The Biggest Investment Factor - BOD033

0:00Pete:So if you've got any questions on this or pretty much anything else, personal finance related. Probably won't tell you like my address or anything. No, no, exactly. Not where babies come from. We're not having that conversation. When a mummy in dad. Love each other very much. The three of these, I feel like my ass print is indelibly marked in this sofa. So now that we've all got a picture of dad's ass in our heads, let's carry on. Hi and welcome to the Bank of Dad podcast. I'm Kate and this is my dad Pete. Hello. And we're here to teach you the money lessons we were never taught at school. There's no judgment, no jargon, just real talk about how to handle your money.

0:35Pete:Just came into my mind that time when I went, hey! And we died laughing for about 10 minutes. I know, it's so funny. But not that funny now. No, no, it's funny. It never is after the event, is it? How are you, though? I'm all right, thanks. At the time of recording, we're still awaiting a mortgage offer, aren't we? It's been months. 20th of May, I've got the offer accepted. It's at the time of recording, the 19th of August. Yeah, it's complicated. It's a complex mortgage, yeah. We are nearly there now. Yes. Mortgage advisor Gary does think it will be soon. And he's been brilliant. He has been fantastic.

1:10We love mortgage advisor Gary.

1:13Pete:He has other aspects of his personality. But to the viewers, he's mortgage advisor Gary. And we love him. What are we talking about today? We've gone quite wanky the whole episode, to be honest. everything is everything's bad because we've done some more generic ones but i think this is investing specific assets allocation

1:40Pete:yeah it's an important topic actually in fact as we'll discover it's potentially one of the most important things to get right when you invest so um yeah important that we go over it and you know it's that like a next level of depth when it comes to investing so we have talked about asset classes and things like that. So asset allocation we're going to get into. Yeah. But before we do... Let's start. Well, what is it that we say? It's time for... It's time for, God. Wanky Word of the Week. It's time for Wanky Word of the Week. Yes, it is. And this week's Wanky Word of the Week is... Risk-adjusted return.

2:19Pete:That's a very high level of wankiness. Yeah. Risk-adjusted return. So this is a way of judging an investment's return in relation to how much risk you had to take to get it. So if you had two investments that produced the same return, but one of them got there with fewer ups and downs, that would have a better risk-adjusted return. So if the risk was the same for both, the returns would be different. but in this example the returns are the same but one of them went up and down less and so it was a smoother ride to get there so that would be a better risk adjusted return okay I think that will probably be clearer when we go through the main body but yeah that makes sense yeah I might have just put my foot in front of your skin I just had to stretch my leg out there that might have come into your shot sorry about that that's okay these must we've done three of these I feel like my ass print is indelibly marked in this sofa so now that we've all got a picture of dad's ass in our heads let's carry on so the beginning bit this is kind of like the basics yeah what actually is asset allocation what is it well it's how you allocate your money across different assets so we will just cover the asset classes again in a second but it's how you divvy up how you allocate your money between the different assets particularly as opposed to how much you split between two different funds or two different shares in two different companies we're talking quite high level asset classes okay right people spend quite a lot of time worrying about what fund to pick what stock to pick is allah allah asication asset allocation really more important than that yes so why And there's been, as you can imagine, people far less interesting than you and me have done deep sub studies on this.

4:19Pete:So the broad mix of assets that you own, the asset allocation is much more important driver of how your portfolio behaves than the individual investments you choose, the funds you choose. it's by some measures well it's universally accepted because of uh very academic studies one done in 1986 and then by some bunch of people one of them was called brinson so they're called the brinson studies and then it was reinforced and this is the one that i was taught when i first became an advisor or shortly after with the ibbotson studies in 2000 and what they showed us that 90 percent 90 percent of the variation of returns in a portfolio come from asset allocation now that sentence is a bit wanky yeah it's talking about variation of returns that don't really mean anything to normal humans yeah when a portfolio has a great year or a terrible year most of that movement comes from the asset allocation not what funds you pick not what not what stocks you pick or anything like that how you spend your money allocation so almost all of the contributing factor towards how a portfolio performs is down to asset allocation.

5:29Pete:So it's important. 90 % for crying out loud. Yeah, that's a big old percentage. Well, you don't get it wrong. No. No, true. Okay, well, yeah, that makes sense. Right. So that was kind of our like intro information before we get into it. What it is and why it's important. Yeah. Yeah. The basics now. Okay. What are the main asset classes and what role do they play in each portfolio? I was very tempted not to write this in the notes and ask you this question back. I'm really, really glad that you did that. Because we did an episode on assets. We did sort of three investment pieces, didn't we? We can do four.

