Some good reads from around the web.

I am sure there are some ordinary Greeks who are being taken to the brink by the crisis, but you wouldn’t know it from most of the news reports.

Invariably the street scenes in Athens look as prosperous as you can imagine, all BMWs and gushing fountains – more Rodeo Drive than road to hell. Interview after interview is conducted in a shiny cafe stuffed with prosperous clientele.

I saw one on CNBC yesterday held on the sunny apartment balcony with a chap who’d lost his job, who lamented that they were struggling to get by on his wife’s 35,000 euros a year (plus whatever benefits he was receiving, which were not cited by the program).

“Sometimes we run out of money,” he said. Maybe when he had to buy new filters for the chrome coffee machine or the other consumer treasure we saw dotted about his home.

Pay day looms

These people undoubtedly feel miserable, relative to where they were. But where they were was in the economic fun house – the equivalent of a kept mistress in pied-à-terre on borrowed time.

As one Greek businessman writes on Bloomberg:

For 30 years, these two [main Greek] parties competed in an orgy of jobs and entitlements for votes. In the span of a generation, the composition and ethos of Greek society were transformed.

Where there had been a mostly self-reliant and hard-working body of citizens, we got an army of state-supported employees with guaranteed job security and early pensions.

As the UK state’s own largesse is gradually withdrawn (despite all the debate about cuts, public spending is still at record levels) we will surely face more trouble here, especially as the deleveraged animal spirits of the private sector seem about as likely to pick up the slack as my mate Graham to pick up a bar tab.

And that’s bad news, because it’s a breeding ground for crackpot extremists, as we’re seeing in Greece:

The troika insists on structural reforms, such as less job protection, limiting trade union privileges, and opening monopolies and closed professions in the service sector.

In short, Greece’s creditors are asking the country to dismantle what was built during the last few decades and led Greece to bankruptcy.

The intent is to make the economy competitive, but those affected don’t see it that way, and they are many.

Close to one in four of the working population depends on the state for his or her salary. Add to them the unemployed at 23 percent, double among the young, plus all those whose salaries and pensions were reduced by the troika’s austerity measures, and you get a large pool of very unhappy and insecure people.

The interview with the jobless chap ended with him saying he might have to rent out his property and take his family back to live with his parents for a while, which he found intolerable at 40-years old.

I agree it sounds miserable (not least on the parents!)

And I’ve heard personal stories from people close to Greece that paint a much darker picture than those the TV news reporters are able to unearth within 20-feet of the lobby of the Athens Hilton.

Yet I’ve heard no reports of Greeks calling for measures like the six-point plan of privatisations and restructuring that Germany is apparently working on to try to save Greece.

Instead, I see people marching for free money to pay for unsustainable pensions, benefits, and tax perks – all to be paid for by foreigners.

Even the IMF’s Christine Lagarde this week called for Greeks to pay their taxes:

“I think more of the little kids from a school in a little village in Niger who get teaching two hours a day, sharing one chair for three of them, and who are very keen to get an education. I have them in my mind all the time.

Because I think they need even more help than the people in Athens.”

While anyone with a heart would feel sorry for Greek children and others who can’t be blamed for the country’s predicament, I’m with Lagarde in tiring of the sob stories from Greece, and also here at home.

I have never been in debt. I didn’t lie to buy a property early on in the housing boom. I refused to pay 10-times average earnings by the time I didn’t need to. I didn’t shop til I dropped and make millionaire footballers or Sex in the City‘s heroines my financial role models. I’ve saved and reinvested a big chunk of my disposable income like most people pay their taxes. I’ve bought some nice things along the way, but I never thought I was entitled to everything.

I’m nearly 40, too, like the unhappy Greek on CNBC. And I rent my home.

So no, we weren’t “all at it” as the journalists keep saying, no doubt because they were all at it themselves.

Some of us avoided getting into debt, worked, saved, and invested. And being held ransom by the millions who didn’t in Greece and here at home (whether as a nation or as individuals) is starting to grate.

There was always another way. Most people ignored it.

Cradle to grave in debt

So as we go into yet another weekend wondering whether European leaders will surprise us on Sunday night with a radical plan D, I am wondering again how this will play out in the UK, too.

Previously I’ve been relatively optimistic. But faced with the political delusion apparent on the continent, I wonder if I’ve been too focused on the narrow economics?

We’re not in the same precarious financial position as Greece – we can print our money, intervene to bolster our banks, devalue our currency, and do a few things the world wants to pay us for – but the ludicrously carefree attitude most people had until recently towards debt, from the former Prime Minister to the average Brit in the high street – is not so far removed.

Few people seem to want to face up to the bill for the party, anymore than they do in Greece.

Shove it to the next generation is the order of the day, whether the choices be spending cuts for the undeserving, tax rises on the wealthier, or pensions curbed for everyone.

Years more of this (if we’re lucky)

For an investing perspective on the unfolding drama, you could do worse than read this interview with hedge fund manager Ray Dalio in Barron’s:

Deleveragings go on for about 15 years. The process of raising debt relative to incomes goes on for 30 or 40 years, typically. There’s a last big surge, which we had in the two years from 2005 to 2007 and from 1927 to 1929, and in Japan from 1988 to 1990, when the pace becomes manic. That’s the classic bubble.

And then it takes about 15 years to adjust.

Unlike the Athens we see on TV, there are many places in the UK where life is tough, shops are boarded up, and people have very low expectations – and that’s after over a decade of easy money from the State and banks alike. I dread to think how bad things could get if it continued for a decade.

Overall I’m still not too worried about the economic situation in the UK – I think it is manageable, as I’ve said many times before.

But I do wonder if I’ve underestimated the political risks?

On the other hand, the sun is out which always makes me feel glum at first, and I had dinner this week with by far my gloomiest friend – a man who reads Grant’s Interest Rate Observer to his kids before bedtime.

Fingers crossed for plan D, then.

From the money blogs

• Rebalancing: Should you bother? – Can I retire yet?
• Investing in a world of Black Swans – Investing Caffeine
• Do mutual funds have hidden costs? – Oblivious Investor
• Embracing the nagging voices of success – Mr Money Mustache
• Happy people make terrible traders – The Psi-Fi blog
• Why I have no faith in market timing – Canadian Couch Potato
• How much is enough to be happy? – DIY Income Investor
• Grexit: Ambulance chasing ahoy? – Simple Living in Suffolk
• 5 financial benefits of being over 50 – Totally Money

Book of the week: If you want to scare yourself as to how bad things could get, there’s always the classic When Money Dies, which dissects hyperinflation in 1920s Germany. I guarantee you’ll have more sympathy for Angela Merkel and the Bundesbank after reading it!

Mainstream media money

• Why Facebook’s own underwriter was shorting it – Reuters & DealBreaker
• The cult of the non-equity… – FT
• … and why it’s not a contrarian signal – FT
• Europe looks good value on CAPE basis, but risks abound – FT (Japan too)
• Falling Euro weakens UK savers protection in European banks – FT
• Lock into a longer term mortgage deal – FT
• My first million: Levi “Reggae Reggae” Roots – FT
• Average Briton pays 149 days salary to the taxman – Telegraph
• Should investors switch from bonds to shares? – Telegraph
• Banks are pulling long-term best buy savings deals – Telegraph
• Free banking should end, Bank official says – Telegraph
• £2,600 bill for data roaming on iPhone in Istanbul – Guardian

Like these links? Subscribe to get them every week.

Further reading:

1. Weekend reading: Charlie Munger on banking regulation
2. Weekend reading: A political day is a long time in the markets
3. Weekend reading: Banks are back edition

A year ago, I thought it would be a good idea to sink £5,000 of my own money into a high-yield portfolio (HYP).

I know, what was I thinking?

Almost as soon as I set-up this demo portfolio – by buying into 20 shares via a low-fee Halifax ShareBuilder account – the markets turned south. And despite a brief flirtation with north in early 2012, south is pretty much where they’ve stayed.

Buying an income portfolio is a long-term game, however, so I have no regrets about setting up this demo when I did.

Firstly, I don’t believe it was obvious a year ago that equities would do poorly. We could just as easily be up as down.

Sure, Europe already looked about as attractive as a busload of Greek pensioners dressed up as 1930s German showgirls, but things also looked grim in 2009. Valuation counts most, and they didn’t (and don’t) look too stretched to me.

Secondly, as I discussed in my follow-up article on benchmarking the demo HYP, the alternatives for income seekers didn’t look exactly attractive. Real yields on cash were negative in May 2011, even if you locked away your money.

True, with hindsight an investor would have done better sticking with cash for the past year, as we’ll see. But you can’t invest with hindsight!

A more sensible conclusion from the mediocre past year for shares is that you shouldn’t put all your eggs in one basket. A mix of cash, bonds, equities, and other asset classes will provide a smoother ride. This demo portfolio is meant to show how a pure HYP performs over time. I don’t mean to suggest you should put your worldly worth into 20 shares!

Still, a 7% fall isn’t a big deal compared to the spanking you’ll get in properly bad years. Also, none of the 20 shares I bought have cut their dividend payouts, as far as I’m aware. On the contrary, they’ve raised them. And that’s what counts most when buying an income.

Income streams can be expected to be far smoother than capital fluctuations, which is why I think targeting income is a better goal for many private investors.

