the obvious, but every pound you spend on charges, is a pound which can’t grow for your future.

Putting it another way, if you need to get a 6% return, and you’re paying 2% in charges, then your portfolio actually needs to grow by 8% to cover the costs and give you the return you need.

Add inflation in to the mix and you can see that every penny saved in costs is important. It’s the one thing you can do something about. You can’t control how well or badly the markets perform. You can’t control whether your fund manager makes good decisions or not, and you certainly can’t control inflation. The only variable you can affect is the cost of your portfolio, so it makes sense to keep that to a minimum.

Remember the power of compounding from session 23 [LINK] – one of the golden rules for personal finance success? It works for you by adding interest onto interest, growth onto growth making your portfolio snowball as time goes on. It can also work against you. £100 spent on charges in year one will miss out on growth in years 2 – 30. If the portfolio grows at 6% and it’s invested for 30 years, your £100 could have become £541, a five-fold increase and more, but it won’t because it is in the fund manager’s or financial adviser’s pocket instead.

Remember also that you are a retail investor, which means you pay full price for everything. Institutional investors with their billions of pounds worth of buying power, pay a fraction of the cost for investments compared to you. Think of it like the supermarkets. You pay whatever price they want to charge you for the bottle of milk you want. But the supermarkets have the power to screw down the farmers to the very lowest price possible, often at the expense of farmers’ livelihoods…

Keep an eye on costs. It is easy to lose track when you’re not physically shelling out cash but instead selling units in a fund to pay the fees. But it’s your money all the same – watch where it goes.

5 – You are your own worst enemy

You’ve done some daft things in your life right? I know I have. There was the time I knocked the door of a girl I fancied to give her flowers on Valentine’s night and then ran off so she wouldn’t know who it was. Not too bad, you’re thinking, but she was there with her boyfriend and I knew it. I was found out, I ruined their evening – not exactly my finest hour. I should have just sent them by Interflora.

But this is about money, not girls. It probably doesn’t come as news to you that you’re not a machine. You are an emotional, organic being who makes decisions, sometimes in the heat of the moment, and sometimes (often?) you make bad decisions.

There are few subjects more emotive than money, and this emotion can lead to some stupid decisions. And yet investors make them all the time.

The biggest mistake of them all though, is bailing out at the wrong time. When is the wrong time? I have absolutely no idea. And neither have you. Trying to time the market is like trying to guess the lottery numbers – a completely fruitless exercise.

To give you an idea of how big a deal this is, a report from an investment platform in March this year looked at the returns gained if you had invested in FTSE100 shares over the ten years to the end of March 2013. If you had stayed fully invested for the full ten years, you would have returned 120.7%. Not too shabby.

But if you had missed just the ten best days out of the 2,500 or so investing days over the ten years, your return would have been just 35.3%. If you had missed the 20 best days, you would have lost 12.8% over the ten years.

You cannot time the market, but people try to do it thinking they are smart, and they do it out of fear when markets are plummeting.

Don’t do it, however much you want to.

6 – You have no idea what you are doing

Hopefully you’ve gathered by now that there is a lot to this investing lark. There are a million variables, from inflation to individual stock performance, macro-economic factors and geo-political ones. And even if everything goes swimmingly, you’ll probably make a bad decision somewhere along the line which will undermine things.

Neither you or I can ever begin to have a handle on all of these variables, or hope to keep our emotions in check 100% of the time.

There are something like 2,500 retail investment funds available in the UK alone. And many more that you can’t get access to because you don’t have enough money. Some institutional funds will require a minimum investment of £500,000 up to £10,000,000 or more. Then there are the individual stocks and bonds to choose from, as well as hedge funds, private equity funds, REITs and a hundreds of thousands of others. And imagine how many more opportunities lie in foreign markets.

You probably don’t possess the skills, time or resources to identify trends, spot anomalies and move accordingly. Fund managers have teams of analysts doing this stuff, and they get it wrong most of the time. Yes, most of the time.

You don’t have the ability to trade quickly enough in this lightning-fast, computerised world where Twitter breaks the news an hour before the news networks do. By the time you have thought about a financial move you want to make and placed the instructions, the markets have moved and you’re too late. And it probably would have been the wrong move anyway.

 Summarise KNOW

Are you getting it yet?! You cannot run money effectively, no matter how much you think you can. Sorry to burst your bubble. I know I can’t manage money, which is why I don’t do it at Jacksons. Many advisers think they can, but I don’t agree. Maybe they know something I don’t, but I doubt it.

Remember the six things to frame the next section:

1 – Asset Allocation is paramount

2 – Risk: Know your limits

3 – Benchmarks are for losers

4 – Costs are a killer

5 – You are your own worst enemy

6 – You have no idea what you are doing

I imagine that you are pumped up now, ready to dive in and get going with your investing. No? Thought not.

