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It has never been more important to take charge of your financial affairs.

Fortunately the tools available to you have never been more powerful or inexpensive. Own The World shows you where to go and what to do to make the very best of your personal finances…

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Wikipedia defines technical analysis in the following way:

“Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume…”

To put this in Plain English:  Over a long period of time academics looking at financial markets worked out a number of methods for predicting where prices in a market would go based on where they had come from.

This may seem quite crazy intuitively but it isn’t when you think a little about human nature:  If a share or market has been going up steadily then, all other things being equal, there is a good chance it will continue to do so, if only because of the herd mentality of the investment community.  Technical analysis tries to generate rules along these lines which help the investor buy and sell with a high probability of success.

The discipline has been developing for several decades and there are now a bewildering array of techniques and theories available to the investment community with scary names like “Bollinger Bands”, “Donchian channels”, “Exponential Moving Averages” and so on.  When you boil it down however, technical analysis is really about waiting until other people are investing in something and then jumping on the bandwagon.  This works because the main thing that causes the price of an asset to move is lots of money flowing towards it (up) or away from it (down).

Just like fundamental analysis, technical analysis is a huge subject and you could spend a long time learning about it but it is my firm belief that you don’t need to learn that much about it to start improving your ability to invest.  Let us look at a couple of technical indicators to give you an example of how simple and powerful technical analysis can be.

An example of technical analysis at work:  RSI – Relative Strength Index

Before reading this section you may want to have a look at this recent article from MoneyWeek’s Dominic Frisby about my use of RSI:

This is a chart of the performance of a London-listed Silver ETF:

Source:  www.barchart.com

This graphic might look a bit complicated but please don’t worry,  let’s look at each section in turn.  The top half or so of the chart plots the daily moves in the price of silver.  The middle graphic with red and green lines show the volume traded.  This is simply the number of shares of silver which changed hands that day.  Days where the bar is green are up days (when the price ends higher than it started) and red days are down days.  The bigger the bar, the more shares in this fund traded.  As a general rule, if there is big volume this gives you an indication that something is happening in the market, so a big red bar is basically bad news and a big green bar good news, all other things being equal.

Most importantly, however, take a look at the bottom graphic with the heading “RSI (14)”.  This is a technical indicator called the RSI.  The RSI is simply a mathematical calculation that gives a range of 0 to 100.[1]  You really don’t need to understand the detail of how it is calculated.  The point I want to make is simply for us to have a look at the relationship between what the RSI is doing and what the price is doing.  This is a form of technical analysis at work.

You can see that the RSI line turns red in this chart if it goes below the number 30 and blue if it goes above 70.  Below the red line is what we call “oversold” and above the blue line “overbought”.  All other things being equal the RSI tells us that an asset is cheap when it is oversold, so we should think about buying it and expensive when it is overbought, so we should think about selling it.

As such, in this example you would consider buying silver when it went below the red line and consider selling it when it went above the blue line.  Hopefully you are with me so far and this doesn’t seem at all complicated.

In reality someone using RSI would most likely finesse the above strategy based on looking at RSI going back a few years and look to buy silver when the RSI crosses back up through the red line and sell when it crosses back down through the blue line.  You would also look for times when this happened with a larger than normal volume given that a big volume day would be a stronger indicator of a change in trend than a low volume day.  Again, hopefully none of this so far is too complicated.

So let us look at how this strategy, using only one technical indicator, might have served us in the last few years.  Previously, we have looked at a number of fundamental reasons that silver is in a bull market – that is to say we would like to have it on our investment shopping list.  As always, however, we would ideally like to buy it when it is cheap and sell it when it is expensive.  We must always be thinking about the price at which we buy something once we’ve decided that it is worth buying thanks to our big picture analysis.

Following the strategy outlined above you should be able to see that you would have bought silver in February 2011 when the RSI crossed back above the red line.  Can you see that the cost then would have been about $31 per share (perhaps use a ruler on the screen to help you see what the price is on the graph above)?  You would then have held it until early May when it crossed down through the blue line and there was heavy volume.  You would have been able to sell your position for about $50 per share.  That is a 61% return in about three months.

Using the same analysis, you then might have considered buying again at the end of May at about $40 and selling in August at about $48 (+20% in three months) and finally buying again in October at about $32 in which case you might have thought about selling again in February 2012 given silver was above the blue line again at about $37 (+16% since October).  In fact, you would not have been looking to sell your silver yet since it had not crossed back down through the blue line.

I should perhaps mention that this is not just theory, this is precisely what I have done with silver in the last couple of years.  To do this I only needed to follow one share price, news about one investment (silver) and one broad strategy – the RSI with a weather eye on volumes.  I should note that all of the information I am referencing here is available online entirely free of charge on the website www.barchart.com.

If you think this is an isolated example and something of a freak it may be instructive to look at some other examples.  Below is the same RSI analysis for a couple of other assets:

The FTSE 100:  How might buying the red and selling the blue have worked out?

Gold:  The same again?

I could include other examples.  Despite how compelling this looks, as with any technical indicator, the RSI is far from perfect.  It does not have a 100% hit rate but in recent years it has been an amazing tool for timing entry and exit into gold and silver in particular and has helped me personally to make a much higher return with just this one strategy than what I would have made in pretty much any mainstream investment fund I could have put my money into.  This is also a very cheap way of investing as the only fees you need to pay are the dealing commissions on buying and selling a London listed share.  There are no commissions to be paid to financial advisers and a minimal fee structure within the product itself.

It is worth repeating that I did not use this strategy completely blindly.  First, I had a strong fundamental view on precious metals as an investment as we have seen.  Secondly, once I had established that gold or silver was overbought or oversold I would do a little bit more work thinking about volumes and the time of year (both gold and silver have seasonal trends).  Thirdly, I read emails nearly every day by market commentators, some of whom specialise in gold and silver.  Importantly, I would take their latest opinions and numbers on board as a final check before buying or selling.  All of this information is available free of charge.

Hopefully this brief example illustrates what can be achieved by using this combination of fundamental and technical analysis.  As you can see such an approach can yield pretty fantastic results over and above obsessing about one or the other alone.

Some of you might be looking at the above and thinking that it all seems rather complicated and time consuming.  Rest assured that you will not need to go to this level of detail or put in this amount of time and effort to still have a huge positive impact on your financial situation.  I just wanted to use this as an example to illustrate what can be achieved with a little effort and an open mind.

Another Example – Mark Shipman’s long term moving averages

Another example of a very simple but consistently successful technical strategy is one outlined by Mark Shipman in his book “Big Money, Little Effort”.   Mr. Shipman was one of Britain’s first hedge fund managers and has an incredible track record of investment success.  In his books he does a superb job of showing how effective some very simple technical strategies can be, particularly if you are a patient, longer-term investor.

Mr. Shipman uses an indicator called a “moving average” (MA).  As he says:  “…moving averages are one of the most basic yet effective trend-following technical analysis tools available to the investor…”.

