Complexity costs

A recent piece in the FT by Jason Butler mentioned some advice the author received from Peter Hargreaves, one of the UK’s richest men, a few years ago:

I asked Peter if he could share some of his money wisdom. He thought for a moment and then replied: “As you know I’ve got a few quid and I can pretty much have anything I want in life. I’ve got one car, one house and one wife, and that’s the way it’s staying. No matter how much you own or earn, keep your life as simple as possible.

Now, (both) long time readers of this blog will know that I am not a fan of the firm Hargreaves Lansdown (though I have professional respect for it as a very effective way to part wealthy fools folks from their money). Nor, for various reasons I won’t cover here, am I generally an admirer of its founder Peter Hargreaves, notwithstanding that he is clearly a very talented entrepreneur/businessman.

However, this blog believes in playing the ball not the man.

I can recognise wisdom when I see it.  And I think Mr Hargreaves’ advice to keep life as simple as possible is profoundly good advice.

How financial progress breeds complexity

For those of us who manage to grow our net worth, saving money, simplicity is an uphill battle.

That first thrill of making more money than you need to live will invariably result in some temptations.  Time to ‘treat yourself’ with a new holiday?  What about new clothes?  Or some art?  Or some furniture?  Maybe even a new car?   Carry on this way and pretty soon you’ll need more space, parking, garage, a yard, who knows.

But, once you’re making decent money regularly you will start wondering how/where to save it.  Now, don’t misunderstand me, there are definitely simple ways to save/invest.  But if you are tempted by property, EIS/angel investing, or extreme diversification, then be care is certainly required.  All of this increases your financial complexity pretty quickly.  Carry on this way and pretty soon you’ll need an accountant to help with your tax return, and you will probably seriously consider talking to a financial adviser.

Once you start investing, time can be a surprising enemy.  Most of us investors learn about ‘buy and hold’ as a strategy pretty early on.  And twenty years in, I would say that ‘buy and hold’ works pretty well.  But buying and holding can nonetheless result in an increasingly sprawling portfolio – as my recent ‘overdiversification‘ blog highlighted.

Property is particularly beguiling.  As a reader of this blog, you probably don’t consider property to be the only way to invest. You might even, like me, consider that property has a place in a diversified portfolio, either via REITs or via buy to let. But have you considered / aspired to owning a weekend place? A holiday home?  A ski chalet? Carry on that way and you’ll probably need a gardener, a handyman, maybe a builder.  That’s one thing if it’s local but it’s another prospect if it’s in another country. Carry on further and you’ll be tempted by a second car, you’ll want access to the business lounge every trip or, worse, you’ll start seeing private jet ads follow you round the web.

Or perhaps, like me, you have become an ‘accidental landlord’.  That ‘accident’ – your first place – is, in London, more likely to be leasehold than freehold, so maybe the maintenance/etc is not your responsibility.  But if it’s leasehold you will have some form of service charge/sinking charge to budget for, and it’s freehold you’ll know all about every roof repair, damp patch, and boiler problem.  Repairs and maintenance are all tax deductible, but make sure you keep those receipts.  Carry on this way and even your accountant will start complaining.

Have I got a complexity problem?

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August 2018: US 1, UK 0

I’m not really sure what happened in August.

At least, you’d think something quite significant happened, given that UK equity markets fell over 3% and US markets rose over 4%.

The swing of the US:UK currency itself was notable during the month but over the month fairly minor – with the USD gaining slightly based on 1 August (but the gain having been much bigger only a week ago).

The Australians have joined the Brits, Americans, French, Italians and Swedes in bewilderment at the nonsense their politicians can get up to.  But the Australian markets haven’t moved much; the currency fell and the equities rose in compensation.

The USA appears to be making more ‘progress’ on trade, with the news at the end of the month being about some Mexico/NAFTA-related agreement.  Maybe that helped.  Maybe.