6:03No, we did three.

6:04Pete:We did platforms, accounts, and then assets. So the main asset classes, so kind of like species of asset, if you like. Yeah, breed. We talk about equities. So that's shares in companies. Yes. That's the main one by far. The second biggest one is bonds. Well, actually, the biggest one in terms of number of things traded every day is bonds. Those are loans to companies and to governments. I feel like I don't have a good understanding of bonds. Well, maybe we'll do an episode, right? Because they are important. And when people talk about premium bonds, I'm like, what's going on? Well, that's the problem.

6:40Pete:It means the word bond means about six different things in personal finance. So a bond and a premium bond aren't the same. It could not be more different. Likewise, a fixed-term savings account, like you put money away for a year, very often called a one-year bond. It's not a bond. It's like they're setting us up to fail, right? There's a wrapper called an investment bond. It's not a bond, but that's what they call them. And it's not helpful at all. So literally, I mean, that's four different things that the word bond is used to describe. Four, sorry, not three, four. And really, this is the main definition of what a bond is.

7:14Pete:It's an IOU. You may remember the example. You are Marks & Spencers. You want to open a new store. you can either go to the bank and borrow the money you can dip into reserves you can issue more shares in Marks and Sparks people buy those shares and you use that money or you ask investors to lend you the money and so let's say I'm an investor and I say I'd quite like a slice of that action I'll give you 100 quid towards your new store me and millions of other people you take my 100 quid and you give me an IOU and the IOU says I, Marks and Spencers, owe Pete Matthew 100 pounds I'll pay you it back in 2035 and while I'm sitting on that£100 I'll give you 5 % a year so it's basically it's a transaction you've got my money, you've got to give me it back in 2035, in the meantime you're going to give me£5 a year so I get an income and as long as Marks & Sparks doesn't go bust I get my£100 back in 9 years time at the point of recording so if you put a big amount in you get a decent wage each year you get a wage, yeah you get a return, yeah income.

8:20And you'll get that big lump back.

8:22Pete:Bonds are mostly about the income. They're very often called fixed income securities. So they differ from equities entirely. Bonds are usually used as a kind of modifier. Think of it as a cordial. You know when you have like squash when you're a kid and you put like a little bit of squash in your case, you put like a load of squash in and a little bit of water. How much squash? Bloody hell.

8:51Pete:So, you know, the amount of water, the more water you put in, the weaker it is. Yeah. Bonds do that to equities a little bit. That's a gross simplification, but it helps. So equities are where all the fun is. That's where the volatility is, and that's where you really make your money. The shares. Yeah, but they're super volatile. Yeah. So you have to be, if you're going to invest in shares, you need to expect the value of your portfolio to rise and fall significantly. But the bonds will make you rise and fall less because you get a yield. Yeah. And because they behave differently. And that's why asset allocation matters.

9:24Pete:Do I have any bonds? You did because you've now surrendered your life to my house because you're ready to buy the house. You were in the 80 % portfolio, so you had 80 % equities and 20 % bonds. All right? Goes to show how much I know. Yeah, so equities and bonds are the main asset types we talk about here. Okay. Cash really isn't an asset class, but I tend to include it just for completeness. Property. Property. Which is, yeah, businesses and bricks, right? It's memorable, see? That's my good friend Andy Hart came up with that. Businesses and bricks. Those are the two things that grow consistently, property and shares.

10:00So equities, bonds, property, cash.

10:02Pete:Equities, bonds, cash, property, commodities. That's things that humans consume. So metals. Yeah. Gold, silver, platinum, all these things, copper, iron, so you can buy those as assets. Even things like orange juice, wheat, sugar, soft commodities, those are called. And then there's a bunch of other stuff like hedge funds, infrastructure. We call those alternatives because they're kind of like the last group. We just lump them together. The main ones by far, businesses and bricks and bonds. Okay. Okay. How should someone thinking about balancing risk and reward when deciding where to put their money?

10:40Pete:We generally, bear in mind, our core focus is to try and simplify this stuff for ordinary people who've got better things to think about. More interesting, certainly. Businesses and bricks is a useful mnemonic because those are the things that have been proven over decades to consistently make people money. Property is understandable, it's tangible. You can stand next to it, you can touch it, you can go inside it and think, this is a property. I understand it, right? Whereas shares are generally zeros on a statement on a login. Yeah. Hopefully some other numbers, not just zeros. Yes. Yeah. Oh, yes.

