What is the minimal risk asset?

Photo of Lars Kroijer

This article about minimal risk assets is by former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.

I believe any private investor can create a sound and well-diversified investment portfolio by using just two assets as building blocks – a world equity index fund, and an appropriate government bond fund.

Other assets can be added to suit. But those two assets alone can be a firm foundation for your long-term investment plans.

There have already been several articles here on Monevator about world index funds. However I’ve not spoken much about the second piece of the puzzle – the minimal or ‘risk-free’ government bond fund.

This article is one of a short series to put that right!

Today we’ll look at how you can decide upon the lowest-risk investment that will be the basis on which your riskier portfolio can be built.

Next time I will describe how and why you should match the time horizon of your minimal risk asset to your investment time horizon, how you invest in your chosen minimal risk asset, and what returns you can expect to make.

What is the minimal risk asset?

For a sterling-denominated investor, short-term UK government bonds are a good choice for your minimal risk-asset.

There is probably no genuinely riskless security in the world today. However the probability that the UK government will default on its debts is as low a risk as we can find when investing in sterling. Thus it is ‘minimal risk’.

Incidentally, cash in the bank is not entirely without risk, as I have discussed before on Monevator. But it is worth looking briefly at cash as a minimal risk asset, as there can be some particular benefits for private investors. Look out for that below.

One of these days I’ll also outline why other asset classes traditionally designated low risk – gold, property, physical assets – are not that low risk at all.

Buy government bonds in your base currency

Your choice of your minimal risk asset also depends on your base currency.

A US-based investor buying short-term UK government bonds has the same security of getting his principal back as any British investor. But they also incur additional currency risk due to exchange rate fluctuations.

If, for example, the UK government bond promised to pay the investor £101 a year hence for a £100 investment today, both investors are equally certain of receiving £101. But while the £101 would always be £101, the US dollar value of that amount will fluctuate quite a bit and is thus riskier.

The US investor would therefore be better served by choosing as their minimal risk asset short-term US government bonds. These bonds would be of a similar credit quality to the UK government bonds, but the returns would be independent of currency risk.

Similarly, a French or German investor could opt for German government bonds.

Wait, what is my base currency?

While most reader’s base currency is obvious (sterling for UK investors, dollars for US ones, and so on) and currency risk is a risk you would rather avoid, your base currency can also be a mix of currencies.

Your base is the currency that you think you will one day need to spend the money in.

For example I live in the UK and will probably have the majority of my future expenses here. But I also spend a lot of my time (and my money) in Denmark, the Eurozone, and the US. I may have future expenses for my children’s education outside the UK, and my wife and I might live or retire abroad one day.

By having my base currency as a mix of several currencies, albeit dominated by sterling, I can better match my future cash needs and reduce the risk of my being caught out by a falling currency against my future foreign-denominated expenses.

Rate my bonds

If your base investment currency is one where the government credit is of the highest quality, those government bonds will generally be a great choice for your minimal risk investment.

But how do you know if your government bonds are the good stuff?

Most people will need to turn to the professional ratings agencies. Today there are three major credit agencies that rank the creditworthiness of bonds – Moody’s, Standard & Poor’s and Fitch.

Here are the classifications these agencies use to rate long-term bonds:

Long-term bond ratings Moody’s S&P Fitch
Prime Aaa AAA AAA
Investment grade Aa1 to Baa3 AA+ to BBB- AA+ to BBB-
Non-investment grade Ba1 to Ca BB+ to C BB+ to CCC
Default C and lower D DDD to D

Source: Author/Various agencies

The credit agencies were widely discredited after 2008 when they wrongly gave high ratings to all sorts of sub-prime garbage. In general though they give you a good indication of the credit quality of a country’s bonds.

Credit ratings change frequently. When you consider adding to your minimal risk asset, you can look up the latest credit ratings on Wikipedia by searching for ‘List of countries by credit rating’. If the government credit of your base currency is listed there as AAA then you have an easy choice for your minimal risk asset.

With the adverse environment of government debt and deficits in recent years, the list of AAA-rated countries from all agencies has shortened. That said, if your home base currency offers AA or higher-rated bonds then it would be sufficient to accept those as your minimal risk asset. If we only accepted bonds with the very highest rating, at the time of writing this would exclude bonds from major economies like the US, UK, Japan and France, which is neither practical nor desirable for many investors.

While there is obviously a reason for these countries losing the highest rating, it is worth noting that the financial markets trade these countries’ bonds at real yields that are among the most creditworthy in the world in any currency.

Beyond government bonds

I have referred repeatedly to government bonds, but what we are really after is the lowest risk investment for you, given your currency and maturity.

In many countries, there are other kinds of domestic bonds related to the sovereign issuer, such as government-guaranteed regional, city, or municipal bonds. Those and similar bonds could be reasonable alternatives as minimal risk assets, particularly if there are tax or other advantages to investing in them. However, you need to make sure that the government guarantee is bulletproof, even in distress.

If you get a superior yield from these alternative bonds compared to the standard government bonds, you are probably taking additional credit risk.

Also, be careful in thinking that adding these kinds of bonds provides you with additional safety. They are typically poor diversifiers of risk, because they tie back to the same creditworthiness as the domestic government bonds.

In the end, government bonds will often be the best choice for the minimal risk asset.

What about cash?

Everything I’ve written so far would apply today to funds and to most very wealthy individuals.

However what if you’re a more typical private investor, with maybe a few tens of thousands of pounds invested in your ISA or SIPP – or even a larger portfolio but with your non-equity allocation still amounting to a low-ish six-figure sum?

Well, these days you may decide it is better to keep your minimal risk asset as cash instead of government bonds.

There are a couple of reasons for this. For one thing, after years of easing by central banks, government bonds yields are currently very low. Depending on which country you’re based in, you may well be able to find cash savings accounts that pay a higher interest rate than you’ll get on similar government bonds.