The HYP valuation, one year on

So where do we stand after a year? Good question, and I wish I’d asked the same thing when the portfolio turned one a fortnight ago.

Regular readers may recall I bought the HYP with real money, partly to make it easier to track. However I didn’t have time to write this post on the HYP’s birthday – and I forgot to note down the valuation. I’ve therefore had to reconstruct it in a spreadsheet.

Here’s where the HYP stood at the end of trading on the 10^th May 2012, using prices from Yahoo:

Note: The portfolio was purchased on the morning of 6^th May 2011, with £250 invested into each of 20 shares. All costs (stamp duty, spreads, and dealing fees) are included.

It’s never nice to see your shares down when you’re not going to be buying any more – my £5,000 investment is the lot for this experiment – but there we are.

Turning to the performance of individual companies, “what was I smoking?” comes to mind most when I look at the two insurers, Admiral and Aviva. They are in slightly different sectors (and Admiral was also hit by company-specific worries) but both do suffer a lot when capital markets are unnerved. I probably went a bit overboard here.

The big surprise for me was Tesco, which I thought of as a stalwart addition. I would never have guessed it’d be the third-worst performer in capital terms.

Alternative 1: The iShares FTSE 100 tracker

As outlined in my benchmarking article, I’m going to compare this HYP against two alternatives – a cheap ETF, and a trio of investment trusts.

For the ETF, I’ve selected the iShares FTSE 100 ETF (Ticker: ISF), which is safe¹, popular, and liquid. I’ve assumed I bought it for the same low dealing fees as the HYP, and that there’s no stamp duty to pay.

However due to the uncertainty over when exactly a Halifax Sharebuilder deal would have gone through on the day of purchase, I can’t be sure exactly what price I’d have paid.

I’ve therefore averaged the opening and closing price of the ETF, which seems the fairest solution. (I’ve ignored the tiny spread, too).

A hypothetical £5,000 was invested on 6^th May 2011. Here’s where it would have stood at close of 10^th May 2012.

Note: Prices from Yahoo.

I’m pretty surprised by how similarly the HYP and this tracker have performed in year one, given all the turbulence and the higher fees of buying the HYP (20 lots of dealing fees plus stamp duty and higher spreads). It shows the power of horizontal diversification.

Still, it’s very early days.

Alternative 2: A trio of income trusts

As further discussed in the benchmarking article, I’ve chosen three income investment trusts to track as an alternative to the HYP.

Once again, I assumed they were bought via Halifax Sharebuilder, and again I averaged the opening and closing prices on 6^th May 2011. Stamp duty and a penny spread on each trust’s share price were also factored in.

Here’s where a hypothetical £5,000 split between the three trusts stood on 10^th May 2012.

Note: Historical prices were not available from Yahoo for Merchants, so were taken from Google.

A similar capital performance here to the HYP and the iShares ETF. Clearly my choice of trusts has been a big factor in the short-term though, so it’s even more important to wait a few years before we overstate any findings.

I personally think investment trusts are a good halfway house between being an enthusiast who fancies managing a portfolio of shares (and perhaps daydreaming of outperformance) and a passive investor who invests via an ETF or fund.

So far, so good.

Income comparison

So much for capital, what about the all-important income?

One snag is that the timing of payments (and of ex-dividend dates) means none of the three alternatives received all the income you’d expect them to get in a normal calendar year. This is a first-year problem, and it won’t happen again.

For the hypothetical ETF and trust holdings, I went through the dividend records (via the Digital Look and iShares websites) and manually totaled the payments due, taking into account ex-dividend and payment dates.

For the HYP, I simply added up all the dividends I received over the period.

Here’s what each system earned between 6^th May 2011 and 10^th May 2012.

Note: Yields are rounded to one decimal place.

As you might expect, the FTSE 100 ETF is lagging the two more specialist income vehicles. But these are very early days.

The next 12 months will provide our first full-year run of capturing all payments due to each strategy. And in the long-term, we’ll see whether biasing for income at the start is still generating a higher income versus the market in 5-10 years time.

First year total returns

Adding the capital valuations to the dividends received gives us the total return earned (or the lack of it) over the year.

Here’s where total returns stood as of close of play on 10^th May 2012.

Note: Gain/loss is rounded to one decimal place.

Did I hear someone at the back shout “Efficient Market Hypothesis?” The results from our first year of following the strategy do suggest a lot of faff to generate much of a muchness.

But you know what I’m going to say, don’t you?

Early days!

Given all the short-term factors I’ve mentioned above, I wouldn’t draw any conclusions from these total return figures yet.

In theory, the fact we’re targeting income from the HYP and income trusts will eventually be reflected in slightly lower capital gains versus the market (the ETF). The total returns should be roughly equivalent.

In practice, I’ve seen high-yield strategies beat the large-cap market even on a capital-only basis, perhaps because they avoid a lot of temporarily overpriced companies that don’t care much about their shareholders. (*cough* Facebook. *cough*).

That’s heresy of course, but we’ve plenty of passive articles to offset the balance! Also, I don’t think the market was at all frothy when the HYP was set-up, so I think there’s less chance of a value-based strategy outperforming, anyway.

We’ll see what the next year holds.

Note: Apologies in advance for any typos. Copying from spreadsheets and then working manually with WordPress’ clumsy table formatting means it’s all too easy to slip up. Please let me know if you spot anything.

1. In terms of how it is constructed. As an equity investment it can go up and down as wildly as any other.

Further reading:

1. Dividend income and the Monevator HYP
2. The Monevator HYP: It’s alive!
3. Diversifying your high yield portfolio: HYP Part 3

The financial cage-rattlers at Vanguard have announced the launch of their first London-listed Exchange Traded Funds (ETFs), in a move that should bring significant long-term benefits to Brit-based passive investors.

The initial line-up of five funds will immediately go to the top of the ETF best buy rankings (by TER), either beating or matching their rival offerings straight off the bat.

Vanguard has confirmed the following five ETFs are ready for launch:

Reports suggest the new ETFs will go live on Wednesday, 23rd May.

The new Vanguard ETFs benefit from a number of key features, namely:

• Physical replication of indices. These are not synthetic ETFs.

• The new ETFs follow broad-based indices, so all are suitable pillars of a diversified portfolio. None of your leveraged Albanian Pilchard Farmers rubbish here.

• They’re Irish domiciled, so you skip stamp duty.

Previously, Vanguard’s UK index fund range has been restricted to a handful of platforms. And because of the different fee menus, working out your best option has been a special kind of torture.

The new Vanguard trackers should be available on pretty much every platform that deals in ETFs, so UK investors won’t be forced into the hands of a measly few providers.

Vanguard ETF or index fund?

Some may be disappointed that the new ETFs are largely clones of existing index funds, but the cheap TERs are worth the entry price alone.

Bear in mind though that in order to buy ETFs you must pay:

• Brokerage commissions – roughly £10 per trade, although you can cut this to £1.50 by using a regular investment scheme (the same price you’d pay for Vanguard index funds through Alliance Trust).

• The bid-offer spread – should be pennies, but spreads can take a while to settle down as a new product finds its level. Ideally holster your trigger finger for a few months to enable the spreads to tighten.

In my view, bearing in mind the above there’s no reason not to switch to the Vanguard ETFs in place of its index funds. If lower TERs are available, you might as well scoop them up.

If you usually buy, say, HSBC or L&G index funds to avoid brokerage commissions, the calculation is more finely balanced. Try a fund cost comparison calculator to weigh up your options.

Depending on how much you invest, it may not take very long for a cheap ETF to pay off. The Vanguard Emerging Markets ETF will edge the L&G Global Emerging Markets index fund after just four years, for example, even if you pay upfront trading costs of 1%.

The best versus the rest

As for ETFs, here’s how Vanguard compares to its rivals in a straight ETF vs ETF TER tear-up:

Note: The Source and Amundi ETFs involve synthetic replication.

Clearly, Vanguard has found plenty of room for price-cuts. It will be interesting to see how their rivals respond.

A new option for global investors?

Just to get away from TERs for a second, it’s also worth mentioning that the Vanguard FTSE All-World ETF looks to be an entirely new beast from the Vanguard stable.

The FTSE All-World index tracks 90-95% of the world’s investible equities across both developed and emerging markets. So this is pretty much a one-stop-shop ETF for anyone who wants to run a global portfolio.

Team it up with a broad-based gilt fund and you’ve got a diversified portfolio in just two steps.

Price war

When Vanguard first stormed the UK index fund market, it forced major price slashery from rivals who’d been using bloated TERs to leech investors for years.

Vanguard’s strategy from birth has been to screw down prices, and now it is one of the largest asset management firms in the world.

No doubt it will make more of its range available as ETFs, and continue to up the price pressure on its rivals. UK investors will be the ones who benefit.

Take it steady,

The Accumulator

Further reading:

1. Not saving enough for your old age? Try a dirt cheap stakeholder pension
2. Vanguard offer some of Britain’s cheapest index funds, but there’s a catch
3. Index funds are cheaper than ETFs

Some good reads from around the Web.

I have to use this week’s Saturday morning piece to point readers to an update to our post about Vanguard funds and Interactive Investor.