Basically all a moving average does is take a number of prices (for example the closing price) over a number of time periods and compute the average.  Moving averages can take daily, weekly or even monthly prices.  On the charts in the above section on RSI, you can see three moving averages that I have chosen to add to the chart:  The green, blue and red lines which are the 200, 50 and 20 day moving averages respectively.[2]

At the most basic level, if an asset’s price today is above a moving average this suggests there is upward momentum in the price, all other things being equal.  I would stress that you do not need to understand this discussion in any depth, all we are trying to do is look at examples of how effective these strategies can be.  If you find the examples compelling you can use the resources I recommend to increase your knowledge of all of these things to the point where you become confident enough to employ these strategies yourself.

Mr. Shipman’s approach to using MAs is quite simply to use the 30 and 50 week MAs for large, liquid stock market indices (primarily the S&P 500) to find long term buy and sell signals.  He suggests you take one of two stances with your money:  Either you have your money in an S&P 500 tracker fund, or you have it on deposit as cash.

Specifically, he shows that:

…if the 30 week moving average is higher than the 50 week moving average, you should have your money in the market (i.e. own an S&P 500 tracker)…

…if, on the other hand the 50 week average is greater than the 30 week average, you should sell your S&P 500 tracker fund and keep your money in cash until the 30 week is higher than the 50 again…

When Mr. Shipman started using this approach, he had to calculate the moving averages himself, initially with a pen and paper but latterly with a computer and his own software.  Today you are able to find this sort of information on dozens, possibly hundreds of websites for free.  This is another example of the point I make elsewhere on the site (and in my book) that today’s financial products and information sources are better than ever before.  The fact that you can learn how to find the RSI or MA for thousands of possible investments entirely free of charge is a huge development in investment and gives you tools that an investor from ten or more years ago could only dream of.

Mr. Shipman wrote his book in 2004.  In it, he looked at the performance of this one simple method of technically driven investment going back to the beginning of 1951.  From 1951 to 2004 the strategy generated 21 buy signals.  71.43% (15) of these positions were profitable, the best of which generated 178.78% (between 1995 and 2001).  The average performance of all of them was 34.76% and the average loss on losing positions was 5.48%.

These sorts of returns are superior to what you are likely to see if you use many financial advisers, particularly once you have accounted for their fees.  I highlight these sorts of strategies purely to show you what is possible today using free information and with a relatively small amount of effort on your part.

I would hope that you have found these two examples of technical analysis sufficiently compelling to want to learn more.  This being the case, let us now look at some resources you might use to do so…

Resources for Technical Analysis

Read: “Big Money, Little Effort” by Mark Shipman

If you only read one book to inspire you about technical analysis, I recommend this one. You will learn more detail about the strategy outlined above.  My other reason for choosing this book is that it is a very easy and quick read.  It contains very important and compelling points in easy language early in the book.  A few minutes of reading will reward you with some eureka moments and a tangible money-making strategy.

Free technical analysis on line

I thought it worth noting that the charts I have used in this section come from the website:  www.barchart.com .  There are many sites on the web that enable you to conduct technical analysis on a wide variety of assets.  When you get more comfortable with using a little bit of technical analysis www.barchart.com will be a good place to start…

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In the last blog entry we looked at how you might make a shopping list of investment themes.  It is my hope that you will come up with some compelling investment themes relatively quickly once you start thinking like an investor and are plugged into the wealth of investment information we have looked at before.

Now comes arguably the most important part:  Working out the specific investment vehicles within those themes which will give you the best chance of benefitting from them.  This is the hardest part but, I would argue, can actually be rather fun once you start to get into it.

“Bottom up” analysis will also help you to make your big asset allocation decisions since it is fundamental and technical analysis (looked at below) that will help you to work out which of the main asset classes are looking most interesting at any point in time.

An example theme:  Oil

Once you have a theme, you are going to start to look for investment vehicles that give you exposure to that theme.  Let’s use oil as an example.  You have decided that it is probably a good idea to have exposure to oil as the world population grows and becomes more industrialised, driving demand for energy and oil in particular.

You are now going to make a second list:  A list of possible investments in the oil space.  Off the top of your head, you have probably immediately thought of Shell and BP as companies that you might add to the list.  You may also have realised that you are able to own oil itself, via an ETF for example.[1]  A little bit more effort and you may come up with foreign oil firms such as Chevron in the US or Petrobras which is a Brazilian company but which trades on the US stock exchange, making it relatively easy to buy through your UK stockbroker.

If you are prepared to put in even more effort you might add oil service companies that are experts in drilling or prospecting for oil.  There will also be ETFs of oil companies and ETFs of oil services companies – i.e. a fund where one investment will give you exposure to a basket of companies in the sector.

Although the above might sound quite daunting, if you are reading MoneyWeek and plugged into the kinds of free email services I have suggested previously, you will learn more and more about companies from all sorts of industries and interesting funds as you go along.  As ever, I would reiterate that there is no hurry here.  Better to get it right than to rush into anything.  Do not be afraid to take time building your shopping list of themes, companies and funds.

Once you have a reasonable list of possible investments for each of your themes, it is time to think about which one, or possibly two investment vehicles you are going to use to put your money to work in that space.  You will do this by subjecting each of the possible investments to some basic fundamental and technical analysis.  It is to these ideas which we will now turn…

Fundamental Analysis – starting with companies (shares)

Fundamental analysis is when you try to assess the inherent or fundamental value of an asset to work out whether it is cheap or expensive.  We have already met certain types of fundamental analysis in previous blog entries and in Own The World, when I look  at how to value property in chapter six, how to value shares in chapter eight and gold in chapter eleven.

As far as shares are concerned, we might think of fundamental analysis as quite simply listing all of the things that might affect the true value of a company by adding up all the positives (profits, cash, property, inventory etc.) and subtracting all the negatives (debt, salaries, all other costs etc.) to get to a number which is the value of the company.  There are hundreds of thousands of people (accountants, stockbrokers, fund managers and financial analysts) all over the world doing this job every day with respect to hundreds of thousands of companies.

You might argue that working out the fundamental value of a company isn’t actually that hard.  It is what accountants do.  At least once a year (although usually twice)[2] a company publishes a document called its Report and Accounts.  This will contain almost exactly what I have described above, that is to say a calculation of the value of the company based on adding up all the positives (profits and assets) and subtracting all the negatives (liabilities).

So far, so simple.  The complexity, which keeps so many thousands of people in gainful employment, broadly arises from three  sources:

(1)   Debate about what the value of a company’s assets are:  How much is a certain factory, office building or brand worth, for example.

(2)   Expectations of what the value of profits and assets is going to do in the future.  Financial analysts produce estimates for both of these.

(3)   Debate about what a sensible amount to pay for that value is.  This is done by using a variety of valuation tools.

A very large proportion of the finance industry spends its day thinking about these three issues.  We can perhaps illustrate this in further detail if we think about earnings per share again (we met this idea in this blog entry when we looked at shares.  Do go back and have a quick look if you have forgotten the term).  What we are saying here is that accountants can give us this year’s earnings number and asset value quite easily.  The trick is to work out next year’s earnings number and asset value as accurately as possible and then think about what you should “pay” for both numbers.

