Investing a lump sum

I have a substantial lump sum to invest over 15 years…

When considering investment options, the finance industry has been guilty of concentrating too much on the tax angle having been lulled into a false sense of security by the unprecedented rise in markets since the 1980’s. It may sound obvious but you need some kind of growth in order to be taxed in the first place. Many products are based on growth assumptions that may no longer be that large or that likely. You only have to look at endowment policies and split capital investment trusts to see what damage is caused when using unrealistic rates of return.

To emphasize the problem with investment growth, it is worthwhile using an analogy of a motor vehicle to show the workings of an investment vehicle. Much of what is sold and bought is concentrated on the way a product is packaged and marketed. In the case of a car, it may be selling the dream or image to match the age bracket of the target market. Because most people are not mechanics or car fanatics, there is little more than a cursory glance at the motor and working parts while great deliberations are made of the colour, feel and shape of a car. In a similar manner, investments tend to be sold on what is known, tangible and appealing. Like all sales tactics there will also be the age old angle of ‘create a fear, offer a solution’.

For investments, the under-the-bonnet bit is either a tantalizing mystery produced by boffins or a past performance sheet showing what great returns have been achieved in the last year (or whatever date looks best). Instead of the continuous rising market that we witnessed from 1982 to 2000 we are now in a very different environment. In the last two hundred years, whenever we have seen a prolonged bull market, this is inevitably followed by a long period of flat or falling markets. What we should be doing is approaching the problem in the opposite manner to buying a car. We need to strip away the glossy packaging and work out how the growth is going to be produced in the first place and make sure it is brutally realistic. There is little point in having an elegant interior if the working parts don’t move the vehicle. In other words, we need to work out the big picture trend in markets and try to generate returns from that.

By breaking down the three major trends over the next fifteen years we can tackle this growth problem in three lots of five year plans, as per Stalin’s approach in Soviet Russia. Like Stalin, it may not be fun or popular but it got results.

Phase I Primary bear market; retirement of 1st wave baby boomers

Although markets had a lucky escape with a rally in 2003, shares have otherwise been a dismal investment for many years. You only have to analyze the FTSE 100 to see that it is still at the levels seen in 1997. It is tempting to look around at the world economy and see lots of economic growth and not question where it has come from. The fact remains that much of the growth in question has stemmed from a consumption binge in the USA which has left many households chronically indebted, in an environment of rising interest rates. The situation is similar in the UK where the rapid impact of interest rate rises on property prices indicates that too many people are overstretched financially, even at these relatively low borrowing costs.

Adding to the poor fundamentals and over-valuation of the stock market we know that the baby boom generation (spawned from troops returning from WWII) is hitting retirement age in significant numbers. This means that we are likely to see some kind of net withdrawal on savings and hence the fuel pump to the stock market will likely see further constriction. In this phase of the market the most important lesson is that those who lose least and maintain their capital will be the winners. Investors should hold plenty of cash and gold while any shares should be bought with large dividend yields in mind.

Phase II Extremes of good value; Baby Boomers (Mark II) start to save

Much like 1982, when stock markets were exhausted and there were extremes of good value, no one will show the slightest interest in shares once Phase 1 comes to an end. As with gold today, a long term bear market will create a built-in assumption that a recovery will never happen. Before the 1960’s, dividend yields on shares were higher than bank interest rates and bond yields, quite logically, because shares were higher risk. It was only when inflation gnawed away at everyone’s wealth that shares were viewed as a way of protecting the value of capital.

When equities become universally unpopular, we know that it will be time to snap up the value stocks. Investors who are looking to compound slowly but surely will be in a great position and will add significantly to their income. On top of this the forgotten baby boom generation of the 1960’s will start to accumulate wealth significantly as they approach the run-in to retirement, which we witnessed before with the liquidity surge into markets during the 1990’s.

Phase III Bull market; switch from Value to Growth

This is the most enjoyable part of investing when most stocks rise. It is important at this stage not to be overly cautious initially. Large upward surges in markets are not that common and need to be fully exploited. Investments should be concentrated on expensive growth stocks. Once the case for investment becomes compelling and we see countless newspaper articles, TV programs and books on the subject then we know the end is near. Without wishing to cause offence to our worthy cabbies, the phenomena known as the taxi driver syndrome is another sign of a market peak i.e. everyone is talking about markets. It is a good clue that the general public is fully involved with investing and there are no buyers left. This is a classic warning to get out.

A very good way of approaching markets in these boom periods is to halve your investments every time they double, thereby maintaining some exposure while keeping the initial investment safe. This is known as top-slicing. With a pension crisis looming world wide we must approach markets in an active manner as the days of ‘buy and hold’ are long gone. While it is never possible to exactly predict the next year in markets, let alone the next fifteen, the above patterns are classic for many previous cycles. By investing in this three phase approach, you stand a good chance of preserving capital initially and gradually compounding over many years, albeit at a low rate. Any bull market period is simply icing on the cake.

Toby Birch
November 2004