The plot thickened almost as soon as we posted that article. Initially prompted by Monevator readers’ comments, it was soon fueling even more confusion among others.

Vanguard funds that were seemingly available on Interactive Investor’s systems – and confirmed as such by staff – turned out to be part of a limited test program, not yet permanent additions to the iii stable. Please read the updated intro to the article for more on what this means.

It’s a pretty frustrating state of affairs.

I won’t go into the specifics of this SNAFU much further, since we’ve subsequently been in discussion with iii staff, who I’m pleased to say have responded with some clarity on becoming aware of the befuddlement their pilot program seems to have caused at least some customers.

But I would like to point out that it’s 2012, and no service provider can rest on its laurels.

The time is long gone when the typical investor checked his share prices in the FT on the train back to Basingstoke before joining his broker or financial adviser for a few G&Ts at the golf club.

Active investors are online, they are communicating with each other, and word gets around fast.

Yesterday we saw the IPO of Facebook, just one company revolutionising the world by capitalising on the power and appeal of community.

Blogs like Monevator have sizable communities, too – we’ve welcomed over one million unique visitors to this site since 2009. They have left thousands of comments, but more importantly they have spread links to our content across even larger discussion forums, such as The Motley Fool, Stockopedia and ADVFN. We, in turn, have spread links posted to discussions elsewhere.

This is the modern landscape that financial service providers will thrive or die in, and it’s best for everyone if the information that spreads is clear and accurate.

Consumers are wising up, sharing knowledge, and growing smarter. Tracker funds are now outselling actively managed ones. Banks are on the hook for billions in compensation partly as a result of grassroots campaigns that began on the Internet. It’s truly a hive of investment activity, as alluded to by the name of one new Web-based service, Investor Bee.

The direction of travel is clear. In my opinion, the future of financial advice and services is clearly online. Online is no longer a place for afterthoughts – it’s at the heart of how we’ll save, invest, and plan for our retirement.

I can only apologise to any readers who were excited by our post on Thursday and who are now disappointed, although I’m not sure what else we could have done, given we’d had confirmation from telephone staff that the funds were available to trade.

Still, we’d rather be contributing to the signal, not the noise.

From the money blogs

• The pleasure/pain principle – Investing Caffeine
• Europe’s depressing prospects – Michael Pettis
• First retire, and then get rich – Mr Money Mustache
• When and how to rebalance your portfolio – Can I retire yet?
• Why do economists say there is an annuity puzzle? – Wade Pfau
• Trading time for money – Get Rich Slowly
• Exploring alternative asset classes – The Digerati Life
• Become a safer investor: Get Married – The Psy-Fi blog
• What the Eurozone crisis means for you – Totally Money

Book of the week: Still befuddled by the potential of Facebook? Check out The Facebook Effect, the definitive book on the company’s first eight years.

Mainstream media money

• The endangered public company – The Economist
• Facebook co-founder Eduardo Saverin’s big tax bill – The Economist
• Banking: Same as it ever was – The Motley Fool
• How Facebook’s bankers kept the day one price above $38 – CNET
• Peston: How serious is Northern Rock’s £2 billion loss? – BBC
• Why can’t the taxman crack the tax codes? – FT
• Tracker sales soar despite the turmoil – FT
• Commemorative coins are mediocre investments – FT
• Preference shares boast yields of 7-10% – FT
• Smaller companies top returns over the long-term – FT
• How to avoid the annuity trap – Telegraph
• A good time to start a business? – Independent
• Retail bonds versus fixed-rate savings – The Guardian
• Greeks apologise with gift of huge horse – The Daily Mash

Like these links? Subscribe to get them every week!

Further reading:

1. Online financial advice in the future
2. Shock news: Asset allocation not as dull as it sounds
3. Crisis investing: Specific news events

Update 18 May 2012: Since this post was written, we have been informed by Interactive Investor that Vanguard funds are NO longer available on its platform. We are told that the company is piloting seven Vanguard funds to ensure its systems work, but will be removing them at the end of testing. We’re advised to inform you that “they will be not be available until further notice.”

We at Monevator are sorry for contributing to this confusion, which was prompted by the fact that readers kept telling us that the funds WERE available – reasonably enough, because they saw them there – and asked us what we thought.

Sure enough, we were informed by Interactive Investor staff that the funds were available to trade.

However, we were not told that the Vanguard funds were only available for a strictly limited period as part of a pilot scheme. 

Interactive Investor have since confirmed that any investors who have managed to buy Vanguard funds during the test period will be unaffected by the end of the pilot scheme. You will still be able to track performance and receive valuations within your Interactive Investor portfolios. However, it is unclear whether you’ll be able to add to your Vanguard holdings through the broker. 

Apparently Interactive Investor is engaged in ongoing negotiations with Vanguard about its entire range of funds, but we don’t know on what terms they will be offered, if at all. 

We’re leaving this post up as an historical artifact, and as something to point readers to when they next ask us about this subject. This is the second time we’ve been confused by iii’s systems here, so we’re backing away slowly, closing the door, and running in the opposite direction. No more updates until we get an extremely official announcement, perhaps signed in blood.

At last! Vanguard index funds are now available through a broker that doesn’t impose platform fees, annual charges, dealing costs, or any other sneaky expenses that can nobble a small investor’s returns.

The broker is Interactive Investor (iii) and this development means Britain’s cheapest trackers can now be bought for sums as low as £20, which previously would have been suicidal in the face of flat-rate fees.

Seven funds from the Vanguard index fund range are available through iii, including a few of the instant-portfolio LifeStrategy funds.

However, this is a developing situation and I recommend you ring iii to check whether the funds you require are available.

When rumours first circulated a few weeks ago that iii stocked Vanguard, I was told that only Vanguard’s FTSE UK Equity fund was available. This despite the fact that the entire Vanguard range is listed on iii’s website. That toe in the water has now become a whole leg, so the possibility remains that iii will go all in at some point in the future.

The currently available Vanguard funds are as follows:

• FTSE Developed Europe ex-U.K. Equity Index Fund

• FTSE Developed World ex-U.K. Equity Index Fund

• FTSE U.K. Equity Index Fund

• U.S. Equity Index Fund

• LifeStrategy 20 % Equity Fund

• LifeStrategy 80 % Equity Fund

• LifeStrategy 100 % Equity Fund

All funds are available in ISA accounts and are accumulation flavour.

Don’t take ‘no’ for an answer

One Monevator reader, Sam, has already reported being told a different story – that only the LifeStrategy 100% fund is available, and not in an ISA.

I have previously found with brokers that the story can change from operative to operative, depending on how au fait they are with their internal systems. So if you get a different tale, ask for a double-check and tell the rep to ignore NASDAQ listings – you are only interested in UK or Irish-domiciled OEICs.

Do let us know about your experiences in the comments section, too.

Sadly, iii’s website isn’t keeping up with events and there is currently no way to tell online which of the funds are available to buy and which are listed for information purposes only.

No doubt this situation will change in time – again many brokers often make funds available over the phone for a period before updating their website. So much for the wonderful world of instant digital gratification.

In general, if you want a fund that your broker doesn’t apparently stock, it’s always worth hounding them about it over the phone. They may well say ‘yes’.

A rare victory for the little guy

It’s taken three years for Vanguard funds to breakthrough on a no-fee platform and achieve the same no-strings-attached status as the HSBC index funds, for example.

The reason Vanguard has been resisted is that they don’t pay trail commission to platform operators (i.e. a fee deducted from the fund’s TER that makes it worth the while of your broker or fund supermarket to stock the fund).

Commission of this kind is due to be abolished by the end of the year under the FSA’s Retail Distribution Review (RDR).

The likes of Hargreaves Lansdown recoup their expenses through a platform fee, while Alliance Trust charges dealing fees for buying Vanguard funds.

Many have predicted that all low-cost online platforms will go down this route, making life extremely difficult for small investors as flat-rate fees take large bites out of modest contributions.

But iii have specifically added the following line to their charges sheet:

Charges for “non-commission paying” products – NIL.

It’s a positive sign that iii are seeking to differentiate their offering from other platforms as RDR approaches. There are no guarantees the situation won’t change, but it would surely be a PR disaster for a firm to stake out that position ahead of RDR, luring small investors in, only to move the goalposts a few months later.

So assuming the Vanguard funds aren’t being used as bait, and the website issues are sorted, this new ultra-low cost option adds up to great news for small investors.

Stop press

Before you take any big decisions, you should know that Vanguard is about to launch five physical ETFs on the London Stock Exchange. The Motley Fool has the scoop.

Apparently the FTSE 100 tracker will have a TER of 0.1%, which will make it an instant low-cost table-topper. Expect a listing in the next few weeks, and a Monevator report to boot.

Take it steady,

The Accumulator

Further reading:

1. Hargreaves Lansdown bags Vanguard funds
2. Is it worth sticking with Hargreaves Lansdown to get Vanguard funds?
3. How to lifestyle Vanguard LifeStrategy funds

One of the most fun things about managing your own investments is coming up with an asset allocation strategy to diversify your portfolio. It’s a chance to tinker like an alchemist to find that blend of asset classes that’s going to help you weather the storms ahead, and see you dancing upon the sunlit plains of financial independence some time yonder.

That’s the dream, and in the weeks ahead I’m going to write a simple guide to devising your own asset allocation.