  • For instance, in the UK you can currently get almost 2% for cash that you lock away for three years, provided you choose from the Best Buy accounts.
  • In comparison, short-term UK government bonds (gilts) are yielding less than 0.5%.

To trust that your money in the bank is safe, there has to be a reputable credit insurance scheme in place. In the UK that’s the Financial Services Compensation Scheme (FSCS), which guarantees deposits in authorised banks to the tune of £85,000.

Now, while the FSCS was set-up by the UK government, it operates independently of UK lawmakers. The compensation scheme is funded by compulsory levies on financial firms authorised by two UK regulators – the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

The scheme has paid out billions in compensation since being set up by Act of Parliament in 2000, and means cash in a bank that’s covered qualifies as ‘minimal risk’ under any sensible definition of the term. However you might wonder what would happen if the FSCS ran out of firepower due to a financial crisis?

In practice, while the FSCS operates independently of the UK government, the latter provides an implicit backstop. For example, in 2008 the authorities and the FSCS worked together to guarantee the deposits of 2.5 million customers of the Bradford and Bingley Building Society, which saw the FSCS receive an initial top-up loan from the Bank of England and later from HM Treasury.1

Effectively then, provided you choose an FSCS-covered bank for your savings, you have the same credit risk as with gilts – because both are backed by the UK government – but you’re getting a higher interest rate.

That’s attractive, and not an option for institutions.

Remember that if you decide to use cash as your minimal risk asset and you have more than £85,000 to find a home for, you’ll need to open more than one account with different FSCS-protected firms – operating under separate banking licences – to ensure all your money is covered.

You will also have to keep moving your cash as your higher-rate terms come to an end.

At some point as your wealth grows you might decide it’s easier to keep your money in bonds, not least for the diversification benefits – government bonds tend to go up when shares fall – and also because the yield on government debt may improve in the next few years, and so reduce this ‘free rider’ gap between cash and short-term government debt.

Remember that any credit insurance backing a bank is only as good as the government providing it. Besides the details of the credit insurance scheme itself, you’ll want to evaluate how the credit markets perceive your government’s standing when deciding whether you can trust such schemes.

Also remember that in a really dire scenario, it’s possible a country’s government may decide to reduce the compensation limits, which might mean it was ‘fake insurance’ – and not there when you need it.

However for the UK and US I believe this is very unlikely indeed (the UK actually extended its coverage to Icelandic banks in the last crisis).

Help! I don’t trust my government!

For all their undoubted economic successes over the past decades, countries like Brazil, Mexico and India do not have highly rated government bonds ­– they are all BBB rated or lower at the time of writing.

If your base currency is one without a highly rated bond available, you face a tougher choice.

For example as an Indian you could buy Indian short-term government bonds, which would not be minimal risk, or else you could buy highly-rated government bonds in one or a couple of foreign currencies, which introduces currency risk.

Depending on the credit rating of your base currency government, you may choose to take the credit risk of the domestic government bonds instead of taking the currency risk of highly rated foreign bonds, or perhaps even keep money in cash deposits in the local bank if that is considered a superior credit option to domestic government bonds.

Incidentally, the absence of a great local currency minimal risk asset is one reason why an asset like gold is the de facto ‘money under the mattress’ asset in places like India.

Older people in certain parts of the world, such as India, undoubtedly remember previous eras of domestic economic turmoil. The thought of buying local government bonds as their minimal risk asset will seem like heresy to them.

And they are right. These investors do not have essentially risk-free bonds in their local currency – however far the government has come. Perhaps one day the credits of these governments and many like them will grow in esteem to the point that they become the lowest-risk bonds in the world, but not today.

As a result, investors with a less-creditworthy domestic government often make their base investment currency the US dollar, because of its status as the global reserve currency. They then choose US government bonds as their minimal risk asset.

While the lower credit ratings of some countries’ government bonds mean that their bonds yield more, this is not a good reason to have them as your minimal risk or safe asset. If you want to add returns to your portfolio, you can do so by adding broad exposures of equities instead. These have the added benefit of both being geographically diversified and adding expected returns.

Consider diversifying even the very low risk that your domestic government might fail

Investing in sub-AA credit ratings is a question of degrees. Some investors would be happy to invest in their BBB-rated local currency government bonds whereas others would rather invest abroad with currency risk than have an AA domestic-rated government bond.

The choice partly depends on your situation and your sensitivity to currency risk versus domestic credit risk.

For those inclined to accept sub-AA domestic government bonds as your minimal risk asset, I would encourage you to think about what else would happen in your portfolio if your domestic government defaulted. In many cases, a domestic government default could have a catastrophic effect on your portfolio and on your general life. If you had diversified some of the domestic risk away by having your minimal risk asset as highly rated foreign bonds, such as German, UK, or US government bonds, then you would at least have some respite when the domestic calamity hit.

Some investors believe that having all your minimal risk assets invested in the bonds of just one government, however creditworthy, is a bad idea. Those investors argue that while the government bonds of Britain or Germany are highly rated today, there is always some risk that they could fail – perhaps even spectacularly and quickly2. Because of this possibility, they argue investors should diversify their minimal risk asset into a couple of different, highly rated government bonds, even if this means taking a currency risk for those bonds that are not in your base currency.

My own view is that if you are invested in government bonds that are among the most highly rated in the world, the probability of a sudden default is so low that for practical purposes it is a risk you can feel safe taking.