Different types of company have very different fundamental financial metrics.  Some companies are capital intensive.  This means that they need huge factories and tonnes of very expensive equipment to do what they do.  Examples of these would include car (automotive), mining, oil, steel and pharmaceutical companies.  Other companies, ones that deal with people and ideas for example, need hardly any equipment at all.  These would include advertisers and other media firms, lawyers, bankers, software programmers and consultants.

Equally, some companies can grow their sales and profits very quickly, for example a company with a new technology that did not previously exist, a great example of which is Apple.  A dozen years ago iPods, iPhones and iPads didn’t even exist.  Today a meaningful percentage of the world’s population own these products.  Apple shares have skyrocketed as a result as have shares in many of the companies that supply them with components for these products.

Other companies find themselves in a market that is dying, sometimes called an “ex growth” market.  Good examples of these would be Eastman Kodak, the photography company, who recently filed for bankruptcy or HMV in the UK who have been suffering a fundamental decline in UK shoppers buying CDs and DVDs in the high street for some years and seen their share price hammered as a result (and has gone into receivership since I originally wrote this).  You might argue that forseeing the problems faced by both of these companies wasn’t really that difficult.

The p/e ratio again

Given these differences between companies, the fundamental value you might place on the profits and assets will therefore also be very different.  If you remember the section on shares from this earlier blog entry, you will hopefully remember the idea of a p/e ratio – the multiple of a company’s profits that an investor is willing to pay to own that share.  This is one of the most fundamental ways of assessing a company’s value.

All other things being equal you might imagine that you would be willing to pay quite a high multiple of profits (a high p/e ratio) for a company growing very fast with no debt and no need to invest in huge factories and machines and a great deal less (a low p/e ratio) for a company with no growth and large debts.  If you find a fast growing company with a great technology on a low p/e ratio, therefore, you will most likely have found a bargain!

The longer you look at investments, the more you will get an intuitive feel for what a company should trade at in terms of fundamental valuation metrics:  A dairy company based in only one country and not growing at all should arguably trade on a p/e ratio of maybe only 5x and is likely to be expensive and liable to fall in value if it is trading at 10x, whereas a brilliant global software company with very high profit margins and massive growth potential might even be cheap on 25x earnings.  That is to say that you might be willing to pay as much as five times the price, in terms of a multiple of profits, for a company that you think has five times (or more) the prospects of another company.

The PEG ratio

One of my favourite valuation tools in this respect is something called the PEG (Price / Earnings / Growth) ratio.  It is worked out by dividing the p/e of a company by its estimated earnings growth.  For example:  If a company is trading on a p/e of 10x and growing its profits by 10% you would say it has a PEG ratio of 1x.  If that company was trading on 20x earnings, the PEG would be 2x.  Another company growing at 20% but trading on 10x p/e would have a PEG of 0.5x.  Hopefully you can see that, all other things being equal, the lower the PEG the better as the number implies you are paying less to get more profit growth.

There are a large number of financial ratios and metrics to look at in fundamental analysis and they each have their benefits and drawbacks.  PEG is just one example and no exception in terms of having benefits and drawbacks.  The only reason I include it here is to show how these sorts of tools of fundamental analysis can be quite elegant and often really aren’t that complicated.  At the most basic level they enable you to “compare apples with apples” when you are trying to find the right company to invest in.

Let us now look at some of the most elementary valuation tools you will want to become aware of to give yourself a real head start in choosing a company to invest in.

Using basic valuation tools

We have looked briefly at the p/e and PEG ratios and I have pointed out that there is a wealth of financial ratios used by financial analysts.  That said, in my opinion, you can make a perfectly informed assessment of whether a company is cheap or expensive using relatively few of these valuation tools.

When we looked at shares, as well as p/e, we looked briefly at earnings yield, dividend yield and book value.  These are all reasonably simple things to understand and freely available on websites such as Yahoo or Google finance or from your stockbroker’s website.

As such, once you have chosen a theme and made a list of companies you might consider to give you exposure to that theme, the next piece of the jigsaw puzzle would be to find out these numbers based on the company’s current share price.  Again, you can find these numbers on various free websites many of which I will write about in future blog entries.

For each company, you might find the current year’s p/e, PEG, dividend yield and price to book (book value per share) and, where possible, the same numbers for next year.  Sometimes you will even be able to get numbers for the year after that but I wouldn’t worry too much about those numbers.  As you can imagine, forecasts of a company’s numbers two years in the future can often be subject to significant revision unless the company has a particularly predictable business model.

Peer group analysis / comparison

Once you have these numbers you are able to perform a very useful and instructive simple analysis of which company might be the best in a given space (sector) by comparing the numbers to each other.  Previously we looked at Sainsburys, Tesco and Morrisons.  In our oil example we may simply want to decide whether to own Shell or BP (keeping things simple and putting dozens of other companies in our “too hard bucket”).

All you need to do, then, is compare companies in the same space to see which one is the best value.  To keep the example simple, if we know that Shell has more attractive financial ratios than BP, this might make us decide that the vehicle we want to own to make a solid long term investment in our “oil” theme is Shell.[3]  Before you take the decision to pull the trigger and buy it, however, you will want to think about a couple of other things:  You will want to see how Shell’s metrics today compare to how they have been historically and you will want to think about where the stock market as a whole is at the moment.

Historical analysis

In our example so far you have established:

1)    That oil is probably a good theme over all.

2)    That Shell is probably a great company within that theme.

3)    That it currently has more attractive valuation metrics than its main rival, BP.

This is all useful stuff and moves us closer to our goal of actually pulling the trigger and buying some shares in Shell.  An additional factor to consider, however, is how Shell’s current valuation metrics compare to those same metrics in the past.  Shell might look more attractive than BP at the moment but what if it is the most expensive it has ever been in the last twenty years?  For example, what if the p/e ratio of Shell going back twenty years has ranged from 5x next year’s earnings to 25x next year’s earnings and it is now trading at 24.5x?

What if Shell’s dividend yield has been as low as 1.5% and as high as 6.5% and it is currently 2%?  This type of approach is known as historical analysis as you might imagine.  Hopefully it is not a complicated idea to suggest that your best chance of buying Shell at the right share price for a long term investment will be when the valuation metrics are historically attractive as well as being attractive compared to their peer group.  If Shell shares are the most expensive they have been for twenty years then, all other things being equal, it may not be a good time to buy the shares.

That said, this might not be true if there is a compelling reason for Shell shares to trade very expensively.  To give a slightly silly but potentially instructive example:  Imagine if Shell’s scientists were to announce that they have just developed a technology which can turn lead into gold. In this instance, you would be forgiven for arguing that the shares now deserve to trade on a higher p/e ratio than in the past.  In fact, solving the age-old alchemists problem would mean that Shell shares should, in theory, suddenly skyrocket and trade on a p/e ratio far higher than ever before when they were just a boring old oil company.

It is obviously unlikely that Shell will ever solve the problem of turning lead into gold but you can of course see that they might announce a huge new oil or gas discovery either of which would justify their p/e ratio being higher than other peers who have not made such a discovery and higher than it was in the past before they made the discovery.  You will need to be aware of these sorts of qualitative differences between companies as well as their financial ratios alone.