But first we need a primer. What are the asset classes that make suitable straw for your passive investing nest?

In the rest of this post, I’ll highlight the pros and cons of the main asset classes.

This will be familiar stuff to many Monevator readers, but it’s always useful to have a frame of reference, especially as the investing world can rarely agree on a consistent definition for anything.

Cash

Filthy lucre, spondoolicks, the route of all evil… We’re all familiar with money, though perhaps not as much as we’d like to be. The simplicity and familiarity of cash is one of its biggest advantages, but excessive devotion to it can be the undoing of the cautious investor.

Good

• You can’t suffer a capital loss.

• It’s liquid like water. If you lose your job and need some food or rent, your cash reserves can quickly be converted to satisfy whatever need is at hand.

Bad

• Cash will be clobbered by inflation over time. £100 will only be worth £74.41 in 10 years, if the ongoing inflation rate matches the historical average of around 3%. 20 years down the same timeline and £100 will only be worth £55.37.

• Historically, cash has earned the lowest returns of the major asset classes.

Risk/Reward trade-off¹

• Risk = Low

• Reward = Low

Time horizon

Cash is useful over any time frame, but you are likely to get poor slowly if you hold excessive amounts over the long term. Spicier investment options are needed to achieve most financial goals.

More on cash

• Cash is king

Bonds

Bonds are I.O.U.s issued by an entity such as a company or government. In exchange for your loan, the bond issuer will pay you a guaranteed stream of interest over the loan period, plus you’ll get your original stake back after an agreed number of years. (Unless the issuer does a Greece and defaults, that is).

Passive investors should only concern themselves with investment-grade bonds, and there are strong arguments to restrict your portfolio allocation to solely to domestic government bonds.

Good

• Government bonds are much less volatile than equities.

• Historically, they’ve provided a better return than cash.

• A lack of correlation with equities makes government bonds a useful way to protect yourself against stock market crashes.

Bad

• Bond returns historically lag equities.

• They are vulnerable to inflation (unless you choose index-linked varieties) and changes in interest rates.

• Many investors struggle to understand bonds.

Risk/Reward trade-off

• Risk = Lower than equities, higher than cash

• Reward = Lower than equities, higher than cash

Time horizon
You can match your bond holdings to any time horizon and know exactly what your return will be, if you hold the bonds until maturity.

Sub-classes²

• Government bonds i.e. UK gilts, US Treasuries
• Corporate bonds
• Inflation-protected bonds i.e. index-linked gilts, TIPS
• Local government bonds
• Junk bonds i.e. high-risk bonds with terrible credit ratings

More on bonds

• Gilts explained
• Corporate bonds central

Equities

Equities (commonly known as stocks or shares) are historically the riskiest and best rewarded of our main asset classes.

That relationship is writ in stone by the laws of finance. Because equities are so risky, investors demand high potential rewards to play the game. Note that word: potential. There is no guarantee that equities will deliver; they do not provide a guarantee of income or capital. Instead, they offer part-ownership of a company and thus a claim on its future earnings.

Good

• Equities have traditionally outgunned every other asset class when it comes to long-term returns. They are the most powerful asset class in your diversified portfolio.

• Equities are capable of outstripping inflation. They’ve historically delivered a return of 5% after inflation, in the UK.

• The longer you hold equities, the better your chance of achieving your financial goals.

Bad

• Severe losses can occur at any time and frequently do. You could easily lose 30% of your capital in a single year.

• Losses can be very long-lasting. Japan is the textbook example of a market that’s failed to recover its value in over 20-years.

• The highs and lows of equity ownership can feed all kinds of irrational behaviour, from panic-selling in the face of loss to piling into a bubble market. Fear and greed rule.

Risk/Reward trade-off

• Risk = Higher than bonds, property or cash

• Reward = Higher than bonds, property or cash

Time horizon
The longer you can hold the better. Five years is the bare minimum, 20 years is a more comfortable stretch.

Sub-classes

• Capitalisation e.g. Large cap, small cap
• Style e.g. Growth, value
• Geography e.g. Domestic, emerging markets, international
• Sector e.g. Technology, utilities, consumer staples

More on equities

• UK asset class returns

Property

As an investment asset class, property (or real estate) refers to commercial property that delivers returns in the shape of rent and the appreciation of building values. It doesn’t refer to your house.

Exposure to commercial property is generally achieved through real-estate investment trusts (REITS) or ETFs. Sticking all your money in a ‘buy-to-let’ concentrates rather than diversifies your holdings and is taking a big punt on the everlasting strength of the UK property market.

Good

• Historically, the risk and rewards of property have been a halfway house between equities and bonds.

• It can be a useful diversifier, as global property returns have demonstrated a moderately low correlation to UK equity.

• Property is also likely to keep pace with the rate of inflation.

Bad

• Property bubbles can pop and inflict large losses on funds.

• Property is illiquid, which can lead to funds imposing exit restrictions on investors during periods of market stress. In other words, they can’t sell their buildings quickly if everyone wants their money back at the double.

• UK investors tend to have a rose-tinted view of property due to the strength of the home market over the last 20 years. However the asset class has historically lagged equities.

Risk/Reward trade-off

• Risk = Higher than bonds or cash, but lower than equities

• Reward = Higher than bonds or cash, but lower than equities

Time horizon
As per equities.

More on property

• A property primer

Commodities

Investing in commodities is the business of speculating on the price of cows, or oil or gold. You are betting that the future price of the asset will be higher than the current price.

However, there are very few opportunities for ordinary investors to bet directly on that spot market price because few of us can actually store several million barrels of oil.

With the exception of some precious metals like gold, a regular Joe’s only option is to invest in commodity funds that provide exposure to the price movements of commodity future contracts³.

Commodity future funds thus don’t make their money from the onward march of the spot price but by trading futures and earning interest on collateral.

Good

• Low correlation with equities may reduce portfolio risk.

• Gold is negatively correlated with equities.

• A good inflation hedge.

Bad

• No long-term source of reward for direct commodity exposure. Commodities don’t pay dividends and future returns should equal inflation.

• There is no clear evidence that investors can expect a long-term return from commodities futures either.

• The workings of commodity future funds are extremely complicated.

Risk/Reward trade-off

• Risk = Equivalent to Large Cap US equity.

• Reward = Inconsistent and hotly debated. Better thought of as a method to reduce the risk of equities.

Time horizon
Commodities should be thought of purely as an equity diversifier and therefore held for a similar timeframe (if at all).

Sub-classes

• Energy e.g. oil, gas, petrol, heating oil
• Agriculture e.g. wheat, corn, soybeans, cotton, sugar, coffee, cocoa
• Industrial metals e.g. aluminium, copper, nickel, lead, zinc
• Livestock e.g. live cattle, feeder cattle, lean hogs
• Precious metals e.g. silver, gold

More on commodities

• Exchange Traded Commodities (ETCs)

Alternative asset classes

Other asset classes exist, of course. You’ll no doubt have heard tales of the killings to be made in:

• Hedge funds
• Private equity
• Currencies
• Volatility e.g. the ‘Fear index’
• Collectibles e.g. art, wine, cars

A passive investor wades into these waters at their peril. Most alternative asset classes can be discounted on some or all of the following grounds:

• Their role in a diversified portfolio is highly questionable.

• They suffer from high costs, or illiquidity, or other barriers to entry/exit.

• A high degree of expertise is required to avoid being spanked by other players in the market.

• Their track record is murky at best.

The bottom line is that any investor can construct a highly diversified portfolio from the main asset classes: cash, bonds, equities and property, and also stirring in commodities if you’re truly convinced by its merits.

Take it steady,

The Accumulator

1. Note, this is the expected trade-off based upon the historical returns of each asset class. Actual risks and returns can turn out very differently.
2. This isn’t an exhaustive list, just a quick run-down of the more common varieties.
3. An agreement to buy or sell a commodity at a particular price, at a set date in the future.

Further reading:

1. Weekend reading: A quick guide to Monevator
2. Shock news: Asset allocation not as dull as it sounds
3. US historical asset class returns

Some good reads from around the Web.

I once asked readers to admit they were nostalgic for the turbulent days of 2008 and 2009, when banks were going bust and stock markets were a bargain.

The post was slightly tongue-in-cheek, with my idea being to remind readers that the bad days don’t last forever, even if the headlines take a while to change.

There is a reason to lament more stable times, though, and that’s that buying cheap is the best guide you’ll get to good future returns from equities.

And cheapness tends to come hand-in-hand with fear and turmoil.

Spain is still partying like it’s 2009

Given how I supposedly love cheap markets and can look through bad headlines and gyrating share prices, I have asked myself if I should be putting more money to work in Europe – and in particular Spain.

While the economic slowdown has dragged on everywhere in the Western world, Spain feels like the clock stopped three years ago.

It’s several years ago that the US and UK authorities forced a bailout of their banking systems. Spain is still doing it. Last week saw its fourth attempt to shore its banks, after the all-but nationalisation of one of the biggest domestic lenders, Bankia.

And while Obama may be tearing his hair out about stubbornly high unemployment in the US, compared to Spain’s 24% rate, the US rate of around 8% seems a boon. UK GDP is dipping, but it’s diving again in Spain.