11:13Pete:Some numbers before the zeros. So, you know, they're somewhat less tangible, but everybody gets property. Property's, generally speaking, a good investment because you can rent property out and it'll make you an income. And generally speaking, property prices rise. Yeah. It's a generalization, but it's generally true. Not very tax efficient, though. So people like me, financial advisors, generally talk about shares more than anything. And we did a whole episode on funds because easiest way for ordinary people to hold shares is inside a fund. And it's those funds that will make you money, but you need to be able to cope with the volatility of equities.

11:55Pete:And so if somebody's thinking about balancing risk and reward, and we talked about risk-adjusted returns, we generally say equities is where the growth is at and you need to dilute to a greater or lesser extent with bonds so if you're super super super super super nervous you might have more bonds if you're super super super nervous you probably wouldn't invest at all because it would freak you out okay but if you're I want to invest but I am on the more cautious side I might go 60 equities 40 bonds yes exactly as opposed to 80-20 or 100 % equities yes you would have more bonds and hence, I mean, I can show you charts if you were interested.

12:35Pete:And the general pattern is the same between a 60-40 portfolio and an 80-20, but just less so. The ups and downs are compressed. It's less volatile. So if you're someone who might panic if it really drops, some bonds to dilute it is good for you. Yeah, because it'll drop less. Yeah. Historically, there are always anomalies. It's never as clear cut as that, but yes. So bonds, think of bonds as, It's like, Rog, I mean, from an age, he talks about whiskey and water. I generally use the cordial thing. Yeah, because whiskey, watering down your whiskey sounds a bit shit. Yeah, people do it. Really? Yeah, yeah.

13:11Pete:So, but whereas cordial... He is a whiskey drinker. He is a whiskey drinker, yeah. So that would be his. Okay, so does your ideal sort of asset allocation change depending on your age or your financial goals? Or does it kind of stay the same? Or anything else? Yeah, not down to age, generally speaking. I think it's a misunderstanding to think you should invest differently when you retire. I think risk is down to access and hence timescale. So, you know, we've said to you, you know, like don't invest money that you're going to use to buy your house. As soon as you'd spotted a house and it was fairly imminent, you basically were disinvesting or fairly quick.

13:45Yeah, I pretty much. Yeah, a couple of months after a month after maybe I cashed out.

13:50Pete:Yeah, because you don't want suddenly that to tank. Especially not when I told the mortgage at P Company, this is my deposit. Yeah, exactly. You wouldn't want that to be five grand less because Trump's done something idiotic somewhere in the world, right? Yeah, I was going to say, he shot somewhere up, yeah, yeah. So you don't invest money you're going to need in the short term. And so risk is more a function of timescale. So if you're retired, you're going to be spending some of your money. So it's not that your overall investment strategy is different. It's just that some of it you're going to be spending sooner.

14:23Pete:Some of it you're going to be spending later. So at Jackson's, we build a ladder of asset allocation. Money you're going to spend in a long time will be higher risk. Money you're spending in the next couple of years will be risk-free. Yeah, that makes sense. And that's the same no matter how old you are. So it's not an age thing. It's an access and timescale thing, I would argue. Okay. Next section. Building a portfolio. Yeah. How do you know whether you're taking too much risk or not enough? Is there a quantifiable sort of optimal level of risk? And the answer is no, at least not one that's quantifiable for normal humans.

14:56Pete:I mean, you should see some of the formula around this stuff. It's enough to drive anybody to sleep. Basically, certainly me. Because this is a deeply technical, mathematical sort of subject if you want to measure it. The problem is you can measure it to your heart's content and put numbers on it, but risk is a visceral human emotional thing. Yeah, that's what I was going to say. It's emotional. it's not necessarily linked to logic because everybody's reaction to risk is different so there's no way of saying that's irrational no it would there's been a sense I don't really know why it came about but there's lots of talk and particularly it strikes me on YouTube and stuff this sort of assumption that people will be rational investors it's like well equity is the way you make money so you put all your money in equities so well that's fine until it halves And then you'll have half of the money that you promised your child would help with the wedding.

15:54Pete:And you could say as much as you like, you've just got to ride it out. You've got to wait. It'll come back. And those are all true. But it's really fucking hard when you see your hard-earned money reduced by half. It's easy to be theoretical, right? But not in the moment. It's easy to say that when you're a millionaire financial influencer. Well, yeah, that certainly helps. Yeah. You're only looking at me when you said that. Because I'm talking to you. I'm going to look at the ghost in the corner of the room. There's no one else in here. Yeah. No, it's, I just, yeah. As somebody who's worked with real humans for 30 years on their finances, the theory is utterly irrelevant when the rubber hits the road.