Market and sector valuation

Another consideration we might make before pulling the trigger and actually buying some shares is to think about the valuation of the oil sector at the moment and the stock market as a whole.  It is possible to find valuation metrics such as the p/e ratio or dividend yield for the market as a whole (in this instance we would use the FTSE 100 or S&P 500 p/e ratio) and for the sector (it is also possible to find financial ratios for the oil sector as a whole).

A final check we might make before deciding to build a position in Shell would be to see if the market and sector are cheap or expensive historically.  This is because share prices are correlated to the value of their sector and the market as a whole.  Even though our analysis so far might suggest that it is a good time to buy Shell:  Oil is a great theme, it is great value compared to other oil companies and it is great value historically, we might want to be a little bit careful of what the oil sector and the market as a whole is doing.

If the FTSE 100 and S&P 500 are up 20% in the last two months or so, there is a chance that the market might fall back.  When the market falls back, it takes share prices down with it.  To be honest, this is probably the least important analysis we need to perform when thinking about making a long term investment in a good quality company.  If a company is looking like it is fundamentally good value today for all the reasons we have already discussed, it is likely that it will be a good investment over the long term.  Nevertheless, it is arguably worth just doing a quick sense check to make sure you are not buying in when shares as a whole are extremely expensive.  If the market or the sector is up 20% in the last few weeks and your analysis tells you that this might correct, then you might hesitate to buy any stocks until it has.

Fundamental analysis for other asset classes

We have just had a very quick look at the idea of using fundamental analysis to find a good quality company.  It may be obvious to you that the metrics we used to look at a company share can’t be applied to the other asset classes.  Bonds, property and commodities have their own distinct characteristics and we must evaluate them in a different way as a result.  As such, it is worth saying a little bit about how we might perform a fundamental analysis of each of the other asset classes.

Bonds

We looked at the basics of what a bond is previously.  A bond does not have a p/e ratio or book value.

What a bond does have, however, are two fundamentally important metrics:  Its yield and its credit quality.  The yield is simply the annual return implied by the bond’s price.  The credit quality of a bond is a somewhat subjective assessment of the quality of the bond made by financial analysts who work at what is called a rating agency.  The three most famous of these are Moody’s, S&P and Fitch.

All these companies do is evaluate the financial strength of the company or government which has issued the bond.  Once they have done this, they publish a rating which tells bond investors the quality of the bond.  Each of the agencies has their own rating scale.  You may have heard a bond described in the press as “triple A” (AAA), or read that a certain government’s bonds are no longer rated “triple A”.  This is the top rating on the rating scale.  Each of the rating agencies has its own distinct rating system and you don’t really need to know any more than that.

The yield is simply the percentage return of the bond implied by its current price.  At the very basic level, bond investors will generally be looking to achieve the highest yield for any given credit rating.  If you were to compare two triple A-rated bonds and find that one was yielding 2% and the other 2.2%, all other things being equal you would want to own the second one with the higher yield.  In fairness this is a highly simplistic analysis as there is a wide degree of differentiation even between bonds of the same rating.  It is these differences that bond investors are looking to exploit.

The most important point I would like to make about bonds is that, more than any other main asset class, I believe they are the hardest for the amateur investor to understand and analyse.  What I have written above is only designed to give you a very basic idea of what they are about, if only so you can understand their terminology a little when you read about them.

I feel strongly that any bond exposure you have in your portfolio should be via bond funds.  Direct investment in individual bonds is generally only possible with large sums of money as most of these products have reasonably large minimum investments and many are also only available to professional investors.  There are exceptions, particularly for US-based private investors but I still feel that bond analysis is too complex for the great majority of people.  It is only worth learning about bond investment in great detail if you have a relatively large amount of money to put to work.  For everyone else, I would suggest that whatever bond exposure you have from “owning the world” will be perfectly sufficient.

Property

We looked in some detail at various ways of valuing property before.  As a reminder, we can think about a property’s total return as a function of the assumed net rental yield (after costs, void periods et al.) plus any assumption you might make for capital growth.  This percentage return number can then be compared to return numbers for other asset classes:  The interest rate on a current account, the dividend yield (plus expected capital gain) of a share or the yield on a bond for example.

We also looked at the idea of house prices as a multiple of people’s salaries.  I like to think of this as the “p/e ratio” of the property market.  In the same way that a p/e of 5x tells us a share is cheaper than a p/e of 10x (at a very basic level), if house prices are currently 6x people’s salary on average, we know they are more expensive than when they are 3x salary.  This is useful information for making big decisions about when property is cheap or expensive versus the other asset classes (again, at a reasonably basic level:  We will still want to account for plenty of other metrics such as demand and supply and the conditions of any local market but it is useful nevertheless).

Commodities

Just as with bonds and property, we cannot conduct fundamental analysis on commodities using the tools we might use on a share.  Gold, oil, wheat, timber and uranium do not produce quarterly earnings numbers or see their price fall when a Chief Executive has to resign in disgrace.

Fundamental analysis of commodity markets is still possible however and there are plenty of individuals and institutions all over the world who spend their time on it.  At the simplest level, fundamental analysis of commodities involves tracking data on their demand and supply.  For metals, analysts all over the world try to assess what mine production is doing, what is happening to inventory levels at various points in the supply chain and make estimates about which direction end-demand is going.  We have already seen examples of this kind of analysis earlier in the book when, for example, we talked about how a slow down in the Chinese economy will have a significant effect on the demand for a raft of commodities such as copper, iron ore or coal.

When it comes to the “soft” (agricultural) commodities, a similar analysis is made, this time the factors would include what is happening to the total amount of the crop being planted globally and what has happened to the harvest in various parts of the world as a result of the weather, for example.

As with bonds, I would argue that it is reasonably hard for the amateur investor to become proficient at the fundamental analysis of commodities.  Again, as with bonds, this need not necessarily be a problem.  First, we have already seen how you will gain sufficient commodity exposure from owning the world and owning inflation as described before.  Secondly, if you do decide you want to get more heavily involved in commodities you will be able to get a wealth of free advice on them from the resources I have suggested before.  Finally, I would argue that commodities lend themselves to technical analysis more than many of the other asset classes, particularly the bigger more liquid ones such as oil or precious metals.

If you are willing to invest a little time in learning about technical analysis, you can start to make a nice return trading the bigger commodities in reasonably short order.  We will look at this in more detail shortly.

A note on Foreign Exchange (FOREX / FX)

There is a large degree of overlap between the FX market and the bond market in terms of fundamental analysis.  This is because interest rates (bond yields) and the financial strength of a country are two of the most important factors in the perfomance of its currency.

As with bonds and commodities, I would stress that the fundamental analysis of foreign exchange is rather specialist and not something the private investor can learn overnight.  As before, you will have natural exposure to a wide range of currencies by virtue of owning assets from all over the world and I would suggest that this is sufficient to give you the asset diversification into foreign exchange that you need.