The credit crisis that nearly froze international trade and finance is still spluttering in Spain, too, albeit more evident in the very high yields on Spanish government bonds. The government’s move on Bankia was partly a response to rising fears among Spanish savers over the safety of their money.

Costa notta lotta

Given all this – replicated to a greater or lesser extent across peripheral Europe – why would anyone consider investing in Spain?

Because it’s seemingly dirt cheap, of course.

The Spanish market is down roughly 25% on the year, with the index flirting around the level it touched in early 2009.

In contrast US markets were recently making new highs. Even after its recent falls, the UK’s FTSE 100 is up over 50%.

This weakness is reflected in a very low P/E rating for the Spanish market of around 7.5, according to FT data. That compares to over 10 in the UK (still not exactly expensive) and around 14 in the US.

You might think that a low P/E is warranted, given Spain smells about as healthy as a morgue during a mortician’s strike. As a fan of the country and a semi-regular visitor, I don’t disagree it’s tough there.

My Spanish friends confirm the country is in a right mess. The structural problems behind youth unemployment are almost worse than the headline figures. Much of what makes Spain so great – such as its hedonistic lifestyle and its family-focused culture – is partly to blame for its woes. Then you have issues like an entire generation raised on consumer credit, who make British 20-somethings look like a legion of proto-Warren Buffetts.

The root and consequence of Spain’s problems is a crazy property boom that took people out of real jobs, took money away from productive investment – and that incidentally acted as a cesspit for much of the easy money that flowed here in Britain 5-10 years ago, too.

It’s very difficult to gauge how much of this has been unwound, but again the hidden cost (graduates who eschewed careers to work on building sites, for instance) could be even worse.

But there’s a but as big as any you’ll see at any Greek wedding.

Spain is international, too

The leading companies in Spain are as multinational ours or Germany’s, and more so than America’s. Even the big banks like Santander make the bulk of their money overseas.

It’s therefore somewhat irrational for shares in Spain to be particularly hard hit by the problems at home. They will certainly suffer in a worst-case scenario for Europe, but arguably the more highly-rated US ones will do at least as badly if the global economy turns south as a result.

Some of the discount is warranted because the big financial companies have a life-threatening Spanish asset base, even if they theoretically have plenty of productive assets overseas.

We all know now that a bank can be wiped out if a minority of its assets flounder. The surviving Spanish banks (most of the little ones have gone) have been setting aside money to reflect their shaky property loans, but nobody knows how much is enough.

You might also argue that there’s a certain markdown that’s justified because of the chaos that ejection from the Eurozone could cause.

But perhaps the biggest fear in a country that was a dictatorship in living memory is a return to those truly bad days. If Spain turned into a basket case like Argentina, we could see one of those once-in-a-century blow-ups that makes looking at the historical returns from international markets so revealing.

I don’t think that’s likely, and I believe Europe can cope with its problems – at least to an extent that will eventually justify much higher share prices.

In fact, some of the solutions to Europe’s woes such as restructuring in the South and higher spending by Germany could be a positive boon for corporates.

However so far I can’t bring myself to go overweight on Europe, even though I’m not a pure passive investor and I think the markets look cheap. I have considered buying shares in the likes of Santander and Telefonica, but instead I’ve restricted myself to tilting some of my index fund allocations more in Europe’s direction.

I’d be interested as ever to hear what everyone else thinks in the comments!

More reading on Europe and Spain:

• Peston: Has Spain flunked the banking test? – BBC
• Flanders: Europe, growth and austerity – BBC
• Is crisis-hit Europe a place for investors? – FT
• The Euro crisis: Europe’s Achilles Heel – The Economist

From the investing and money blogs

• Horseshoes, handgrenades, and asset allocation – Rick Ferri
• The shocking international experience of the 4% rule – Wade Pfau
• 80-20 your career – Free Money Finance
• Price of happiness rises to £20,000 [sort of!] – Ahead of the Curve
• What I learned from my parents about money – Simple Living in Suffolk
• Do I need emerging market stocks? – Oblivious Investor
• Dividend floodgates widen [US S&P 500] – Investing Caffeine
• Why do ships have lifeboats? [On complex ETFs] – The Munro Fund
• Angels, pinheads, capital gains, and dividends – The Psy-fi blog
• Food rules – a shortcut to better health – Mr Money Mustache
• Defending revamped investment trust ‘ongoing fee’ data – The AIC

Book of the week: I’ve been re-reading Charles Ellis recently. His Winning the Loser’s Game is now on its fifth edition and you should all browse it once in your lifetime, even though the detail is US-focused.

Mainstream media money

• Op-ed: It’s game over for the climate – New York Times
• Facebook floats next week – The Economist and The Telegraph
• Hope and poverty – The Economist
• Natural gas: Awash in the stuff – The Economist
• Longer commute, bigger waistline – The Atlantic
• Eurozone holiday home sell-off – FT
• Why buybacks are a ‘steal’ – FT
• Full state pension for stay-at-home mothers – Telegraph
• Richer, richer: Highest-end house prices still rising – Telegraph
• How cost effective is your gadget? [Slideshow] – Telegraph
• [The Monevator effect?] Trackers outselling active funds – Telegraph
• The Blackrock World Mining Investment Trust – The Independent
• How budget airline fees add up [Graphic] – The Guardian

Like a good read on the weekend? Then subscribe for free!

Further reading:

1. Weekend reading: On 2009 and 2010
2. Andy Brough of Shroder’s thinks UK market looks good value
3. Weekend reading: The bull market is one-year old, but the bear market is ten

A few weeks ago, I mentioned I’d stopped putting new money into shares around Christmas, and that I’d become more defensive in the active part of my portfolio.

I was also wondering where to stash the cash I’d raised from CGT defusing and a (still) imminent windfall lump sum.

Was there a good alternative to another Pavlovian lunge for equities?

It proved a lucky time to get reflective, given the subsequent market falls. I don’t claim to be able to call the market, but I do keep an eye on it, and now two years in a row I’ve been fortunate to see shares slip just after I’ve gotten slightly less gung-ho about valuations.

It all helps, but I don’t think I’ve developed an unflappable sense of market timing – amusing though it would be to claim as much in 100-pixel high letters on Seeking Alpha.

(Here’s my market call: Sooner or later the FTSE All-Share is going to be a lot higher, and likely on a loftier P/E rating. I don’t know when, and nor does anyone else. I invest in anticipation).

Besides, I was really just tinkering at the edges.

I have been extremely long the stock market since 2009¹ because to me equities seemed cheap compared to the alternatives, which mostly look about as appealing as drowning your sorrows with a Slush Puppy on the Titanic.

I didn’t set out to become quite so overweight in equities, nor for my lob-sided bet to last so long. I had hitherto always retained a big cash cushion, at least.

Then again, I never imagined interest rates would be held at 300-year lows for three years, even as inflation topped 5%. These are unusual times, and my actions have been adaptive (and not particularly astute – I’d have made money with a lot less volatility if I’d held a sensible amount of government bonds throughout, instead of dumping them too early on fears of a bubble).

I don’t recommend this lack of diversification, although equally I don’t think it’s a terrible idea in your 20s and 30s if you can take the gyrations (and assuming you’ve an emergency fund, and that equity markets look cheapish).

In my circumstances and with my unusual temperament it suits, but even I don’t want to be like this forever.

What I currently like apart from shares

When shares seem to be leaving the bargain basement, it’s commonsense for even an ultra-aggressive investor to consider shoring up on diversification.

But how? A few readers asked me as much via email.

I couldn’t tell them and I can’t tell you what you should do to follow me for two good reasons:

1) This is an educational website, not the diary of a guru. Read and ponder but don’t copy. Most readers will be best off with at least 90% of their money invested passively, rebalancing mechanically, not speculating.

2) The stock market fell, and so I’ve reinvested most of the free cash back into equities anyway!

With the FTSE now around 5,500 and the UK market on a P/E of 10 or so, I’m not quite so concerned about lightening up any further. I never thought UK shares looked dear, and now they’re cheaper again. Europe looks a steal.

Long may it last! The last thing I want is for the stock market to go up while I’m earning money and buying shares, especially when cash and bonds are paying a pittance. I owe a Greek politician a few Euros (or some drachma, soon enough).

Nevertheless, here are some of the choices I made or considered on the road to staying close to where I started, just in case you find them interesting.

Gilts

Dismissed as too expensive. I’ve been wrong about this before. The Accumulator has made a good case for holding your nose and government bonds regardless.

Index-linked NS&I certificates

I’d love more of these tax-free beauties, but as I warned when they last showed their face, they’ve proven more fleeting than an English summer. In current conditions I would buy these whenever they’re offered.

Cash savings account

The worst of times. You can get 3.5% in an ISA, but my annual allowance always goes immediately into the stocks and shares flavour.

Outside of an ISA, you can get over 4% if you lock your money away. But it’s taxed (and harder than on dividends or capital gains) so the net rate is unattractive. For emergencies only.

Peer-to-peer revisited

I’ve been a tad more active with Zopa recently: I got money away in the prime three-year market at on average close to 7% earlier this year.

Long-time readers may remember when I was spooked by a rash of bad debts. Apparently the Zopa risk machine was on the blink for a week in 2008; that clustering didn’t escalate, after all.

