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Private lessons

I am a private investor about to start a new portfolio. My golf club pals have told me that there are many pitfalls to watch out for. What in particular should I be aware of?

Private investors frequently lose large amounts of money by making bad decisions.

When buying household items such as washing machines, it is reasonable to research the market for suitable products. There are publications which provide details of specification and performance which you can reasonably rely on when deciding what to buy.

This is because if the product has performed in a particular way in the past, you can reasonably expect it to do so for you. Unfortunately, nothing could be further from the truth when it comes to investments.

The list of potential pitfalls is immense. However, here is a brief summary of some of the more common mistakes.

First, relying on past performance. As you will have gathered, using the same buying method as for household items is a bad idea. There is very little evidence that raw past performance data is any indicator of future investment returns. For this reason, you should also ignore all the glossy ads as they will tell you nothing that is useful.

There are two main types of investment approach that you can adopt – active or passive. Active fund managers try to achieve outperformance by selecting stocks which they believe will outperform the market or by timing the sale and purchase of stocks.

Passive managers simply buy the market or segments of it but do not make stock selection or market timing decisions. Active fund managers tend to charge more than passive fund managers in return for the extra value that they are supposed to be providing.

Research into the drivers for fund performance has indicated that, with some limited exceptions, stock selection and market timing make very little contribution. It will therefore come as no surprise that the vast majority of active managers fail to outperform the markets in which they operate.

It therefore makes little sense paying extra but not getting extra. A passive approach is likely to be both cheaper and more predictable since the funds can be expected to simply perform in line with the market sectors in which they are invested.

Then there is failing to adopt a coherent strategy.

There is a reason why you want to establish the investment portfolio. It may be to provide for a secure retirement or to fund a project in the future.

Before you invest a penny, you should clearly determine what you are doing it for and for how long you want to invest. As part of this, you should consider carefully how much risk you are prepared to take.

This is very important because it will determine the asset allocation of the portfolio. By this I mean the split between equities, fixed interest (and cash) and property.

Based on the most appropriate asset allocation split for your preferred risk level, you may be able to make some reasonable assumptions about the sort of return you can expect.

This will help you to work out whether, given the funds currently available to you, you can expect to achieve your financial planning objectives. If not, you may need to either adopt a higher risk profile to improve your chances or reduce the amount of your target requirements.

Having adopted an asset allocation that you are happy with, it is important to ensure that it is maintained on a regular basis.

Over time, the individual components of the portfolio will perform at different rates. As a result, it may expose you to either too much or too little risk, either of which could be damaging to your personal finances. To correct this, the portfolio should be rebalanced back to the original split at regular intervals.

Another common mistake made by many private investors is to constantly look at the value of their portfolios. This is unhelpful and probably causes a lot of stress. It is likely to make the investor adopt an overly short-term approach and, as a consequence, make another very common and expensive mistake – selling out because the market has gone down.

This is largely responsible for the underperformance against the markets seen in many private investor portfolios. If you sell when the markets have just gone down, you are simply crystallising the losses and moving away from the very assets which have the best chance of recouping them.

Finally, do not invest in funds you do not fully understand and avoid choosing funds that appear to provide returns very much higher than the rest of the market for no obvious extra risk.

In general, if you do not understand how it works, keep clear of it. One of two things is likely to happen. Either you will not make any money or you will lose a substantial amount. If looks too good to be true, it is too good to be true.

Chris Wicks is a director of N-Trust


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