That said, just as with commodities above, if you have got to the point where you have a reasonably large amount of money and are interested in using some of it to trade more aggressively, there are great returns to be made in foreign exchange, particularly for the UK-based investor who is able to use a spread betting account.  Just as with commodities, FOREX also lends itself to technical analysis which we will look at below…

Action points and resources for fundamental analysis

As ever, there are literally thousands of books you could read to learn about fundamental analysis.  To really get to grips with the subject you should probably read a few of them but it is my belief that you will get a pretty good idea about things and most likely get quite inspired about investment generally if you read just this one, at least just to get you started:

“One Up on Wall Street” by Peter Lynch

Mr. Lynch is one of the most famous American investors of all time.  He made just short of 30% a year for thirteen years running Fidelity’s Magellan fund and he appears at number six in the table in chapter four where we looked at some top performing fund managers.  This book shows you how, with a little bit of knowledge, you can have a very good chance of making a better return on your money than many professional investors and I can highly recommend it as a result.

MoneyWeek Magazine again

If you subscribe to MoneyWeek you will begin to get a feel for how fundamental analysis works as there are weekly columns teaching you about these things.  There are also very good video tutorials on the MoneyWeek website.

There are plenty of other books which will help you to learn more about fundamental analysis in the bibliography and in the resources section of the website.  Now let us turn our attention to technical analysis…

The post Fundamental analysis appeared first on Plain English Finance.

The first “filter” for finding these ideas, might  be described as “top down” analysis.  This is where you use your knowledge of current affairs, economics and things financial to come up with fundamental themes that, for logical reasons, are likely to be a good place to put your money to work.

We have  looked at two such investment themes in earlier blog entries (and in my book):  That the world as a whole continues to grow and that inflation is higher than many people realise.  Once you start to look at the world with your “investors” hat on, you will, I hope, start to recognise other similar themes.  Here are a couple of quick examples:

Example One:  Growth in the developing world

We have already established that the world’s population is growing significantly.  At the moment, there are about 200,000 people being added per day to the global population.  At the same time, the standard of living in many countries in the world is improving such that hundreds of millions of people in countries like India, China, Brazil or Turkey can now aspire to a “middle class” lifestyle in a way their parent’s generation never could.

This reality has given us our “big picture” idea to “own the world” but if we think in more detail about the implications of this reality we should be able to identify more specific investment themes.  For example, the fact there are millions of new mouths to feed in the developing world should be very positive for agriculture as a whole.  It will also no doubt be positive for the energy sector and for any company involved in construction in these high growth economies.  Another correlated theme would be the improvement in water or telecom infrastructure required.  In fact, if you stop to think about it, you would most likely be able to brainstorm any number of investment themes which stand to benefit from global growth.

Example Two:  An aging demographic in the old world

At the same time that populations are growing and becoming wealthier in most of the developing world, they are doing something rather different in most of the developed world:  Specifically much of the population in the developed world is aging.  In Japan and Europe in particular, an increasing proportion of the population is approaching and passing retirement age.  Again, a moment’s reflection on this reality should yield some logical conclusions about the sort of investments which will benefit:  We might conclude that any companies making products for or providing services to the elderly are likely to see the demand for those products and services increase.

As a result, they are likely to enjoy less of an uphill battle to grow their sales and profits than companies in other sectors.  You probably don’t need me to tell you that these might include companies in the healthcare space:  Companies that make drugs or medical devices such as pharmaceutical and biotech firms or who build or service nursing homes for example.

These are only two themes.  I would hope that both of them seem entirely logical to you and, moreover, that you can see how starting to think like this can yield quite obvious places to go looking for superior investment returns.  Once you start to think like an investor you will get an intuitive feel for things you believe might give you the best chance of making superior returns on your money.

Your very own theme-driven investment shopping list

Each time you think of something which seems like a good idea, I suggest you write it down and start to build a shopping list of things that you would like to invest in, all other things being equal.  This is a great place to start.

Given my own “top down” analysis of what is going on in the world at the moment, my personal top-ten at the time of writing might look something like this:

1)  Precious metals and precious metal mining funds / companies.

2)  Oil and oil services funds / companies.

3)  Healthcare, pharmaceutical and biotechnology funds / companies.

4)  Emerging market infrastructure:  Water, railways, automotive, agriculture.

5)  Potentially explosive frontier markets:  Zimbabwe, Mongolia, Burma, others?

6)  Rich country funds (bonds and shares):  Singapore, Qatar, Norway, Canada, Australia.

7)  The world’s best technology companies:  Microsoft, Oracle etc.  Not Apple (too expensive – see  key concept three).

8)  The world’s best consumer goods companies:  P&G, Unilever etc.

9)  The world’s best tobacco and brewing companies (“sin” investing).

10) Clean energy / new energy technologies that don’t require government subsidy. Uranium, thorium, rare earths etc.

To be honest, the list of themes that I am keeping an eye on is substantially longer than this as I am constantly getting excited about all sorts of things but hopefully you can see how helpful it is to start drilling down from the hundreds of thousands of things you might invest in to ones which are likely to enjoy a fair wind for structural reasons.

The “too hard bucket”

For what it is worth, in the process of thinking about investible themes I will often save myself a great deal of time and effort by completely discarding themes which I would describe as being in what I call the “too hard bucket”.  There are many areas of investment where I believe the individual investment vehicles are just too complicated to analyse with consistent success.

Two examples of this, as far as I am concerned personally, are financial services companies, particularly big banking groups and any company that relies to a great extent on government contracts, a good example of which would be defence companies.

It is entirely possible to make a great deal of money investing in banks if you are very clever and have a deep knowledge of a large number of complex investment ratios but for the average investor, banks are just too complicated.  An important thing to bear in mind about investment generally is that you should limit the number of things you invest in, I would argue to less than about twenty to thirty assets in total.  This sort of number gives you the advantages of diversification and the ability to keep on top of them all.  If you own much more than this, things become rather too complicated.

Given there are so many things you are able to invest in (if you have your accounts with the right provider), there really is no great loss in deciding to ignore anything that you feel is too complicated.  There will always be plenty of other options left for you to succeed with.

For this reason, I am very quick to put any area of investment that I consider too much work to keep on top of in the “too hard bucket”.  The downside is that you might miss out on spectacular growth in a sector from time to time but I think this is a small price to pay to avoid the enormous headache of trying to follow a fundamentally complicated and opaque industry sector like banks or defence companies.  Never be afraid to put things in the “too hard bucket” and move on to something that is simpler to understand.

To conclude

Building your list of investible themes is your crucial first step.  The next and more important step is to work out the specific investment vehicles (funds, shares etc.) to own within those themes to give you exposure to them.  You will also want to do your best to buy those specific vehicles  at the right price – i.e. a price which gives you the best chance of investment success in the years ahead.

This is where our third key concept comes in:  “Bottom Up Analysis” of which the two main types are fundamental and technical analysis.  We will look at the basics of these shortly.

Before we move on, however, let us look at some resources that will help you get a handle on our second key concept as quickly as possible:  I recommend the following three action points and resources in order of importance…

Resources you might consider for Key Concept Two:

(1)   Subscribe to MoneyWeek magazine and read it as often as possible.

…If you only take only ONE action after reading this book I would recommend subscribing to this magazine and getting into the habit of reading it…

It is my heartfelt belief that if you live in the UK, the single best financial publication you should ensure you subscribe to and read as often as possible is MoneyWeek Magazine.  This is most likely the best investment in your financial future you can make.  By doing so you will ensure that you enjoy a constant stream of well thought out investment themes as well as specific investment vehicles such as individual funds and shares.