Furthermore, Zopa has made itself more attractive with the introduction of a Rapid Return facility enabling lenders to potentially close out most or all their loans – an option originally only given to borrowers. It’s not perfect or free, but it’s better than nothing.

I’ve also realised that as an early adopter I’m paying a lower fee of 0.5%, versus 1% for new members. I do like a perk!

On the other hand, Zopa long ago removed the one-year terms I used to prefer (and it is fiddling again with the length of terms).

Zopa has been running for about seven years now, and I feel that (as best we can tell from the outside) it’s proven it’s not going to blow up overnight. I’ll probably put more cash into Zopa in the months ahead, and may investigate other peer-to-peer platforms.

Remember though that being a Zopa lender is not the same thing as opening a cash savings account –the loans you make to individuals are more akin to a corporate bond, and you get no compensation from the FSA if a loan goes bad.

I may be over-cautious, but for this reason I don’t think I’ll ever go crazy here (so no more than around 5% of my net worth).

Corporate bonds

I feel investment grade corporates only look at all good value currently because gilts are so expensive. As for higher-yielders, junk bonds in the US just hit an all-time low.

If junk bond buyers are right about the prospects of the companies issuing their junk bonds, then I’d rather be in the shares.

Quixotically enough, I did put an order in for a slug of the latest Tesco Personal Finance corporate bond, which is paying 5% and runs for 8.5 years. This looks attractive to me, but for a specialist view check out the write-up on the excellent Fixed Income Investor.

It’s free² to buy into these at launch, which helps. With no dealing costs or spreads I wouldn’t mind investing in a few such offerings from various top-tier companies at 5% or more and holding to maturity, to create a slightly risky mini-portfolio.

Lloyds preference shares

I sold my 2010 tranche of these non-payers; I own some beaten-up Lloyds shares, too, unfortunately, and wanted to cut exposure. I got out at just over breakeven (no thanks to the huge spread).

I would have done better to hold given that I bought back in earlier this year, and again more recently.

Lloyds’ recent results confirmed its intention to resume payment on these securities, and sure enough the LLPC shares I own just went ex-dividend.

I’m hopeful I’ve locked in a long-term yield of over 10% on purchase here, with the potential of capital gains to come, and all in an ISA. I’ve bought a meaningful amount, but I suspect I’ll wish I’d bought more.

They’re much riskier than traditional fixed interest and shouldn’t be considered an equivalent, but the potential rewards are far higher, too.

Tilt towards more defensive shares

Over the past couple of years, I’ve churned a particular portion of my active portfolio like a hedge fund manager rolling in a bathtub of his client’s money.

In this account, I’ve gradually favoured more defensive shares as the market rises – generally ones that pay a decent dividend – then switched back later into either an ETF or else risky shares on big dips.

In the turmoil of late 2011 I switched out of the likes of Unilever into riskier fair, for instance, then earlier this year I switched back.

That sounds more elegant than the reality.

I only do all this trading because I’m so overweight the stock market overall: I am prepared to pay for (the illusion of) more control. It’s not ideal on either a cost or returns basis, but because markets have gone sideways, I feel it’s paid off – not least because I’ve slept better at night.

Note though that the majority of my individual share portfolio wasn’t touched in the past year, except to defuse capital gains.

Gold / other commodities

Considered and rejected. I do retain a little physical gold with Bullion Vault, partly as an experiment, but it’s not a very meaningful amount.

I’ve actually softened my views on gold over the past few years. I do still think it’s a barbarous relic, as Keynes wrote, but I’ve decided at heart we’re all barbarians so gold will have its moments. I’ve no idea how to value it though.

This leaves me to look at charts, cross my fingers, and hope. I may start to trickle money in if it gets below $1,500. I’d only be looking to build a 1-3% position.

I’ve occasionally looked at various ways to buy into timber, which is a great long-term asset in a funk due to the US construction slump. Some trusts look very cheap in terms of the discount to their net assets, but the managers extract a pretty pound of flesh in fees.

Currently on the back burner, but timber may get some windfall cash.

‘Special situations’

These are a couple of shares that I’ve bought because I think something unusual is on offer that’s not closely correlated with the wider stock market.

US residential property

I would love to buy into the US housing market directly. I think it looks cheap, especially off the beaten track.

I’m too scared to fly to Florida to buy a couple of ‘condos’ with ‘no money down’, mainly because I’m afraid I’d get arrested for asking for that in the wrong place…

US listed REITs or housebuilders are an option, but we’re back to equity risk.

I’ve an American friend who I trust and respect, and who I’d consider buying with. But he’s a cautious fellow, and isn’t biting!

To be honest, this is flight-of-fancy stuff. I’m no natural landlord, and I still don’t own a UK home, with all the tax advantages, as I fear they’re still too expensive.

However if I were writing this blog as a native of most of America, I’d be out shopping for a house tomorrow.

1. At one point in early 2009 I was selling physical possessions to buy shares!
2. My broker gets a half percent kickback from Tesco.

Further reading:

1. Plan to invest as shares fall
2. I’ve nearly maxed out my Zopa lending
3. Zopa interest rates falling

There is nothing like investing when it comes to exposing yourself as a weak-minded gimboid.

I know all about buying stocks low and selling high. I understand the rationale behind Warren Buffet’s aphorism, “be fearful when others are greedy and greedy when others are fearful.”

Yet when my portfolio hits red, I fret. When my return numbers glow green, I can feel the pleasure centres in my brain light up like Vegas.

That uptick in fortune may cost me every time I buy more equities, but hang the expense, I want to be a part of this now! The party’s on and I need to get my snout in the trough, quick.

I know this because despite being a good passive investor who pound-cost averages and rebalances annually, I am not an entirely mechanical man. And oh, the flesh is weak.

Only flesh and blood

I have until now allowed myself a measure of freedom: a certain amount to invest every year that isn’t dictated by the calendar.

Don’t get me wrong. This isn’t a gambler’s float, used to punt on some company that’s rumoured to be on the verge of inventing cancer-curing jam.

I still invest my discretionary dollop in index trackers, but I’m free to do so whenever I wish.

And I couldn’t take the plunge last year when the market did. I wasn’t brave enough to blow my ammo when equities were relatively cheap. I held on and on until the upswing in March, and got less for my money.

Oh, of course I had my excuses. My brain was able to provide me with plenty of self-justification, reassuring me that reason was in control not instinct:

• I was worried about my job.

• My company was restructuring.

• My monthly drip-feed was already casting cash into the cavernous cakehole of the capital markets.

• I better not throw in anymore in case I’m axed – then I’ll need every penny.

But in reality the overweening fear of loss was in charge.

It turns out that I am just one of the herd, a member of the cattle class. I’m not special at all. I react and feel like everyone else making up the statistics that show that irrational behaviour costs investors.

The US Dalbar study keeps tabs on the consequences of our bad behaviour, revealing that:

The average equity investor has underperformed the S&P 500 by 4.32% for the past 20 years on an annualised basis.

That’s a shocking amount to lose because we can’t control our urges.

Gorilla warfare

It takes willpower to overcome the apeman within. And there’s evidence that willpower is in limited supply for all of us. We can’t bank on having enough in reserve when we need it.

So the fewer decisions that are left up to my meat-bag of a brain the better. Passive investing would be much easier if I could program a robot to handle it all for me and to physically prevent my continued interference. Ah, a lazy investor’s dream of the future.

Given that I don’t expect Amazon to ship me my own automatic investing droid anytime soon, I need to automate as much of the investing process as possible, because the one human behaviour that does work for me is inertia:

• I don’t stop the broker’s direct debit that comes out of my bank account.

• I don’t mess with the regular investment scheme that funnels money straight to my chosen funds.

• I don’t take money out of lock-in schemes like ISAs, pensions and fixed-term bank accounts, where a cost is imposed upon me for doing so.

Inertia is the great human pacifier. It’s a force that’s regularly more powerful than fear in my world, especially if the fear is intangible like an investing loss.

Eliminate all carbon units

But there are other weak points of human intervention that could yet scupper my plans.

I can fiddle with my asset allocation every time I choose the next fund to buy and, boy, what mischief I could get up to when it’s time to rebalance.

So far I have resisted the urge to keep thrashing my winners but it’s always taken a stiffening of resolve, and a quick prayer of deliverance to the passive investing gods.

Will I do the right thing in the future? I can’t say for sure. I’m regularly tested and I’m only a passive investor.

If you recognise these weaknesses, then it’s worth knowing that the closest current proxy for my investing robot is the Vanguard LifeStrategy fund series.

It’s an index-tracking, fund-of-funds with built-in rebalancing features – truly automatic investing. All I need do is pick the asset allocation of my choice, set-up a direct debit to keep it oiled and then let the program run.

The human being thus retires from the game (which is the point of the exercise after all) and leaves the rest to the robot. No more worries about pesky emotion.

Take it steady,

The Accumulator

Further reading:

1. Simple mind games to stop passive investors hitting self-destruct

Good reads from around the Web.

Lee and Rob, two up-and-coming personal finance bloggers in the UK, are calling for better financial education in schools.

Over on Five Pence Piece, Lee writes:

Right now students leave the family unit to enter further or university education – or the even more daunting world of work – with only the vaguest hint of how to manage their money, wages, taxes and bills.