Minimal risk assets and you

Here are my own recommendations for minimal risk assets for various base currencies:

Base currency: Suggested minimal risk asset: Alternative minimal risk asset:
US dollar US government bonds Mix of world-leading government bonds
(take a currency risk)
Euro German or AAA/AA Eurozone government bonds Mix of world-leading government bonds
(take a currency risk)
UK Sterling UK government bonds Mix of world-leading government bonds
(take a currency risk)
Other currency with AAA/AA government credit Domestic government bonds Mix of world-leading government bonds
(take a currency risk)
Other currency with sub-AA domestic government credit One or a mix of world-leading government bonds (take a currency risk) Domestic government bonds
(take a credit risk) or bank deposits if a strong credit bank (or other)

Source: Author

As you can see, I believe your minimal or ‘safe’ asset is not necessarily your domestic government bond.

Consider a Spanish investor who is after the lowest risk asset, and does not want to take a currency risk. This investor should not be buying Spanish government bonds that are relatively lowly rated, but rather should buy German government bonds that are also euro denominated.

If this investor did not want the minimal risk to be the bonds of just one government, he could diversify by either adding other euro-denominated government bonds, or he could accept the currency risk of investing in highly rated non-euro government bonds from the US or UK.

Watch out for more on risk

Below you’ll find a video that recaps some the things I’ve discussed in this article. (You will also find other interesting videos on my YouTube channel).

In my next article I’ll explain why and how you should match the time horizon of your investment to the minimal risk asset, what returns you can expect from these minimal risk investments, and how you can go about buying them.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

  1. In the end, B&B customers were transferred to rival Abbey and compensation was not required.
  2. For those who don’t think government bonds can default I would encourage you to read This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff (Princeton University Press, 2011). The authors make a mockery of the belief that governments rarely default and that we are somehow now protected from the catastrophic financial events of the past.

from Monevator http://monevator.com/what-is-the-minimal-risk-asset/

Weekend reading: The returns from the world’s greatest active investors

Weekend reading: The returns from the world’s greatest active investors post image

Good reads from around the Web.

I am not one of those who believes active investing will always gobble up the majority of our savings, like some baleen whale mainlining krill with a cheeky glint in its eye.

The trend is your friend, as most good active investors know, and the trend is towards passive investing:

  • The simplicity of pairing a global tracker fund with a bond ETF is impossible to beat. For many people that might be all the portfolio they need.

True, there are some counters.

For example, much of the growth of passive funds under management to-date has been into ETFs, and much of that money is traded actively. So the growth in passive may be somewhat exaggerated.

I’m also regularly reminded by Radio 4’s Moneybox – which I almost always listen to after filing my Weekend Reading articles – that sadly there’s no shortage of suckers out there. Every week seems to bring another person who gave their life savings to a man on a phone, or who thought a 15% return per year with no risk sounded reasonable, or who bought big into the Kazakhstan vodka boom1.

Hedge funds, too, make me wonder. Despite the side-splittingly hilariously dreadful performance of hedge funds as an asset class, they still have $3 trillion in funds under management.

If the rich will throw their money away like that, why shouldn’t the rest of us?

Then again, have you seen the bathrooms, cars, and the plastic surgery favoured by many of the world’s truly loaded?

‘Discerning buyer’ isn’t the first phrase that springs to mind.

The world’s greatest active investors

Whether active investing will eventually be shunted to the sidelines by passive investing in the years ahead is still too early to call.

But one thing I am sure of is that even if only a minority of money is putting into active funds in the future, there will always be some people – like me – who try to beat the market for ourselves.

Regular readers will know of this tension at the heart of this blog. I’m surely in the top 0.01% of being informed about the case for passive investing. (Does that sound arrogant? Editing a blog that champions exactly that, week in, week out, for a decade, could get you there, too!)

But despite this excess of knowledge, I myself invest actively. Much to the amusement of the fully passive and superior role model, The Accumulator.

The following table – tweeted out by fellow seeker after glory Richard Beddard – reminds me why:

Table of returns of the greatest fund managers of all-time.

Returns of (apparently) the greatest fund managers of all-time, to 2014.

This data comes courtesy of Excess Returns, a 2014 book by Frederik Vanhaverbeke. I haven’t read it but I might soon.

Now, I can already imagine some readers readying their rebuttals: Survivorship bias! One in a million monkeys would toss heads one hundred times! Some of those records were built in older, more inefficient markets! This or that structural benefit is available to them and not to us! You don’t need to beat the market to retire happy!

And of course I agree. I’ve written a blog about this stuff, remember.

I’m just being honest. I’m still fascinated by the intersection of markets and businesses. I like pitting my wits against the world’s millions.

And this table shows what’s possible – however unlikely.

If you can’t join ’em, beat ’em

When I was 16-years old I bet my father I could run a one minute mile. I never did, not least because I was in hospital two years later. But I was getting there.

I was sprinting 100m close to 11 seconds, too, which was pretty fast for my frame.

Well, those days are gone. I try to keep physically fit – on a budget, of course – but the flaming torch of failing to be one of the world’s genetically gifted freaks long ago passed to another generation.

But Warren Buffet, on the other hand, he’s 86-years old.

Watch your back, Buffett!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: Fancy paying less than 1% a year for a two-year fixed mortgage? Of course you do – it’s the joint lowest rate on record, says ThisIsMoney. But it also warns you’ll need a 40% deposit and £1,495 free to pay fees to win over the good people at the Yorkshire Building Society.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.2

Passive investing

Active investing

  • The global economy is enjoying an upswing. Really. – The Economist
  • Merryn blows the dust off her ‘Buy Japan’ thesis [Search result]FT
  • Running an active fund? Win early, then be consistent – Bloomberg
  • Dividend bonanza was prompted by tax reforms [Search result]FT
  • 20 surprising facts about Warren Buffett – Entrepreneur
  • Why the big bond bull market needn’t crash [Podcast]Bloomberg

A word from a broker

  • Ten most frequently asked questions about ISAs – Hargreaves Lansdown
  • A deep dive into “the top 25 UK equity fund managers” – TD Direct