It is a great read, they have a brilliant editorial team and have been producing common sense and making me money for many years.  If you do subscribe, you will find the magazine in your letter box every Friday.  I tend to spend about twenty minutes every Saturday morning reading it over breakfast.  I think you will be surprised at what an easy read it is.  It even has sections on wine, cars and property to lighten the tone.  I can’t recommend it highly enough.  If you would like to take advantage of their standard offer of three free issues then please use the link to the resources section above.

(2)   Subscribe to the following free email services:

One of the best things about investment today is how much excellent information you can get entirely free of charge.  All you need is an internet connection and an email address.  I personally subscribe to dozens of free and paid email services and get as many as thirty such emails a day, many of which I read and all of which I skim.  I do not for a minute suggest you do the same.  I am obviously extremely interested in the subject.  You also don’t need to subscribe to all the services I do because I will highlight the most important things you need to be aware of every now and then in my Plain English Finance email.

These then are the email services I suggest you subscribe to.  Remember that it only takes a second to hit delete and you can always unsubscribe from these services if you no longer feel they are providing you with valuable information.

(1)  www.plainenglishfinance.com email

I hope you will forgive the self-promotion but obviously I truly believe you should subscribe to my free email service.  Unlike many of the other free services I suggest below, I will only send an update from time to time to remind you of all the excellent steps you can take to get your finances humming and to highlight anything I think is particularly interesting or important for you to be aware of.  This is categorically not a daily email as I will only send you information when I think it is very important.  It is perhaps worth noting that Plain English Finance is fully regulated and authorised by the Financial Services Authority in the UK.

(2)  MoneyMorning

This is MoneyWeek Magazine’s free daily email and I think it is superb.  Click here to go to their sign up page…

(3)  Stansberry & Associates

This is a first-class US-based investment newsletter service.  If you want to receive their research products you can pay hundreds or even thousands of pounds to do so but, fantastically, you can get very useful information from their free email services.  Three of their best are:  The S&A Digest, The Growth Stock Wire and Daily Wealth.

You can subscribe to them all by emailing:  customerservice@stansberryresearch.com .

There are dozens of other excellent free email services, but I feel these three are a very good starting point and will provide you with plenty of extremely useful information entirely free of charge.

(3)   Read “The Ascent of Money” by Niall Ferguson (or watch the DVD of the television series).

Professor Ferguson was named one of the one hundred most influential people in the world by Time Magazine recently.  This book is a superb summary of the history of money.  It takes you all the way from ancient history to the financial crisis of the last few years.  It is of practical importance for your development as an investor that you have a basic grasp of the history of money and the various financial products.  This is the best book for this purpose that I have read to date.  There is also an accompanying television series which you can buy on DVD (link above) which might be a more fun way of acquiring the relevant knowledge if you are not a big reader.

Let’s now move on to our next Key Concept:  “Bottom Up” analysis and understanding fundamental and technical analysis:

The post Taking Things Further Part IV: Using “top down” analysis to find themes… appeared first on Plain English Finance.

“Behavioural finance” is an area of study within economics and finance which attempts to factor fundamental traits of human psychology into assumptions about how we make investment decisions.  Many of these traits are not immediately obvious, in fact quite a few of them are counter-intuitive.  This is why many people are often entirely unaware that they are falling foul of one or other of them when they make poor investment decisions.

The Chartered Institute for Securities and Investment (CISI) work book for the “Principles of Investment Risk and Return” examination has a section on behavioural finance in which it describes no less than forty-six psychological biases or theories that can negatively affect our ability to make sensible investment decisions.

We have already talked about three of these in my blog entries about property:  Money illusion, anchoring and the endowment effect.  As a quick reminder:  Money illusion refers to our tendency to ignore inflation when assessing the value of something.  Anchoring concerns how people are inclined to give too much weight to their recent experience and ignore what happens in the long term and the endowment effect is where individuals demand more to sell something than they would be willing to pay for it and are unwilling to acknowledge their asset is worth less than it was previously.  Just being aware of these three biases is a good start.

You will no doubt be relieved that it is not my intention to list and explain all forty-six psychological biases here.  This would take up a great deal of space and I don’t believe you need to know about them all in detail.  Two things are important, however:

(1)  That you understand and acknowledge that psychology has an impact on your ability to invest successfully.

(2)  That, as a result, you do take the time to read at least one of the three books I highlight at the end of this section:  “Trade Your Way to Financial Freedom” by Dr. Van K. Tharp.

“Trade Your Way to Financial Freedom” should appear in any list of the best investment books of all time.  One of the key reasons for this is the excellent job Dr. Tharp does explaining how crucial your psychology and beliefs about money are for financial success.

If you have the wrong attitude and beliefs about money you are unlikely to get ahead financially.  This isn’t new age psycho babble nonsense, it is just that if you believe “the stock market is a casino” or that “investment is very risky”, you will never bother to take the time to learn what you need to learn.  You will not equip yourself with the knowledge or a plan to get ahead and you will not save or invest any money.  On the other hand, if you see the incredible things that are possible through investment you might take a different view and start learning, saving and investing.

“The Magic Of Believing”

Perhaps most important with respect to investing psychology is believing that it is possible to make significant returns on your money.  Hopefully you remember my “sprinter” analogy from a previous blog entry:  When looking at stock market returns, too many people fixate on the returns made by the “average” fund or share or on the fact that a particular country index has gone sideways or down.  The more you read about the world of investment, the more you realise that there are plenty of investors who consistently make high returns from whom you can learn, or with whom you can invest.  As Dr. Tharp says:

”Financial freedom is really a new way to think about money…   Financial freedom means that your money working for you makes more money than you need to meet your monthly expenses…”

If this sounds unrealistic to you then the first thing I would say is that there are thousands, if not hundreds of thousands of people in the world today for whom this is a reality.  The only thing standing between you and joining that group of people are knowledge, belief, time and a little effort.

The title of the first section of ”Trade Your Way to Financial Freedom…“ is:  ”The Most Important Factor in Your Success:  You!“.  We all have different personalities, different attitudes to risk, different work ethics, different commitments.  It is important as you get to know more about investing that you choose strategies which fit you personally.

A key consideration, for example, is how much time you have to devote to running your money.  For most people, when you start on this journey you will have a full time job.  It would be foolish for you to choose an approach to investing that required you to monitor share prices for most of the day.  You would need to use an approach to growing your money which could yield decent results in a few minutes a day or an hour a week at the weekend perhaps.

A full discussion of how you might do this is beyond the scope of this blog entry but you will start learning about these things when you immerse yourself in the resources I am about to recommend.  For now, please just be aware of the fundamental point that we are making here: That psychology and attitude are key.  If you believe that you can make good money from your money this is an important step on the way to true wealth (and / or an early retirement).

An example of what is possible:

Curtis Faith and “the turtles”.  Learning how to be an amazing trader in one week…

In an earlier blog entry, we saw examples of some fantastic returns made by conventional professional investors with a reasonably long term approach to investing money.  I thought it might be worth giving another example of what can be achieved by people with no previous knowledge of how to run money learning how to trade in a very short space of time.