The little that is taught is about the math and not about the personal responsibility, the benefits of being financially astute and the dangers of not. It does not present the knowledge in a fun and ‘wow’ style; it’s just all about the numbers in the maths lesson.

Rob continues the theme on his own blog:

I was never taught anything about personal finance and to be honest with you I wish someone had at least taught me how to fill in a tax form or taught me my responsibilities with capital gains tax.  These are all things I had to teach myself when I didn’t see why they weren’t taught at school.

The two would like other personal finance bloggers to share their own views on educating youngsters in the ways of debt, APRs, and interest only mortgages.

I’m happy to highlight their campaign. But I’m not sure they’d want me on their team!

I’m skeptical of school-taught education, to be honest, especially pseudo-practical knowledge that is theoretical until you’re faced with buying your first house, say, or taking out car insurance.

I’ve seen plenty of people’s eyes glaze over as I’ve tried to explain how mortgage repayments work over the years. I don’t think little Johnny gives a monkey’s.

But to not be totally negative (who could argue with the aims?) I would certainly teach kids about compound interest, perhaps by alluding to the still-magical £1 million figure. That could capture the imagination.

Beyond that, I’d probably try to find something that appealed to the here and now, rather than to their future selves.

Lessons in the second series of The Wire gripped the young proto-gangsters with the economics of a corner drug dealing spot, but I’d hope things are not so bleak yet in the UK.

Perhaps using the personal finances of a top-flight footballer or a reality TV winner might do the trick?

The bottom line is our education system is teaching kids to start working life mired in debt by going to university without evaluating the return, so I don’t think Rob and Lee should hold their breath.

But I wish them better luck than even the mighty Martin Lewis had with his e-petition to Parliament.

From the money blogs

• Does birth order influence financial behaviour? – Len Penzo
• Do you have the courage to be wealthy? – Roshawn Watson
• Divide and conquer ETFs – Rick Ferri
• How to manage risk? Diversify! – Investor Junkie
• Investing with the sentiment pendulum – Investing Caffeine
• I’m rich and life is perfect: What now? – Mr Money Mustache
• Is someone getting the best of you? – Objective Wealth
• How to set and use investment goals – UK Value Investor
• BoE governor going out on a whimsy – Simple Living in Suffolk

Deal of the week: I sheepishly admitted to a published novelist the other day that I only read five or six novels in a year. As a teenager I read more in a month! He harrumphed. Perhaps I was a bit insensitive, but am I unusual? A friend swears by audio books, and I see Amazon spin-off audible is offering a free audiobook download to seduce the unconverted.

Mainstream media money

• Selling Edvard Munch’s The Scream – The Economist
• Europe: Going for growth, but how? – The Economist
• On buying gold (and more) – Marc Faber & Jim Rogers on Index Universe
• Time to invest in U.S. natural gas? – Wall Street Journal / Fool
• What they don’t tell you at graduation – Wall Street Journal
• Roth: Goldman Sachs thinks my clients are muppets – CBS
• Yes, you can become a millionaire farmer – MarketWatch
• All signs point to lost decade – The Fiscal Times
• John Lee: Share prices can bely true value – FT
• Interest-only loans disappearing fast – FT
• Tech sector backed for value and growth – FT
• Overvalued US will be worth the wait – FT
• Investment trusts with a multi-decade income record – Telegraph
• Cheap way to buy an iPhone 4S – Independent

Like these links? Subscribe to get them every Saturday.

Further reading:

1. Two new personal finance tools for Monevator readers
2. Why I wish they’d taught me about compound interest at school
3. Personal finance tools and calculators

Companies have good and bad years, which temporarily elevate or depress their earnings¹ and so skew their P/E ratios.

When added to the vagaries of forecasting, this prompts some investors, led by 1930s legends Graham and Dodd, to instead compare prices with average earnings across multiple years (taking into account inflation) to derive a cyclically-adjusted P/E ratio (also known as CAPE).

By comparing a company’s current multiple-year P/E ratio to its historical average, you can then try to decide whether the shares are cheap without being misled by short-term blips.

Ten years seems to be the most favoured timescale, though some people work with five or even three-year histories.

Newsflash: Company earnings oscillate

What a company earns in any particular year is dependent on many different factors. These range from how well it executes its business plan and the trading conditions in its sector to the performance of rivals, the mid-life crisis potential of the MD, and even dumb luck.

But nearly all companies’ earnings are also affected by the ups and downs of the business cycle.

Stock market indices are just a collection of listed companies. When you add up a weighted average of the earnings generated in a single year by all the companies in a particular index, individual factors such as management skill or new product developments just disappear into the noise.

On this aggregate view, the earnings total varies mostly with the wider economic cycle, since nearly all companies are affected by it to some extent.

Earnings are cyclical: Over a period of years, the total earnings from all companies in an index will tend to rise during economic expansion, and fall sharply in slowdowns or recessions. For successful companies, the trend will be upwards over the decades. But most will suffer setbacks en-route.

If companies are cyclical, so are stock markets

Because earnings are cyclical, we might decide to calculate a rolling P/E for the whole market based on an average of multiple years of earnings, just as Graham and Dodd did for companies.

The resultant cyclically-adjusted P/E ratio is most often calculated over ten-year periods. It’s often known as PE10 as a result, which is less of a mouthful!

PE10 is also dubbed the Shiller PE, in honour of the US academic Robert Shiller, who popularized PE10 when he used it to predict the stock market crash of 2000 on the basis of an elevated P/E ratio versus ten-year earnings.

But whatever you choose to call it and however many years you look at, the idea is the same – to try to see if a market looks good value compared to history, perhaps also by considering where you think we are in the economic cycle.

(The start of) the trouble with PE10

I want to stress immediately that in that last throwaway comment is one of the big problems with PE10: It’s rarely clear what the economy will do in the next year.

• For example, it’s often joked that economists predicted 12 of the last six recessions.

• As for growth, Western markets took far longer than expected to emerge from the global slump of 2008.

In the absence of a functioning crystal ball, we are left with forecasts, best guesses, and playing the odds if we want to try to time our entry and exit into the stock market by the PE10 measure.

Given that capitalist economies have historically tended to expand for more years than they’ve contracted, you might decide to assume any current expansion will continue into the near future.

But be under no illusions. Boom and bust will never be abolished, and some years you’ll find an apparently healthy economy collapses out of the blue, taking company earnings with it.

Sourcing PE10

I’m not going to tell you how to calculate an accurate cyclically-adjusted PE ratio.

I’ve never personally done the maths, and others have explained in great detail how they calculate PE10 if you’re keen and something of a maths masochist.

Unfortunately for lazy souls like me though, PE10 data is hard to come by for almost all markets, as far as I’m aware.

The exception is for the S&P 500 in the US, where many people track the PE10 ratio. There’s even a regularly updated graph plotting PE10 for the US index:

PE10 for the S&P 500. Yes, most of the falls look obvious in retrospect, but they're not so clear at the time. (Chart from multpl.com)

You sometimes see investment banks quoting PE10 ratios for the UK market, but I don’t know of a go-to source. Macro hedge funds and the like compute this sort of data for themselves, but they don’t make it publically available.

Richard Beddard of iii provides a somewhat jerry-rigged version of PE10 for the FTSE All-Share index. Another UK blogger used to offer self-calculated updates of a shortish-run PE10 ratio for the UK. Sadly his last post on the matter was in summer 2011.²

If you know of other sources, please do share in the comments below.

Not the droid you’re looking for

I wouldn’t get too caught up on seeking a spurious level of accuracy when looking at PE10, anyway.

A figure from a reliable-sounding authority quoted in the press is good enough for me for six months or so, assuming no major earnings shocks in the interim.

That’s because I doubt that PE10 is the fine-tuned timing tool that certain of its adherents claim it is. I therefore don’t need it to three decimal places.

Just as one year’s earnings are a unique event, so are the past ten years. A longer-term timescale is usually better in the mean-reverting world of investment, but there’s no magical reason why looking at ten-year data suddenly becomes extremely accurate for forecasting.

As I write in 2012, for instance, the ten-year history includes two big earnings collapses, one of which was the largest since the Second World War. That’s unusual, and the ten-year history might therefore be unduly depressed, in turn over-inflating the PE10 ratio. I think the next ten years could be better.

On the other hand, perhaps earnings over the past ten years were illusory, having been fueled by credit expansion in the first half of the decade that led to unsustainable consumer spending and indebtedness. If so, then to what extent we still need to work off the excess remains to be seen.

Moreover, many companies took on too much debt in the go-go years. The PE10 ratio looks at market capitalisation not enterprise value (the latter would factor company debt in the numerator, the ‘P’ part of the ratio), so it doesn’t tell you anything about changes in balance sheets.

Again, this is another hindrance to the usefulness of looking at ten-year figures.

To counter that point in turn, some of the most indebted companies went bust or were radically devalued in the slump (property companies, for instance). Perhaps ongoing earnings will be of a higher and more sustainable quality, justifying a higher PE10 ratio?

I could go on. The point is that contrary to what some imply, PE10 will not see you dive effortlessly in and out of the market like a seagull stealing chips.