Other stuff worth reading

  • Squeeze an extra £1,000 a year from your cash nest egg – ThisIsMoney
  • U-turn over Budget plan to increase NIC rate for self-employed – BBC
  • How to use ISAs to reduce your inheritance tax bill [Boo! Hiss!]Telegraph
  • Space, the final frontier for investors [Search result]FT
  • But, but… I thought Bitcoin was supposed to be cheap? [Search result]FT
  • Defending Jim Cramer’s call to sell stocks in October 2008 [Search result]FT
  • Comma comeuppance: When rogue punctuation proves costly – BBC
  • Five things you should never say to a woman in tech – Recode
  • Iceland’s recovery will be tough to sustain – Bloomberg
  • Oh, and New Zealand is getting full – Bloomberg

Book of the week: I re-watched The Big Short the other night, and I enjoyed it even more second time around. Who would I rather be, I wondered? Christian Bale’s hedge fund outsider Michael Burry, Ryan Gosling’s hilarious big banking insider, or the lunatic played by Steve Carell? Probably none of those… maybe Brad Pitt’s character, who I thought was super cool even if Pitt’s fans boycotted the film on account of his supposedly ill-fitting suits. (I suppose Mr. Pitt is held to a higher standard.) It also reminded me that I still haven’t read Michael Lewis’ most recent effort, The Undoing Project, which tells of the genesis of behavioural finance. Seems a bit worthy by comparison, doesn’t it?

Like these links? Subscribe to get them every week!

  1. No, there’s been no such boom. But if there had been then someone from Tunbridge Wells would have tried to get in early – late – and invested the kids’ inheritance.
  2. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.

from Monevator http://monevator.com/returns-worlds-greatest-active-investors/

Seven psychological quirks that destroy investment returns

Illustration of a brain made of gears.

This is a guest post from Tim Richards, whose Psy-Fi blog is all about psychology and finance. It was first published here in the depths of the bear market in 2009. I thought it’d be fun to showcase it again on the eighth anniversary of those lows, with markets now giddy at all-time highs! People don’t change…

Making money from stocks is easy enough if we can defeat the main enemy – ourselves. There’s no getting around the fact that us humans are subject to lots of biases and psychological quirks that combine to destroy our investing returns.

The first line of defence against this is to recognise the problem.

Here are seven psychological quirks to look out for.

1. Overconfidence and optimism

Most of us are way too confident about our ability to foresee the future, and overwhelmingly too optimistic in our forecasts.

This finding holds across all disciplines, for both professionals and non-professionals, with the exceptions of weather forecasters and horse handicappers.

Lesson: Learn not to trust your gut.

2. Hindsight

We consistently exaggerate our prior beliefs about events.

Market forecasters spend a lot of time telling us why the market behaved the way it did. They’re great at telling us we need an umbrella after it starts raining as well, but it doesn’t improve our returns. We’re all useless at remembering what we used to believe.

Lesson: Keep a diary, revisit your thinking constantly.

3. Loss aversion

We hurt more when we sell at a loss than we feel happy when we sell for the same profit. But stocks don’t have memories – decisions on whether to buy or sell should always be independent of your buying price.

Lesson: Ignore buying prices when deciding whether to sell.

4. Regret

Investment decisions should overwhelmingly be about risk, and risk implies a judgement, which may turn out to be wrong, often through bad luck rather than bad thinking.

Becoming overly focused on past decisions that have gone wrong without analysing whether the decision made was rational under the circumstances isn’t rational. Investing involves making mistakes and is often down to luck.

Lesson: Learn to live with mistakes.

5. Anchoring

Ten years or more of research has shown we have a nasty tendency to ‘anchor’ on specific numbers. Psychologists can change the results of simple estimation questions (for example, how old do you think Woody Allen is?) simply by posing an earlier unrelated question containing a number.

Lesson: Don’t get fixated on specific numbers, such as buy prices, stop loss prices, or index values.

6. Recency Bias

We pay more attention to short-term events than the longer-term. So the effect of a short-term downturn in a company’s fortunes may be exaggerated, or we may simply assume that current market conditions will persist forever.

Lesson: Buy some history books, and look beyond the short term.

7. Confirmation Bias

We just love other people to confirm our decisions. And other people just love us confirming their opinions. In fact we could just get together and have a regular love-in but it doesn’t make for good investing. The only money you lose is your own.

Lesson: Make your own decisions; don’t worry about what others think.

Special bonus quirk!

As a bonus investment quirk, my all-time favourite is Myopic Loss Aversion. This is where investors can’t stand the sight of red ink in their portfolio – they avoid short-term losses at the expense of long term gains.

Such people should be physically restrained from buying shares. Let them play checkers with five-year olds or something they can always win at.


Many people who invest heavily in shares tend to heavily exaggerate their own abilities and downplay the role of luck in stockmarket investment. Sadly there is a lot of random stuff in the market which we can’t control.

The easiest way of managing these psychological ticks is to invest regularly and for the long-term in index trackers and avoid selling no matter what the circumstances.

Failing that – go take a course in weather forecasting. At least you’ll be more help than most market forecasters who can only tell you that you need an umbrella after it starts raining.

P.S. Woody Allen is 81. Most of you will have thought lower, unless you really knew the answer.

Tim Richards has written a book – The Zeitgeist Investor – which is all about what happens when our brains and the stock market collide.

from Monevator http://monevator.com/psychology-and-investment-returns/

Weekend reading: Bashing the budget

Weekend reading: Bashing the budget post image

Good reads from around the Web.

Chancellor Philip Hammond says Wednesday’s controversial Spring Budget will be the last (and not just for him). The Spring Budget is set to become the Autumn Budget, while the Autumn Statement will be reborn as a Spring Statement. Oh, and the Spring Statement won’t really be a Stealthy Second Budget, supposedly. Meanwhile for now we all get Summer Off.

According to the BBC, this kerfuffle is aimed at giving us more time to prepare for tax changes and the like ahead the new tax year, which begins in April.