16:39Pete:I mean, 2008, the great financial crisis, the market dropped by 40%. I mean, we spent six hours a day on the phone reassuring people, not bullshitting people, not sugarcoating you. We were saying, yes, it's bad, but this is why you should hold your nerve. And, you know, we didn't lose a single one. That one person, for legitimate reasons in that case, who actually bailed out at the wrong time, but they did it. But in the most part, we kept everybody in their seats and everybody was glad 18 months later that we had when they were better off as a result. Whereas if they bailed, they would have had to sort of wait and see when the good time was to get in.

17:12Pete:And that requires you to make lots of good decisions instead of just not making any. just riding it out so it's hard there is no ideal sort of there's no sort of immediately quantifiable correct level of risk maybe look at how you are like react to things if you're constantly on edge or constantly checking well maybe you've picked something too risky maybe you're on the cautious side so maybe you need to dial it back a bit or if you're like really confident and don't have a problem with it yeah you know your your ability is a your behaviour is a good guide. So if you are checking every day, it might be a bit volatile for you and it's making you nervous.

17:53Pete:If it's causing you lost sleep, jeebus. Nothing's worth that. We need to determine the difference between risk tolerance and capacity. So our tolerance might be high. We might just think, I understand this stuff. I understand that portfolios can fall. That's fine. But there is some money here that I don't want to risk because I cannot lose it because I've earmarked it for a house or whatever. Yeah, or my daughter's wedding. Yeah, so capacity then is very different. I don't want to lose any of that money, but my pension, which I'm not going to touch for 20 years, I've got capacity for that to fall because I know in the long run it'll rise.

18:27Okay.

18:27Pete:So tolerance and capacity are two different things and you should invest accordingly. Yes. Which is why most people have pots. Yeah. In some form. You know, pension pot is long-term retirement stuff, but maybe the ISA is for my big holiday for my 30th birthday. Yeah. Or whatever. Yeah. No, I like that. It's all fairly logical, I would say. What's the biggest mistake people make when building an investment portfolio? A portleo? Portleo. This is the third one we've done in a row. An investment portfolio. It's a great word, portfolio. Is it? The biggest mistake people make is overcomplicating. Sure.

19:08Yes. If you're having to spend all of your free time.

19:13Pete:managing assessing returns on a weekly basis unless you love that well if you do then fill your boots but honestly question whether you're mentally stable i'm joking i'm joking yeah if it is a hobby then so be it but yeah obsession about performance returns i think is not a life optimally lift yeah you're going to nature again um this is all said and checked yeah Yeah, the thing is I'm the laziest investor in the world. I basically built a career on simplifying this stuff for people. And it's a core value of us at Jackson's, which we live by every day, is how do we simplify and simplify and simplify?

19:49Pete:Because it helps with engagement. It reduces costs. It reduces the chance of missing things if you simplify stuff. Yeah. So I just think too many people, particularly those who are interested in finance, meaningful money listeners. Yeah, I've seen this with their questions. Right. They wear complexity as a badge of honour. It's like, look at my 75-line portfolio, and I'm just snorting, looking at my one fund pension. And just think, I never even think about it. And that's not to say yours is right and theirs is wrong. No, they're just different ways of doing the same thing. But don't make it more complex just so that you can say it's a complicated portfolio.

20:30Pete:No, for sure. If you want to and it brings you... It brings you joy, then that's fine. but not for me over complication I just think it gets in the way of literally everything else better but bear in mind our view that money is a tool and not an end in itself it's only if it's a real passion of yours that actually managing it is an end in itself those are the exceptions most people are not like that no it's funny I always like look forward to payday because I'm like oh I get to sort out which goes into what pot and what I'm going to save and whatever takes like 30 seconds and I'm like oh oh that's it for another Got away for a month now.

21:06Pete:There you go. So overcomplication, don't do that. Don't, unless you, well, no, because then it wouldn't, if you like it, it wouldn't be overcomplication. It'd be the right amount of complication for you, I guess. Okay, so when the market starts to go a little bit wibbly-wobbly, or the technical term, volatile, should you change your asset allocation? I'm trying to find the most emphatic way to say... Go for it, go like really sweary. No, no, no, no. Go on a rage. No, no, I'm not going to do that. It's not necessary. It's not really me. You should never change your asset allocation in response to short-term events.

21:38No.

21:38Pete:It makes no sense to do that because it requires you to make multiple good decisions. You're just loading up work. So, right, the shit is hitting the fan. I'm going to change my asset allocation, which usually means I'm going to sell into cash, at least in part, right? Well, that requires you to firstly time that well. And by the time you make that decision, markets have already fallen. Yeah. Right? So you've certainly not sold at the top. Then you have to decide when might be a good time to go in. And then you'll be just crippled by, well, should I go in over time? Should I drip feed back into the market?