Relatively few people are aware of some of the spectacular results achieved by completely inexperienced traders who are taught how to use a systematic approach to running their money.  Many people have made huge amounts of money impressively quickly doing this.  The best example I am aware of concerns a group of novice traders called “the turtles”.

In 1983 two of Chicago’s most famous traders made a bet with each other:  Richard Dennis bet his friend William Eckhardt that he could show anyone how to be a successful trader in only two weeks.  They were on holiday and, rather randomly, happened to be visiting a turtle farm in Singapore.  Dennis was convinced he could “raise traders like the farm raised turtles”, hence the rather strange name they gave the group.  For what it is worth, this bet is rumoured to have been part of the inspiration behind the Eddie Murphy and Dan Ackroyd film “Trading Places“.

On returning from their holiday, Dennis and Eckhardt put an advert in the paper inviting people to apply to be taught about trading.  Within a few weeks they had chosen a small group of individuals with no previous trading experience.  They taught the first group about basic technical analysis and human psychology for two weeks and taught a second group the same lessons in one week after honing their message.

What then happened is legendary in trading circles:  ”Over the next five years the Turtles each earned an average return of over 80% per year…” The best performing member of the group, Curtis Faith, who was 19 years old when he started as a “turtle”, made over 100% per year…

As a result, Mr. Faith turned $2 million into $31 million in just over four years… (remember at 100%, $2m becomes $4m, then $8m, then $16m, then $32m)…

How they did it is detailed in his excellent book:  “The Way of the Turtle”…

We are already aware that there are plenty of investment professionals who have made consistently good returns over a large number of years.  The point I am making here is that there are also people making spectacular returns after an incredibly short period of learning about money.  One of the most important things these people have in common is their attitude and belief.

As I have already said, rather than obsessing over the statistical “fact” that it is very difficult to make high returns on your money it would seem to me that a more enlightened and fruitful approach would be to seek out individuals that have made high returns and study them and the techniques that made them successful.  The following resources will put you squarely on that path:

Action points and resources you might consider for Key Concept One:

Here are some of the resources you might consider looking at to help you really understand the first of our key concepts:

If you take only one action…

…Take the time to read ”Trade Your Way to Financial Freedom…“

Even better, find a little more time and read the other three fantastic books listed below.  I would highly recommend that you do take the time to read these.  Remember, there is no hurry, everything you take the time to read will add to your financial skills.

“Rich Dad, Poor Dad:  What the Rich Teach Their Kids about Money That the Poor and the Middle Class Do Not”  by Robert Kyosaki.

This book is not specifically about investment or trading.   It is a more general book about personal finance.  A key message in the book is that “…the poor and the middle class work for money… the rich have money work for them.”  This is clearly one of the fundamental ideas behind Plain English Finance.  Another point the book makes is how poorly education systems around the world prepare people to look after their personal financial situation.  You will know by now that this is a view I share very strongly.  This book has changed the financial lives of a vast number of people since it was first published and is one of the best selling books on general finance ever written.

“Think and Grow Rich” by Napoleon Hill.

In this section we have seen how important you attitude to money is.  People who believe that money is scarce and hard to come by are the least likely to succeed in getting hold of any.  Those who believe that it is within their power to become wealthy vastly increase their chances of this coming true.   Napoleon Hill’s classic book on this very subject was originally published in the 1930s and has changed the lives of millions of people ever since.  As with “Rich Dad, Poor Dad”, a quick glance at the Amazon reviews will show you that this book has the power to improve more than just your financial situation.  This book is absolutely first class and required reading in my opinion.

“Way of the Turtle:  The Secret Methods that Turned Ordinary People into Legendary Traders” by Curtis Faith.

I have already outlined what this book is about.  It is a fascinating study in what is possible.  I confess there are some slightly dry sections on specific trading methodology which some people might find a bit off-putting, hence why I have listed it at the bottom of the books you might consider from this section.

So that is human psychology and your attitude to money taken care of, now let’s carry on to the next section and have a look at how to get up to speed on top down analysis by looking at how you might improve your understanding of current affairs, economics and economic history…

The post Taking Things Further Part III: The importance of human psychology… appeared first on Plain English Finance.

 It is my belief that there are four key concepts which you need to think about for consistent investment success:

(1)    You will need to understand a little about human psychology as it relates to investment decisions…

(2)    You must be able to perform basic “top down” analysis:  That is to say, work out big themes which help you to asset allocate most effectively.  (To to this requires a basic grasp of current affairs, economics and economic history)…

(3)    You will need to be able to perform basic “bottom up” analysis to chose specific assets and make sure you buy them at the right price.  (To do this you will need to gain a basic understanding of both fundamental and technical analysis). We will look at what these are shortly…

(4)    You will need to arrange your financial affairs with various third parties so that:

1. …you are able to invest cheaply in all the main asset classes…
2. …you receive a constant stream of possible investment ideas…

If you can get moderately up to speed on these four things you have a very good chance of making returns in advance of many professional investors and of what many people think is possible.

I would argue that relatively few people are up to speed on all four of these, including many finance professionals for the sorts of reasons I have highlighted in an earlier blog entry.  Largely as a function of human nature, many professional and private investors fall down on one or more of these ways of thinking about investment.

It is a relatively rare person who thinks explicitly about human psychology, has a basic grasp of economics and economic history, follows current affairs, respects and has at least a basic understanding of both fundamental and technical analysis and, in addition, knows how to arrange their affairs to be able to invest in all major asset classes in a cost effective fashion.  If you really want to “take things further” you should aim to become one of them.

Getting up to speed on these key concepts may seem like a tall order.  You might be reading the above and thought that you are not even familiar with what some of it means.  Nevertheless, it is not as out of reach as you might think.  If you are willing to make the effort to focus your attention on the most important information you can give yourself a good chance of being in a small minority of investors in the world who have taken account of all four of the above key concepts and given themselves the best chance of making money on their money as a result.

So let us deal with each of these concepts and the resources you might consider to get you up to speed on them.

Click here to read about our first concept:  The importance of human psychology…

The post Taking Things Further Part II: Four Key Concepts for Investment Success… appeared first on Plain English Finance.

It is my belief that the investment method we outlined is a great approach if you would rather not spend a significant amount more time learning about money and finance.  It will ensure you pay low fees, end up with an excellent spread of assets and have a high chance of making consistent returns.  This can yield wonderful results in the long run thanks to the power of compounding.  I would hope that those of you who have read this far have found the arguments logical, backed by evidence and compelling as a result.

Whilst I believe that the strategy suggested is an excellent solution for anyone who doesn’t want to spend too much time on their finances, at the end of that piece I noted how there really is no substitute for “taking things further” and learning more about all things financial.  We will start this journey here…

Given how dynamic the financial world is today and given how big a subject investment is,  I believe it is worth taking a more proactive approach to looking after your money, particularly if you have a reasonable sum to invest.  Learning more about finance and investment will mean that you raise your chances of growing your money more quickly whilst simultaneously increasing your confidence that you can do so as safely as possible.

Given what a huge subject finance is and how it is constantly changing, the information in the last chapter of my book which is replicated in the next few blog entries, is absolutely not intended to be a comprehensive guide to everything you need to know in order to become a successful investor.  That information would run to thousands of pages and would need updating weekly, possibly even daily.