But fear not, it is still worth putting money away for the future, and you can do it right – here’s everything you need to DO when you’re starting out:

Everything you need to DO 

1 – Opt for passive investments

Active investing means that someone, usually a fund manager, is making decisions about what stocks and shares to buy and sell at any given moment. That person seeks to add value to your investment by making good decisions.

Passive investing says that if you want to invest, say, in FTSE100 shares, you should buy all the shares in the FTSE100, in the right weights, and track the market up and down. This tracking can be done by computer for the most part, and if there are no fund managers with 7-figure bonuses to pay, your fund charges are much cheaper.

There is research in favour of and against both active and passive investing. Each side has its zealots, who are generally very dull people, best avoided.

It is clear to me though that the vast majority – some would say three in four – active fund managers under perform the market they are trying to beat. That’s fine. If you can pick the one in four who is outperforming at that moment then you’re golden. But I don’t reckon you can do that consistently. Plus, managers move around from one job to the next. Is it the manager who is making great decisions, or the team of analysts behind her? If she moves from one company to another, the analysts will stay where they are and their decisions will presumably be enacted by the new manager.

It sounds like hard work to me. Finding the managers in the minority who outperform, and then keeping tabs on them.

I’d rather opt for a tracking method, which keeps the costs down – very important and still gives me access to the market, which is the driver behind any growth or losses anyway.

Trackers come in many different flavours, which I’ll need to expand on in a future session. Look for words like tracker, index, and Exchange Traded Funds or ETFs.

2 – Start with a broad-based, multi-asset fund

Assuming you are starting out investing, you should build a foundation of a broadly spread, multi-asset fund. This will do the bulk of the work for you in the early years. Look for a fund which invests in markets across the world, and into different types of asset, likes share, bonds, property etc. You definitely want to stay away from buying individual shares – this is a mug’s game for the most part.

The types of funds I suggest you look for are often marketed as risk-based portfolios, so will carry names like Balanced, Moderately Cautious, Defensive or Adventurous. Pick one which suits your understanding of the level of risk you are prepared to take.

Find one with some track history. We all know the caveats that are peppered all over these things: Past performance is no guide to future performance etc. That is all true, but you should be able to see how much the fund has gone up and down by. Do some homework into how the markets have behaved in the last ten years – has the fund you’re looking at coped well with the volatility of recent times?

Some of these funds use passive holdings underneath, but the asset allocation is managed. This is an important distinction from full active funds. Remember the importance of asset allocation? What if you had an expert doing that, but the underlying assets held in the fund were trackers? That’s perfection for me. This is how I am building my pension. I don’t want to manage it, but I recognise the importance of asset allocation and I want that managed to an adventurous risk profile. But I don’t want to pay unnecessary charges, so I have found a fund which is invested in passives underneath.

No, I can’t tell you which one it is. I’d be breaking about a million rules if I did because it would border on advice – you’ll have to do your own homework I’m afraid.

This broad-based fund will serve as the core of your wealth-building strategy. It should do you well for the long term.

3 – Harness the combined power of compounding and pound cost averaging

Compounding, as I mentioned earlier, is where your money grows like a snowball, with money added to money added to money as time goes on.

Think of it like this. If you have £100 at 10% interest, at the end of the year you will have £110. At the end of the second year, you won’t have £120, you’ll have £121. The £10 interest you earned in year one has had interest paid on IT in year 2. IN year three you get interest added to your original £100, plus the £21 interest earned in the first two years and so it begins to grow.

When you’re investing, the investments you hold will throw off income of some kind in the form of dividends usually, but sometimes interest. It might not be much, but you should roll it up into the investment and buy more units or shares in your portfolio with the income. You will be amazed at the differs this makes:

Investing in the FTSE All Share between 1986 and 2007, you would have had a return of over 1000% if you had reinvested the dividends, and ‘only’ 400% if you had taken the income out. That’s fine unless you need the income, in which case you may want to invest differently. In fact, I’ll add that to the pipeline as a subject for a future session of the podcast, because it’ll be useful.

Compounding your returns in this way is a key driver of growth so make sure you use it.

Pound cost averaging is the process of buying units in an investment at different prices over time. Here’s an example.

You have £100 per month to invest. IN month one the units in your chosen fund are £1 each, so you buy 100 units.

In month 2, the units have slumped in price to 50p, so this month, your £100 buys you 200 units.

In month 3, there’s a fantastic surge in prices and your units are now worth 32 each, so your £100 only buys you 50 units.

At the end of three months, you have bought 350 units, at three different prices.