Well, maybe. Because does that seem to have been any motivation for governments in the past decade?

On the contrary I suspect Hammond may be secretly planning to launch a 24/7/365 Budget. One long unending rollercoaster of financial meddling, streamed on Facebook and pithily summarized via hourly Tweets.

So relentless have been the changes to pensions, taxes, and whatnot in recent years, it must be a drag for them to have to sit around waiting for another Budget to come along before they can have a fiddle again.

Instead, why not just get the latest wheezes out the door pronto?

We’ve had Just in Time manufacturing for years. Let’s have Just in Time policy! It can’t take long to get the back of a fag packet typed up.

(Lifetime ISAs, I’m looking at you…)

Dividends for dummies

Seriously, I have had colds that have hung around for longer than the shiny new Dividend Allowance was left unmolested.

I’d only recently updated Monevator to explain the ‘new’ dividend taxation regime, and now the Allowance has been slashed to £2,000. Annoying enough for me – imagine the hassle writ large across the financial services industry.

I mean, if the £5,000 Dividend Allowance is really so grossly ‘unfair’ then why wasn’t it unfair less than a year ago when this government introduced it? If we’re going to tax investments outside of tax shelters harder, then let’s get it all changed at once so we know where we stand, rather than hiking dividend tax rates, then introducing a new clunky complication to the system with the Dividend Allowance, and then immediately begin chipping away at it. Its policy by Frankenstein.

Ditto the NIC hikes the chancellor has slapped on the self-employed.

Hammond said he’s asked Matthew Taylor, chief executive of the RSA, “to consider the wider implications of different employment practices.”

That review is due to report in summer, but heck, why wait for Taylor’s considered conclusions? Let’s just get some NIC hikes rolled in now, ahead of the review, and keep everyone on their toes! They will likely be rolled back by a Tory backlash anyway, before being rolled back in again as a result of Taylor with the Autumn Budget.

And they wonder why people find this stuff so vexing?

More on the omNICshambles Budget:

  • At-a-glance summary of all the Budget details – BBC
  • Dividend Allowance to be cut to £2,000 – Money Observer
  • This equals a 68% tax ‘pseudo dividend allowance’ cut in two years – Telegraph
  • Why on earth raid the self-employed and small business? – ThisIsMoney
  • “ISAs to come back into favour, say experts”. [Sigh. ALWAYS fill ISAs]Guardian
  • Tax on dividends is a raid on two million small investors – Guardian
  • A novel take: “Dividend crackdown a tax on widows”Telegraph
  • The capital gains tax take has trebled under the Tories – Telegraph
  • Theresa May’s honeymoon is officially over after the tax hikes – Telegraph

Sorry I’m a bit late with the links this week. Reasons!

Have a great rest of weekend.

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

  • Why good (bad) companies can be bad (good) investments – Musing on Markets
  • Meeting company managers is not all that – The Value Perspective
  • A deep dive into Standard Chartered – UK Value Investor
  • Europe still looks relatively cheap and attractive [Graph]Schroders
  • Reader Gregory flagged up this market-beating Hungarian fund – Concorde
  • A quick look at a UK logistics and warehouses REIT – DIY Investor (UK)
  • Eight lessons learned from running a prop desk – Yahoo

Other articles

Product of the week: The Spring Budget saw Philip Hammond confirm a new NS&I savings bond will launch in April. ThisIsMoney is rightly underwhelmed. The three-year product will pay 2.2% – not even a market-beating rate – and you can only put in £3,000. Atom Bank pays the same, and will take £100,000. (Remember the FSCS limit though.)

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • A clinical test of the five most important Smart Beta factors [Search result]FT
  • How to get started with a simple passive ETF portfolio – ThisIsMoney

Active investing

  • Hedge funds run by women outperform [Search result]FT
  • Does Warren Buffett not understand risk-adjusted returns? – Bloomberg
  • The case for owning too many equities – Morningstar
  • Goldman Sachs’ lesson from the ‘quant quake’ [Search result]FT
  • Mutant turtles: A real-life Trading Places story [Podcast]Bloomberg
  • Ultimate stock-pickers: Top 10 buys and sells – Morningstar
  • SEC rejects Winklevoss Bitcoin ETF – ETF.com
  • 15% of hedge fund staff work over 60 hours a week – Business Insider

Other stuff worth reading

  • Why are Britain’s new homes built so badly? – Guardian
  • No pay rise for 15 years, IFS warns workers [We’re a decade in]Guardian
  • £40,000 to buy your new-build leasehold back – Telegraph
  • How to retire successfully – Guardian
  • I always enjoy the ThisIsMoney podcast [Podcast!]Share Radio
  • Richard Dawkins: Britons have not spoken on Brexit [Video]BBC
  • Lonely EuroMillions winner moves back in with her mum – Daily Mail
  • Is Russia’s president really the richest man in the world? – MarketWatch

Book of the week: Barel Karson was disappointed by passive guru Larry Swedroe’s The Incredible Shrinking Alpha, noting:  “[The authors] seem only interested in one dimension: linearly factoring historical returns, and implicitly assuming these don’t change going forward.” Anyone read the book and care to comment?

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  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.

from Monevator http://monevator.com/weekend-reading-bashing-the-budget/

How to find small cap dividend shares

Photo of Todd Wenning

When The Investor asked me to continue my series on dividend investing, I decided it was time to step out from behind my moniker. The name’s Todd Wenning, aka The Analyst, nice to meet you. Please see the bottom of this post for full details. As a regular Monevator reader who enjoys the community here, it’s a pleasure to be back with you talking dividends!

Today I’d like to explore dividend-paying smaller companies, also known as small cap shares.

Look through most dividend-focused portfolios, and you’ll find them heavily weighted toward blue-chip stocks. There’s nothing wrong with that, and FTSE 100 companies can serve as a solid anchor in a dividend portfolio.