What I do hope to achieve in these next few “taking things further” blogs is:

1)    …highlight some of the key concepts you will want to understand to get up to speed on finance…

2)    …point you in the direction of some good quality resources which will help you get to grips with these concepts…

3)    …give you some examples of what can be achieved if you do…

If you read chapter 12 of “Own The World” or take the time to navigate through the next few blog entries, you should be able to start on the road to knowing how to do three important things:

1)        Make decisions about asset allocation

Throughout my book and various blog entries, we have established how important it is to invest in a wide variety of assets.  We then looked at a largely formulaic way of achieving this using the “keeping it simple” approach.  If, however, you are prepared to get to grips with various basic aspects of finance, you will get to the stage where you can finesse your asset allocation to take advantage of phases where one asset is performing more strongly than the others.

Armed with a reasonably in-depth knowledge of basic financial analysis, economics and economic history, you are capable of making big picture decisions about when certain assets are more likely to perform better than others.  As an example, anyone with a good grasp of relative value between the various asset classes might have decided to be heavily weighted towards the precious metals from 1971 until about 1980, towards equities from the early 1980s until about 2000 and then back to precious metals at that point until today.  This approach would have resulted in very high returns indeed for no less than forty years.

Many people will read the above and argue that making these calls successfully is impossible.  This is certainly a fashionable view in the finance industry.  That is to say that “hindsight is 20:20” but it is unrealistic to think that anyone can time markets as successfully as in my example above.

I politely disagree.  As I have said several times before, you will never be able to make these sorts of calls with perfect timing but without question there are ways of comparing the main asset classes to each other which highlight times when one or other of them is more likely to be good value.  We have already seen some of these methods in previous blog entries, for example in the section on gold when we compared the gold price to the oil price and the level of the stock market.  I would repeat that one of the reasons relatively few people succeed in making these big picture asset allocation decisions is quite simply that relatively few people take the time to understand and look at all asset classes or even work out how to invest in them.  This is true for private and many professional investors.

That said, there are plenty of examples of professional investors who have made these calls over the years.[1]  Increasingly you are able to learn who these people are and follow their advice, often entirely free of charge.

Optimal asset allocation also changes with your age

The other thing to bear in mind here is that one of the universal rules of sensible investment is that you should become more conservative with your investments the closer you get to retirement.  When you are young, you can afford to a bit racier in a bid to grow your money as much as possible.  At the most basic level, this implies owning more shares and less bonds, all other things being equal.  As you get older, however, you should be thinking more about the return of  your money than the return on your money.

There would be nothing more tragic than having a nasty negative year in your late fifties, for example and giving up a large amount of the pot you have worked so hard to build.  Having a down year in your twenties or thirties will mean you lose less money in total (given your pot is smaller at that point) and have more time to make it back.  Generally this means that as you approach retirement you ensure that you keep more of your money in bonds and cash and less in shares.

As you gain a deeper understanding of these things, you will be able to make your own decisions about how to allocate your money to shares, bonds, commodities, cash and real estate as you get older.  This is not easy by any means but the more you learn, the better chance you will have of getting it broadly right over the years and this will have a very positive impact on your ability to make great returns whilst minimising your risk.

(2)  Start thinking about investing in individual assets

Once you have learned a bit more about finance you might also consider investing in individual assets yourself (rather than just funds as discussed in the last chapter).  For example, armed with the knowledge that follows, you might soon feel confident enough to choose an individual share or commodity that you think has a particularly bright future.

I have owned a fair few things over the years which have gone up 100% or more.  Last year I sold a commodity which made me over 160% profit in just over eight months and a share that was up 350% in about 18 months.  Obviously, these sorts of gains don’t happen all the time and there are always losers to contend with but, as you can imagine, you don’t need too many successes like these to have a significant positive impact on growing your pot until it can fund your target lifestyle.

You are unlikely to experience these sorts of returns owning a basket of funds as suggested in the “keeping it simple” section.  Finding and investing in big winners and avoiding losers requires more knowledge but it really isn’t that difficult to get a point where you can start to have a go at this if you are prepared to learn a little and ensure you are using the right resources.

(3)  Start thinking about learning how to “trade”

Once you have had a look at the material that follows, you will be more likely to start “trading”.  That is to say, you will consider making more regular purchases and sales of financial assets and holding them for a shorter period of time than if you were following the method I suggest in the previous chapter.  If you manage to do this successfully it can have a significant positive impact on your returns as we shall see.

If you can use certain techniques to improve your chances of buying the right assets at the right time and to buy low and sell high, you stand to make significant returns.  This isn’t easy but there are methods of investing which achieve consistent returns, particularly if you understand certain valuation metrics and are willing to think globally and about a diverse range of assets.

One thing worth bearing in mind when thinking about becoming more of a “trader” rather than an “investor” is that, in my opinion, you should only use part of your capital to do so.  This is related to the point about asset allocation above.  Even if you have a reasonable amount of money to look after and feel confident that you have learnt a good deal about exciting trading strategies, I would suggest you continue to keep a large portion of it in more conservative, longer term investments.  Another tragic scenario in investment, which too many people fall foul of, is to decide to use more aggressive and short term trading strategies that you are excited about with all of your investment capital.

It is perhaps helpful to think of “trading capital” as another one of the fundamental components of your asset allocation strategy.  That is to say that even if you think you’ve become quite good at short term trading you might allocate your money something like:

40% longer term investments in shares and share funds.

25% in precious metals and other commodities.

10% in bonds.

10% in real estate funds.

15% to “wing around” trading more risky assets (perhaps foreign exchange or very small, higher risk shares for example).

To continue the example:  As a UK resident you can use a spread betting account to have lots of fun with trading.  You might, therefore, allocate the “wing around” 15% of your capital to a spread betting account.  A small minority of people who become good at this after putting in the work can make extraordinary returns with spread betting.  My point is that, arguably, even those people should still only use about 15% of their overall pot for that purpose.  Any profits they make might then be used to buy more of the other four asset classes.  This is far safer than using 100% of your capital to spread bet.

A Final Point on “Taking Things Further”

Before we move on, I want to make a key point about what follows:  There is a chance that as you read it for the first time, much of the information and terminology will seem alien and quite possibly rather daunting and complicated as a result.  To a great extent the ideas in this chapter are rather complicated.  Getting up to speed on finance in any detail is no walk in the park.  I stand by the statement I have made in my book and in earlier blog entries, that you would be able to make a great positive difference to your finances in less than the time it took you to learn how to drive because I believe reading chapters one to eleven of my book and setting your affairs up as recommend in “keeping it simple” qualifies as taking less time than learning to drive.

The journey to true financial literacy advocated here, however, is a longer road to travel but one I hope you are prepared to at least consider.  You may find some of the sections to be rather complicated to begin with but I would hope that if you are willing to persevere and, most particularly, to start to immerse yourself in the resources suggested, you will find you start to get these concepts reasonably soon.  I repeat that the benefits of doing so are life changing.

So now let us turn our attention to the basic ideas and resources which will help you to achieve the three goals above…

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