Obviously this is exaggerated for effect and clarity, but the effect is that you reduce the risk of your investment by smoothing the returns. When the market goes down, the batches of units you bought at lower prices will suffer less than the ones you bought at the top end, and vice versa, when things go up, You have more units to take advantage of the rise.

And so your performance curve snakes through the middle of the ups and downs – exactly what you want it to do.

These two techniques will help you maximise the growth and reduce the relative risk of your portfolio – use them.

4 – Don’t watch your portfolio too closely

Investing is a long term game, generally. If you are putting money away for a short-term need, like a new car or a holiday, you shouldn’t be investing it – put in the bank and keep it safe.

But if you are truly wanting to invest for the long term, say 10, 20 or 40 years, what does it matter if the value drops by 5% this year? Or 10%? Watching the value of your investment too often is a sure fire way to put yourself in an early grave. It is no fun when things go down, so why put yourself through it.

If you buy into the science that, over the long term, the asset allocation will do its job and ride the market cycles, then why watch the ride too closely?

I have fired clients when they decide to log into their portfolio every day and call me whenever it goes down. There’s nothing you or I can do about market movements, so why worry?

Now, if you are approaching the time when you might need the money, say you’re getting close to retirement, then you should be revisiting the portfolio and reducing the risk accordingly. There are plenty of horror stories about people getting to retirement and markets take a tumble. They are shocked to find their pension is 30% less than was ‘promised’ by their adviser.

Your adviser should be keeping in touch regularly to review things and check if your circumstances have changed. But this is about DIY investing. Do yourself a favour and check in at most once a month.

You may want to take an interest if you feel that world events are getting really serious like they did in 2008/9. But even then, if you have decided that you can cope with a certain level of volatility in the value of your money, then hold your nerve and stick to your guns. I’m proud to say that every one of my clients did that during the credit crunch and great recession of the last few years. Not one of them have regretted doing so because they are all significantly better off now as a result. I had to do some convincing in some cases, but they thank me now.

5 – Experiment with satellites

Once you have a reasonable size portfolio – I’m can’t tell you how much ‘reasonable’ is – you might want to experiment a bit with some different types of investment. So for instance, I get clients call me sometimes and ask me to move £5,000 or so into some fund or share that they have read about in the paper that weekend. That’s fine, and can make investing fun, as long as you remember:

• Don’t risk more than you can afford to lose
• Keep the satellites funds as a small percentage of the whole portfolio, let the core do the heavy lifting
• Still watch the costs

This is probably further down the road than many people are ready for. I’m not doing this yet; I’m still building my core to a level I’m comfortable with. I don’t reckon I’ll be experimenting for at least another ten years. (I’m 38).

Remember those three rules and have some fun if you must, but guard against thinking you’re a star portfolio manager if you make a couple of good calls. It won’t last. Let the asset allocation of the core do the work for you.

6 – Use your tax allowances

There is no need to pay more tax than is necessary. So use ISAs to shelter your investments, and use pensions as well if relevant for you. Watch video episode 222 [LINK] for a bit of an insight into the question of pensions vs ISAs.

Just make sure you use the allowances that are there for you.

Summary

So that’s how I would build a portfolio from scratch:

1. Opt for passive investments
2. Start with a worldwide, multi-asset fund which matches your risk profile
3. Harness the combined power of compounding and pound-cost averaging
4. Don’t watch your portfolio value too closely
5. Experiment with satellites as your portfolio builds
6. Use your tax allowances

That, folks is the boring, uninspiring way I suggest you  make money. If you want a racy, up and down kind of ride, you will not like this. But if you want to get where you want to go with as little excitement as possible, but stand a better chance of getting there at all, then this will serve you well.

I wonder what you think of all this? I’d love to hear your comments. Maybe you think I’m an idiot, or a genius – I’d love to hear both views. I can take it.

Leave a comment below or leave me a voicemail at meaningfulmoney.tv/feedback

This week’s reviews

No reviews this week, which is probably a good thing as we’ve gone on long enough already!

Next Session Announcement

Next time we'll be talking about some Financial New Year’s Resolutions – how very original. It took me ages to come up with that! If you ahem any questions about that, leave me a voicemail: meaningfulmoney.tv/feedback.

This is the last session of the podcast until the 8^th January – I’m giving myself two whole weeks off, which will be lovely.

I’d like to wish you all a very Merry Christmas; I hope it is happy and blessed and that you enjoy good health and quality time with your loved ones.

2013 will always be the year that this podcast really took off, and you have made that possible. Thank you for giving me your time each week; I really, really appreciate it. Please tell everyone you know about the show, and leave me a review at meaningfulmoney.tv/iTunes if you haven’t already.

Outro

I hope you enjoyed this session as much I enjoyed preparing  and delivering it.

Thanks for listening – I'll talk to you next time