In my last article, I indicated that I wanted to cover investment idea generation for an investment portfolio in more detail. The very first stage of building a portfolio of investments, far before investment idea generation, is to define your investment goals. For the purposes of this exercise, let us define our goal as income generation for an individual that is employed full-time. They have 12 months of essential expenses in a ring-fenced account to pay for their living costs should they lose their job and so will suffer no consequences if the income fluctuates. Instead, they can treat it as a supporting income to fund discretionary luxuries such as holidays, home improvements or gifts to friends, family and charitable giving.
Investment Idea Generation: Portfolio Construction
Once an investor has decided on their goals, they can begin the process of generating ideas for their portfolio. This is the point where most retail investors freeze as they discover the many thousands of different investmentsthat are available to them. A sensible investor now begins a process of \’filtering\’ investments by eliminating those that are unsuitable and attempting to focus on those that are most likely to help them achieve their goal. One way to do this is to decide on the \’type\’ of assets they want to invest in. Some of these are set out below;
- Bonds: A company or institution issues bonds to borrow money. They are usually issued on fixed terms – for example, HSBC wants to borrow £10m for 10 years and offers to pay a lender (or bond holder) 1% each year for ten years after which they will return the £10m in full.
- Equities: A company wants to raise money (or the owners wish to share their controlling interest in the business). The company splits itself into millions of pieces or ‘shares’ and sells these to individuals or institutions. The owners of those shares then share in the profits of the company. If the company makes more profit, the price of the shares goes up (people are willing to pay more to own a part of it) and if it makes less money the price goes down (people are willing to pay less to own a part of it). Companies can choose to distribute profits to shareholders in the form of dividends, but these can be cancelled or reduced if the company does not make enough money to continue paying them.
- Precious Metals: Investors can choose to hold precious metals such as gold, silver and platinum, which produce no income but are conversely correlated to the value of the currencies. For example, if an ounce of gold costs £1,000 and the government decides to print more pounds and issue them to the population, the cost of the ounce of gold will increase.
- Cash: Cash holdings are exactly what they sound like. Money held in cash will not appreciate and will lose value over time due to inflation. It will not, however, lose its ‘relative’ value (i.e a share might decline from £1.10 to £1.05 in a month but £1 in cash will remain £1).
These assets can be valued a number of ways but for the purposes of portfolio construction, an investor must take a view about their value relative to each other, as well as their expected future performance. Assets perform in different ways based on external factors. One of the most direct links is with interest rates, to which most assets have an inverse relationship.
For example, if interest rates are at 3% (that is to say, you could store cash in the bank and receive 3% a year), then investors are unlikely to buy bonds paying less than 3% (after all, if you hold the bond to maturity, you would receive less back than if you had left the money in a bank account). If interest rates fell to 2%, then investors would then see bonds paying more than that as a more attractive investment, increasing demands for those bonds. This would push up the price of those bonds and push down the yields.
Generally, all asset prices tend to increase with falling interest rates and decrease as interest rates climb based on this principle. Broadly speaking, interest rates are known as the ‘cost of money’ – low interest rates mean money is cheap, stoking demand via personal and corporate borrowing, increasing asset speculation and decreasing the cost of servicing and refinancing debts.
Secondly, you have macroeconomic factors. If a country is ‘booming’ economically (i.e GDP is increasing, wages are increasing, unemployment is low or falling etc) then demand for assets in that country tend to be strong. If, on the other hand, the entire world is booming, then asset appreciate tends to be strongest in those countries where economic growth is best relative to other countries.
Thirdly, investors must consider currency valuations. If GBP falls relative to USD, then American investors can buy more goods and services (and assets) priced in GBP in their own currency. Therefore a weak domestic currency tends to increase foreign investment and a strong domestic currency tends to decrease it. This, of course, must be balanced against inflationary concerns; if a currency becomes too weak relative to others, then the cost of imports can become prohibitively expensive, damaging companies who require the import of goods or services and reducing or eliminating their ability to generate profits.
By going through these steps our investor can narrow down their field of assets to focus their investment idea generation process on those assets which are most likely to help them achieve their goals.As this investor wants to generate an income from their portfolio, assets which do not distribute a form of income (such as dividends or bond coupons) will be relatively less attractive to those that do. Quantitative Easing (compulsory bond purchasing by central banks) has forced many bond yields into negative territory (meaning that buying them is guaranteed to lose an investor money) so these are not particularly attractive.