Even Professor Shiller concluded his original paper with humility, warning that PE10′s apparent predictive abilities might just be a coincidence.³

More concerns about PE10

My point here isn’t to tell you the market is cheap or expensive. It’s to warn you that cyclically-adjusted PEs may be a useful tool, but I don’t think they’re the silver bullet they’re sometimes touted as.

PE10 became much more popular in the choppy post-2000 investing climate, not least in the light of Shiller’s seemingly vindicated prediction. Understandably (if optimistically) people looked for ways to better time their entry into the stock market, and to get a sense of when to take money off the table.

There has been some research suggesting a valuation-based timing strategy might improve risk-adjusted returns compared to fixed asset allocations, but the margin seems slender to me.

Other respected voices have flatly dismissed PE10. Passive investing guru Rick Ferri says times have changed:

“Shiller’s method is fine in a bear market when people feel compelled to justify low prices, and had it existed, PE10 may have worked okay prior to 1950 when dividends were high and earnings payouts were also high.

If you look at a [chart] of real earnings growth and real price growth there wasn’t much from the mid-1800s to the mid-1900s. But there was dividends.

After 1950 [...] fewer companies paid dividends (only about 30% of companies pay dividends today), and the dividend payout ratio is also low (about 35% today).

Since the 1960s people have expected earnings growth due to earnings reinvestment and stock buybacks, and they got it. So, today, PEs should go higher than the 125 year ‘average’ PE 10 when the economy begins to recover.”

Taking another tack, my blogging friend Mike at Oblivious Investor has pointed out that if PE10 worked in the past, then it probably won’t in the future. This is because such inefficiencies tend to be ironed out once they become well-known.

As for me, I think valuations do matter to future returns, and PE10 gives us another way of measuring them.

But I also think that the average person – and quite possibly everyone else, discounting for luck – is poorly placed to make a finely graduated call based on it.

In the March 2009 stock market lows, for example, what looked a high PE10 ratio compared to the bear market bottom of the 1970s was frequently given as a reason to steer clear of US equities.

The US market went on to double within less than three years!

For those who do want maths to tell them what the market will do in the future, the excellent Moneychimp offers a simple calculator that uses PE10 to estimate future returns for the US market, and also to adjust for dividends.

It’s a bit larky, which is how you should treat PE10 in my opinion.

A useful measure, in perspective

Personally I keep an eye on both simple and cyclically-adjusted P/E ratios. But I don’t take either too seriously.

Making up some numbers for a fictitious market for illustration: I wouldn’t sweat it if a market was on a PE10 of say 20 versus its historical average PE10 level of 15. But if its PE10 got towards 25 for any extended time in this illustrative instance, I’d consider that fair warning.

Your own mileage may vary. Passive investors are strongly advised to ignore the whole sideshow in favour of fixed allocations and mechanical rebalancing, except perhaps at times of seemingly extreme over-valuation – the year 2000, say, not the hindsight overvaluation of 2007.

And those don’t come along very often.

1. A quick reminder: Earnings in this context are basically the same as profits. Dividing the share price of a company by its earnings per share in a particular year gives you its P/E ratio.
2. The blogger remains a Monevator reader however and sometimes does requests, if you ask nicely.
3. He wrote that in 1996 and his prediction pretty much proved right, though, so he might be more strident now.

Further reading:

1. Valuing the market by P/E ratio

Many passive investors are in a pickle over gilts (or US Treasuries or whatever your domestic government bond might be, if you’re tuning in from outside the UK).

Mechanical asset allocation rules dictate that we must sink a proportion of our savings into government bonds, according to our individual risk tolerance. But aren’t we on a hiding to nothing, as gilt prices have soared and yields dwindled thanks to government manipulation of the market?

It certainly seems so when an investing legend like Warren Buffet comments:

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

Surely the only way for gilts to go is down as interest rates rebound? Surely some kind of ‘active’ evasive manoeuvre is required?

What are gilts for?

Let’s ignore for now the fact that similar fears were widespread a year ago, only for the UK gilt sector to return 15% in 2011 and the index linked gilt sector to weigh in with a 21% rise.

Let’s even assume that this chart-topping performance makes it all the more likely that gilts must drop.

Before leaping into action we need to consider a few questions:

• How catastrophic will the ‘inevitable’ bonfire of the bonds be?

• Why do I have a gilt allocation anyway?

• What if things don’t turn out according to the forecasts?

To answer the first question, the role of government bonds for investors who are building their capital is to reduce the risk of underperformance by equities.

The more your portfolio is insulated with gilts, the less violently it should convulse as it’s held to the bare wire of the market.

Hence ‘merely human’ investors are less likely to go panic-sell crazy during market turmoil, and you’re better diversified should equities not live up to their long-term performance billing.

These important protective features of gilts remain true even in the face of the current market situation, and particularly given the economic uncertainty faced by the world.

If we should slip into a Japanese-style economic ice age, your gilt positions will provide a stable source of income and a welcome redoubt against deflation.

And if you pare back your gilt allocation to a point where your portfolio is riskier than you can truly stand, you may well do far more damage to your long-term prospects than you would in that much-feared gilt bear market, if instead equities fall, your nerve snaps, and you belatedly sell your shares at low prices.

This is because bear markets in bonds are generally pretty tame in comparison to equity nose-dives.

How bad can the losses be?

According to Vanguard, the largest annual loss that a 100% UK bond portfolio would have suffered in the last 30 years is -6.27% (in 1994).

Compare that with the -29.93% sliced off UK equities in 2008.

Better still, gilt funds¹ come with an in-built recovery mechanism. As the price declines, yields rise, so as your bonds mature they can be reinvested for a lower price into new gilts that pay higher levels of interest.

As Vanguard² points out, this mechanism eventually works in our favour:

Over the long term it’s interest income – and the reinvestment of that income – that accounts for the largest portion of total returns for many bond funds. The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising rate environment of the 1970s and early 1980s.

Duration is the key characteristic on your gilt fund factsheet that shows how badly it will be affected by a rise in interest rates and long it will take to recover.

For example, if a gilt fund has an average duration of 7 years then it will lose (or gain) approximately 7% of its net asset value (NAV) for every 1% rise (or fall) in interest rates.

A duration of 7 also means that the fund will recover its original value within seven years as higher interest payments compensate for falls in price (though the recovery can be faster in practice).

What action can I take?

One thing you can do, therefore, is to make sure you only invest in gilt funds with a duration that’s no longer than your time horizon. That way you can’t suffer a capital loss on your portfolio’s gilt allocation.

And if you’re strapping in for the long term then you can take comfort from the fact that you’re likely to be able to ride out sharp rises in interest rates.

Interestingly, though a rapid rise in interest rates would seem to be a nightmare scenario for bond investors, the Vanguard study I quoted above found it actually delivered the highest expected return over 10-years (in simulations upon intermediate holdings of US Treasuries) in comparison to scenarios that are more bond-friendly in the short-term.

But if such reassurance is not enough to stay your hand, then it is possible to maintain your allocation to defensive assets while reducing your exposure to a price drop (otherwise known as maturity risk).

You can do this by increasing your allocation to shorter-dated gilt funds at the expense of longer dated funds.

This works by shifting some of your allocation from a long dated gilt fund to an intermediate fund, or from an intermediate fund to a short-term fund.

The table below shows what kind of difference that would make in terms of duration, using some example UK-listed gilt funds:

If interest rates rise by 1% then the iShares ETF’s duration reveals that it will only lose 2.57% of its value in comparison to a 9.5% loss for the Vanguard intermediate fund.

But if interest rates fail to budge, we can see from the yield-to-maturity that the short-term fund will pull in less than a third of the income of its intermediate rival.

If you’re more worried about volatility than long-term returns, a shift of this kind could make sense – particularly if you already have a high allocation to fixed-income.

Another way to trim your exposure to maturity risk would be to increase your allocation to cash.

The best instant access bank accounts yield 3% and you can get a two-year fix at 4%. That’s considerably better than the current yield on gilts, your portfolio will be less volatile, and there’s no risk of a capital loss.

As ever, the risk with cash is that it has delivered the worst historical return over the long-term and is highly susceptible to inflation.

The slippery slope

The elephant in the room for passive investors is that once you start trying to outsmart the market, how will you know when to stop?

Interest rate forecasts are a total lottery. After the credit crunch, it was widely predicted that interest rates would rise in 2010, then 2011, and now 2013. I’ve seen commentary that predicts a flatline until 2015.

Once rates do rise, when will be the right time to get back into gilts? Will you be able to do it when equities are crackling like a fried egg in Death Valley? Or will you be too busy diving in and out of gold?

If you’re a long-term investor, you shouldn’t dump your gilt funds. Historically, they’ve always been a drag on a portfolio, but they’re not there to boost returns. Gilts are there to diversify risk.

If your risk tolerance hasn’t changed, then your allocation to gilts shouldn’t change either.

Take it steady,

The Accumulator

1. I’m going to refer to gilt funds throughout the rest of this post, as I assume that most passive investors won’t want to strain themselves buying and managing their own gilt ladders.
2. The study is based on the US market, but the UK is analogous enough for our purposes.

Further reading:

1. Gilts (UK government bonds)
2. Vanguard LifeStrategy funds turn passive investing catatonic
3. Vanguard dealing fees fall, adds new funds