That said, large companies tend to be the most covered companies by the City, and there are thus limited opportunities to outfox other investors.

Small cap dividend shares, on the other hand, often fly under the City’s and other investors’ dividend screens. I believe this makes them attractive candidates for those of us doing our own fundamental research.

Further, even if large investors wanted to invest in small caps, they frequently run into the problem of not being able to buy enough of the business to make a difference in their portfolios.

As individual investors, we can take more significant stakes in small companies.

Not for everyone

Naturally, small caps aren’t without their risks.

Relative to large caps, small caps tend to be less diversified, have a harder time accessing capital in recessions, and their executives may jump ship when offered a bigger paycheck at a larger company.

Not to mention their share prices are usually much more volatile. Daily moves of 5% or more in either direction are not uncommon.

As such, wading into the small cap pool requires patience, a business focus, and a stoic mentality.

So when evaluating small-cap dividend-paying stocks, I get interested when I see one or more of the following attributes.

1. Low debt or preferably no debt

A few years ago I was speaking with the tenured CFO of a small cap firm in the U.S. His company had a net cash balance sheet (i.e. they had more cash than debt) and I asked him if he was under pressure to increase the company’s borrowings.

He replied that whilst investors were urging him to borrow now (in a good market), those voices were silenced during the financial crisis a few years earlier.

Debt’s siren song can be enticing for small enterprises wanting to get big quickly. Too often they forget that leverage cuts both ways. If the economy, industry, or company faces a downturn, that extra leverage only exacerbates the problem and puts the company at risk.

As Warren Buffett put it in his 1987 letter to Berkshire Hathaway shareholders: “Really good businesses usually don’t need to borrow.”

All else equal, it’s a positive sign when a company can grow using internally generated cash.

2. An invested leadership team

If I’m going to invest in a smaller company, I want to see that my interests and management’s are aligned to the greatest extent possible.

One way to check this is to evaluate management’s incentives.

When reading the remuneration report, ask yourself, “Upon which metrics are management’s bonuses based?” and “Will those metrics encourage the right behaviour?”

I also like to see that management and the board together own at least 5% of the outstanding shares. By having skin in the game, they are less likely to take undue risks or pursue growth-at-any-cost acquisitions that might jeopardize the dividend.

3. Steady free cash flow generation

Since dividends are paid from free cash flow (i.e. the money left over after the company reinvested in the business), it’s a positive sign when the company has displayed an ability to generate free cash in various markets.

A pure commodity company, for instance, may have bumper free cash flow during booms, only to burn through cash in the troughs

Volatile cash flows are a less-than-ideal scenario for dividend investors. Instead, focus your attention on firms that can deliver cash flow in both good and bad markets.

Steady free cash flow generation across the business cycle can also serve to build the board’s confidence in the business’s long-term prospects, leading to dividend increases every year.

4. Dominant in a profitable – ideally boring – market niche

What’s the firm’s Total Addressable Market (TAM)?

If the company is growing rapidly in a large TAM (say, social media) it will surely attract competition from larger firms with robust resources.

On the other hand, a large company will likely either acquire a small company that’s dominating an attractive-but-limited TAM, or else leave it alone.

If the small company operates in a decidedly dull industry – think industrial parts, safety equipment, waste management – then that’s even better. These industries are less likely to attract new participants. This helps the small company maintain profit margins and free cash flow production to support the dividend.

5. A payout ratio below 50%

Companies, large or small, that pay out much more than 50% of their free cash flow are likely in mature or declining industries. These types of companies can boast high yields make for good investments at the right price, but if dividend growth is important to you, focus instead on companies with ample cash flow after dividends.

If you trust the management team and there are good reinvestment opportunities, management can plow the extra cash back into the business to accelerate growth.


Given the relative lack of City coverage, investing in small-cap dividend-paying shares takes some extra research on your part. Yet because they aren’t often included in popular dividend-themed ETFs or mutual funds, I believe the return on your research time can be higher than if you focused solely on blue chips.

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.

from Monevator http://monevator.com/how-to-find-small-cap-dividend-shares/

Investing for beginners: What is a share?

Investing lessons are in session

Most people who invest their money for the long-term decide they should own some shares (or equities, as they’re also called).

This is a good idea. Over the past 116 years, the UK stock market has historically delivered an average after-inflation return of 5.5% a year.1

In comparison, bonds have returned on average just 1.8% after-inflation over the same period, and cash a puny 1% a year.

So shares look like a winner when it comes to money you plan to tuck away for long-term growth, such as in a pension.

But what is a share?

What a share is

Shares denote slivers of ownership of companies.

By owning a slice of a company via its shares, you’re entitled to a portion of the wealth that the company generates over time.

Your particular entitlement varies with the size of your stake – in other words, the number of shares in the company that you own.

Western economies have tended to expand over the decades (boosted by inflation).

This economic growth has been reflected in the performance of our publicly owned companies, which in aggregate have become much more valuable over time.

As a result, shares have provided the best gains for investors over the long-term compared to the fixed returns from assets such as cash and bonds.

Share prices can go up and down

To be clear, the shares we’re talking about here – shares in public companies – are those traded on the stock markets.

Such trading means that as well as often receiving an income from your shares – called a dividend – you can also sell your shares in the future. Hopefully at a higher price than you bought them for!

This combination of dividends and capital growth is how shares deliver their returns to investors.

However it’s important to realize that the value of shares does fluctuate both ways – that is, their prices go down as well as up.2

In a stock market crash in particular, share prices can fall a lot.

Hitherto most Western markets have eventually bounced back, even from big slumps like we saw in 2008. This has rewarded investors who sat through the crashes rather than selling.

Nevertheless, until prices do recover your wealth has been reduced – even if you prefer to think of it as a paper loss because you haven’t sold.