In the UK we saw the media running with the ‘no deal’ ball.  How much of this was silly season, and how much reflected the overlooked aspect of the Cabinet’s Chequers deal in which they agreed to take ‘no deal’ planning much more seriously, I couldn’t say. It has certainly nudged me to move my portfolio a bit more out of the UK than I might have done.

So, all in all whatever drove the big market movements in August somewhat passed me by. But 6 point swings between UK and US equity markets, after currency effects, are not common.  Thank goodness I have almost double the allocation to the USA – which rose by over 4% – than to the UK – which fell by almost as much.

2018 08 FIREvLondon weighted markets

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Overdiversity

Diversification is the “only free lunch in investing”, and I love it. However, I came to the conclusion as I started tracking my investment performance rigorously that I had overdone it. Since that realisation I have been rowing back slightly. I appraised my progress recently, and this rather dry blog post sets out my findings.

I track all my investment portfolio holdings in one single investment spreadsheet. One advantage of this approach is that I have a consolidated view of my portfolio which ‘de-dupes’, and makes it fairly easy to see large positions that amass when I buy the same ETF in multiple portfolios.

What is the appropriate number of holdings to diversity accurately? You’ll find as many answers as responders to that question. But consensus seems to suggest 20 holdings is more than sufficient, especially if you are using collective securities such as index funds or ETFs.

When I began my unified tracking I had no fewer than, erm, 228 holdings. Over two hundred holdings.

Almost every single one of my holdings I have personally chosen. With a reasonable amount of consideration, time and of course fees associated. Multiply this by 228 and pretty soon it sounds like a lot of time wasted.

How did I end up with 228 holdings?

Here is the breakdown from late 2013:

  • 29 ETFs. Of these 29 (15%) of them were ETFs, amounting to just over 30% of the total portfolio value. VUKE was originally my largest, at just under 10% of my total portfolio; these days IUSA is my biggest, with about 5% of my portfolio.
  • 57 Funds. Ouch. This was a testament to having used my fair share of IFAs and private bankers over the years. This lot added up to around 25% of my portfolio’s value. The largest holding was about 2% of the total.
  • 122 equities. Half my holdings are directly held equities. They amount to about a third of my total portfolio value. They included, originally, 57 holdings of less than £10k each.
  • 12 bonds. Individually held bonds are quite exotic things really so no wonder I don’t have many. Though my largest is 2% of my portfolio, the total amounts to only 5%.
  • 8 cash equivalents. Eight! Five separate currencies, held in 8 different ways in total.

I decided, roughly when I wrote my Investment Philosophy, that this portfolio was needlessly complex and should be slowly pruned. The complexity cost of such a large portfolio is significant:

  • Higher transaction fees. My minimum opening position used to be around £1000. At this level I am doing a lot of transactions and my in/out fee is over 2% even before stamp duty. With a higher average trading amount I cut my fees.
  • Higher paperwork/admin time. Almost every single one of my holdings spits out income payments. I track many of these individually. Typing in £0.31 of tax credit on a Fidelity account for some <£2000 holding is not good use of time.
  • Reduced mindshare. Warren Buffett has long espoused the ‘20 punch card‘ approach. He has a point. His point is choose wisely, and get it right – and limiting yourself to fewer bigger decisions improves your odds. And of course to stay up to date with 20 investments is far easier than keeping tabs on 228 investments.
  • Carrying deadweights. Looking back at my 5 year old portfolio I recognise holdings that I knew were suspect, but I ducked the challenge of making a decision to liquidate them. When they’re small, the damage they are doing to the portfolio doesn’t feel worth the bother.
  • Diluting my best picks. Some of my best performing investments have been my smallest. I have had a hunch, and invested £2k, £5k, or something similar. If I’d made my entry ticket bigger, and adopted a different approach to selling out duds, I think I’d have made more money without taking on appreciably more risk.

In any case, after quite a lot of gradual pruning, optimising and spring cleaning, my current portfolio looks considerably better on my ‘overdiversity’ measures:

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