Such volatility (and uncertainty) is what makes shares riskier investments than cash or bonds.

You simply don’t know what your shares will be worth on any given day or month, even if you believe that over the long-term you’ll be rewarded for owning them.

And when prices do fall, it can take years for them to recover.

Look at this graph showing how the UK stock market has behaved since the year 2000:

A chart of the FTSE All-Share since 2000

The FTSE All-Share index from 2000-2017. (Click to enlarge)

As you can see, since 2000 investors in the UK market have had to endure two big declines. There was a slow slide from 2000 to 2003, and a sharper slump around the financial crisis, beginning in 2007.

Indeed, if this graph were the only evidence you were ever shown about investing in shares, you might wonder why you’d bother.

The level of the market today (right hand side of the graph) is not hugely higher than where it was in 2000 (left hand side), even after enduring all those ups and downs.

Some reward!

It’s important to note though that this graph, like most stock market graphs you’ll see, only shows capital growth. It doesn’t include the dividend income I mentioned.

Dividends are worth about 3-4% a year from the UK market. The total return picture is much more attractive if you assume dividends paid were reinvested back into the market every year.

We saw that in the historical return figures I quoted at the start of the article, which do include dividends.

Also, even 17 years is only really just getting into the ‘long-term’ when it comes to shares.

For a wider perspective on how shares can deliver strong gains over time, here’s a graph of how the US market has performed since the late 1970s:

US S&P 500 index, from 1977 to 2017. (Click to enlarge)

Since 1977, the US stock market is up more than twenty-fold. Again this does not include dividends, which would have massively boosted those capital returns if reinvested.3

I know that 1977 may seem a very long time ago, particularly if you’re young.

But if you’re in your mid-20s, say, then you’ll probably be saving for your retirement for 40-odd years. Forty years would take you back to 1977, where many people like you began investing in US shares for their own retirement.

Certainly there would – in retrospect – have been better and worse times to invest over those long four decades.

But the main thing to notice is the pattern of slumps and recoveries. This is what you have to steel yourself for when you invest in shares.

Don’t lose it entirely

It’s also important to note we’ve been looking at overall stock market movements so far.

Put simply, when we say ‘markets’ in this context, we’re referring to the shares of all the companies listed and traded in a particular country.

So the UK market refers to the shares of companies listed on the London Stock Exchange.

Data providers further divvy these shares up into various stock market indices. These indices makes it easier to track the performance of groups of companies, among other things.

For instance, in the UK we have the FTSE 100, which is the index of our 100 largest listed companies.

We also have indices that track the shares of energy and mining companies, indices of smaller companies, property companies, and so on.

Now, when I say markets have always bounced back from the worst crashes, that’s true in all but a handful of cases.4

But individual companies, in contrast, can and do go bust. And when a company goes bust, its shares can become worthless.

If you’re an investor in a company that goes bust – or one that simply goes down a lot in value and you sell, for that matter – then you will lose money.

There’s no compensation schemes or other protections in that case.

When you buy shares you are a true investor in a business venture. And when the business goes bust, the venture did not turn out well.

Diversify your shares

We see a picture then where stock markets overall have tended to post great long-term returns, even though some of the companies trading on those markets have delivered diabolical results.

In the worst cases big companies have gone bust, and their shares have become worthless.

What is happening here?

The seeming contradiction is simply down to the strong returns from the very best performing shares more than making up for the terrible returns of the worst.

  • The most value that can be destroyed when a company goes bust is 100%.
  • But if a business does very well or becomes very popular with investors (not always the same thing) it can go up in value by 200%, 300%, 10,000% or more.

This wide variation of returns from individual shares – together with the risk of permanently losing your capital in any that fail – is why it’s super important to diversify your holdings across many different companies.

Fortunately this is nowadays easily done.

The easiest way to invest in shares

As we’ve seen, deciding you should own some shares only opens another can of worms!

Besides preparing yourself for the market’s ups and downs, you might also consider:

  • What amount of shares is it best to own for your age, income, aims, and attitudes towards risk?
  • How do you decide which shares to own?
  • What’s the best way to own them?

We can’t answer the first big question in this short piece, but other Monevator articles can help you create your own plan.

However for the other two questions, we’re convinced the simplest way for most people to own shares is via a global equity tracker fund.

Such a fund holds small stakes in many thousands of companies all over the world. This hugely diversifies your investments – not only across different shares, but also across different countries, currencies, and business types.

And as a tracker fund, it’s a low-cost passive investment that will leave more of your money free to compound over time.

  • We’ve also written about how to choose the right global tracker fund.

For much more on passive investing in general, head over to our passive HQ.

Key takeaways

  • Shares are slices of ownership in publicly traded companies.
  • Over the long-term, the returns from shares have outpaced those from bonds and cash.
  • Share prices can go up and down, and in the worst case you can lose all your money.
  • Overall though, stock markets have tended to go up over time.
  • Diversifying your money across the shares of many different companies helps protect your investment from the worse outcomes.
  • A global tracker fund is a cheap and effective way to invest into a diversified portfolio of global shares.

This article about shares is one of an occasional series on investing for beginners. Please subscribe to get our articles emailed to you and you’ll never miss a lesson. Why not tell a friend to help them get started?

Note on comments: Please remember this series is for beginners, and any comments should reflect that, rather than confuse. Thanks!

  1. My data here on returns for UK shares, bonds, and cash all comes from the Credit Suisse Yearbook 2017.
  2. To a lesser extent the dividends they pay are volatile, too. Dividends can be reduced or even cancelled by a company if it hits hard times.
  3. Unfortunately most graphs of stock market returns don’t incorporate the impact of reinvested dividends.
  4. The most important exceptions are Russia, China, and Germany, where markets were disrupted by revolution and war, and Japan, which is still well below the peak it reached in the late 1980s.

from Monevator http://monevator.com/what-is-a-share/

Weekend reading: Why is Nest making active decisions about worker’s pensions?

Weekend reading: Why is Nest making active decisions about worker’s pensions? post image

Good reads from around the Web.

I believe humans are causing climate change. There is overwhelming consensus among scientists. Those who argue otherwise almost invariably come from a certain demographic, who I won’t name because I told reader @mathmo I’d try to be more sparing with labels.

Suffice to say, they might as well argue against gravity.

If Einstein wants to argue with scientists1 about gravity, I’m interested. If a middle-aged Top Gear fan wants to argue with scientists about climate change, they can do so elsewhere.

Liberal Snowflake credentials safely re-affirmed then, let me get to my own indignant outrage.

Why on earth is the government’s workplace provider Nest making active investment decisions based on its employees’ opinions about climate change?

Nest knows best

In a short interview last week, Nest’s director of investment development explained to Share Radio that it had identified climate change as a key risk to returns.

According to The Guardian, the pension provider is therefore shifting around 10% of its members’ investments into a new climate change fund that dials back on fossil fuel firms and favours renewable energy:

Nest is now looking after the pension pots of more than four million UK workers, investing £1.5bn on their behalf, and has signed up more than 290,000 employers.

These numbers are expected to increase markedly over the next few years, making Nest a major shareholder and, it hopes, a difficult voice to ignore.

Why is Nest making such decisions for its members? Why does it need a voice? Why is it not just investing in tracker funds?

As we all know around here, most active funds fail to beat the market. Why is the default option for auto-enrolled workers not just a cheap and effective global index fund, paired with a bunch of gilts?

Climate change is hardly a hidden risk. Even Exxon Mobile’s new chief executive has reiterated that behemoth’s calls for a carbon tax to help tackle it.

The market price of Exxon, Shell, BP, and other fossil fuel firms should reflect these known risks – as well as the potential rewards of having vast reserves of a super-potent fuel.

What do Nest’s decision makers know that the market does not? Nothing, I would suggest. As far as I am aware they are not drawn from the sliver of proven billionaires who’ve made their fortunes reading the market’s runes.

They are no doubt perfectly decent salaried employees, doing what they think is right. I think they’re getting it very wrong in the process.

I agree environmental degradation is a huge threat. But the market will determine over the next couple of decades whether the reserves of big oil companies and the like will end up ‘stranded’ and left in the ground, and if so which alternative energy will take up the slack.

My own hunch is solar, but I wouldn’t bet four million citizens’ retirements on it.

Whose retirement is it, anyway?

Incidentally, we get a lot of emails from people who want to invest passively but don’t want to invest in, say, big oil companies, or banks, or bomb makers.

We’re overdue an article on this. I understand the thinking, even if I’d suggest your views are perhaps better expressed outside of your portfolio. But the point is it’s your personal decision.

I can’t find recent figures, but as of 2013 the stats showed that 99% of Nest savers were in the default fund. These people are not making an active choice to bet against the market on fossil fuels. I doubt most realise their pension provider is, either.

Pension auto-enrollment is a great initiative, but making these active decisions risks undermining the whole project. Tracker funds exist and they do the job best for the greatest number of people. It’s maths.

I think the government should go to Vanguard, Blackrock, and the other leading tracker providers and play them off against each other to get a special deal for bringing four million new customers to the table.

Nest should focus on educating and encouraging savers (a very valuable role) as opposed to playing George Soros – or trying to change the world at the risk to its savers’ retirements.

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

  • Weathering a low-growth investment outlook – Vanguard
  • UK market forecast to pay over £100bn in dividends for first time [Factsheet]VT Munro Fund
  • The employment income to net worth ratio – The Finance Buff
  • What is happening to the world? – 3652 Days

Product of the week: It’s time to lock yourself into a 10-year mortgage, says The Telegraph. It recommends First Direct, which charges 2.49% if you’re borrowing 60% of a property’s value and 2.89% for 80% loans. While very low, these rates are still well above the cost of two-year mortgages. But they provide certainty, in an increasingly uncertain world.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.2

Passive investing

  • 5 ways passive investing is actually quite active – Bloomberg
  • Don’t let a bad process derail your investments – Bloomberg

Active investing

  • How money-losing Snap could be worth so much – New York Times
  • John Lee: Independents add value to your portfolio [Search result]FT
  • Some very high income funds have delivered at the cost of capital returns – Telegraph
  • What to make of these twice-in-history S&P valuations? – Bloomberg
  • Buffett: US stock market is not too expensive – CNBC
  • More than six in 10 asset managers are bored at work [Search result]FT
  • By the Bible: New fund “backs arms firms, avoids brands promoting gays”Telegraph

Other stuff worth reading

  • Merryn: My big Budget hope? Scrap the pensions taper [Search result]FT
  • Britain will become a nation of renters, says economist David Miles – ThisIsMoney
  • OECD warns of potential global property crash – Telegraph
  • How will the new Lifetime ISA work? [Search result]FT
  • Radical economics, rethought [Podcast]FT Alphaville
  • Look to the land for the cause of Britain’s housing crisis – Guardian
  • Violent criminals can get off lighter than people late with their water bill – Guardian
  • Mem Fox on being detained by US immigration – Guardian
  • The Walled Off Hotel: Artist Banksy turns hotelier – Guardian

Book of the week: Warren Buffett smuggled a book recommendation into his much-discussed annual letter. He said Shoe Dog author and Nike founder Phil Knight is “a very wise, intelligent and competitive fellow who is also a gifted storyteller”. Knight’s memoir was the best book Buffett read last year. Shoe Dog is just £9.99 on Kindle.

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  1. i.e. Propose a new working hypothesis.
  2. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.

from Monevator http://monevator.com/why-is-nest-making-active-decisions-about-workers-pensions/