Equities, on the other hand, are yielding 3-4% in most markets, relative to interest rates of around 0.5%. This makes cash and bonds relatively less valuable to equities for seeking an income. Despite this, over a decade of low interest rates have forced asset values into the stratosphere, GBP is strengthening, and the UK economy has been torpedoed by the COVID pandemic and is on a shaky footing. This makes equities a more attractive prospect than bonds for generating an income but the investor should recognise that equity values could decline significantly if interest rates begin to climb.
Cash and precious metals are two interesting options; neither produce an income but both provide options for the investor. If the investor uses all their capital to buy equities and later finds an opportunity, then they must sell something to open a new position. If they make the wrong decision, they would actually damage their portfolio, in that they would sell a strong company for a weak one, or invest in something that grows less strongly than the original investment would have done.
In theory, as more pounds/dollars/euros are printed, the value of gold will increase as the quantity of gold is relatively fixed. I am aware that more is dug out of the ground each year, but fundamentally, an individual is not ‘suddenly’ going to discover a deposit that triples the amount of gold in circulation. By comparison, the M1 level of GBP (composed of physical currency and coin, demand deposits, travelers\’ checks, other checkable deposits, and negotiable order of withdrawal accounts) has increased more than fourfold since the year 2000. It will never reverse either (after all, what incentive is their to do so – if you keep printing money then you can spend it on whatever you like…just ignore those pesky historical examples of Germany, Venezeula, Brazil, Zimbabwe, Yugoslavia, Hungary and so on…).
Investors also need to consider their tolerance for valuation volatility; if prices of equities decline 20% how will they feel and what will they do? If they sell, they could have ended up ‘buying high and selling low’, destroying capital. How great is their tolerance for withstanding this compulsion? How sure are they? This too, will impact the focus on their investment idea generation process – if they have a low risk tolerance, they probably want to avoid highly speculative, small cap investments, and have a higher weighting towards large-cap, blue chip stocks and bonds.
For the purpose of this article, I’m going to assume a high tolerance for valuation volatility; they know they can withstand a drawdown, no matter how severe, and would continue to value an equity based on the underlying company performance rather than solely on the price (gold star in my book, but remember; each investor\’s portfolio and investment goals are unique – what I think is a great idea might not be for you!). This allows u, in our next article, to explore individual assets in which to invest. This will typically be more concentrated than a collective investment (an individual would have to be significantly wealthy to hold more than 30-40 individual positions of reasonable size compared to a single ETF which could hold hundreds).
Investment Idea Generation: Collective vs Individual Investment Vehicle Selection
If, of course, an investor doesn\’t have a high tolerance for valuation volatility, they could invest in a collective investment vehicle. An investment ‘vehicle’ is simply a pre-selected group of assets which you can buy that provides exposure to lots of underlying assets. They provide instant diversification and in some cases allow you to benefit from the insight and skill of a research team at a relatively low cost. Deciding on which of these (if any) you like will help to narrow the focus of your investment idea generation process. A few of these vehicles are set out below;
- Investment Trusts are vehicles which are actively managed (they have a team buying and selling individual assets based on an investment mandate or philosophy). They issue a prospectus which outlines this philosophy and issue a set number of shares to the market meaning that if you want to get your money back you have to sell your shares to another investor. They usually charge a fee based on their performance and a fee for assets under management.
- Unit Trusts are vehicles which are also actively managed in buy and sell units directly from the market (meaning that if you want to get your money out the UT will buy them back from you).
- Exchange Traded Funds (ETFs) are an investment vehicle which is typically ‘passive’, meaning that they will track a fixed set of commodities and buy and sell based on whether they enter or exit that index. For example, a FTSE 100 ETF will own the 100 largest companies on the London Stock Exchange, ignoring their price, sector, profit margins and any other valuation metrics. It will check the values of these companies on a fixed schedule (typically quarterly) and buy and sell the companies in accordance with their There are now thousands of ETFs in existence providing access to just about every investment strategy imaginable. You can also buy ‘active’ ETFs which have a more bespoke management philosophy and a management team taking decision on allocations to underlying assets.
Personally, I am an active investor that selects individual assets to invest in. I produce individual valuations of those assets to determine when I believe they are selling for less than their true worth, as well as trying to identifying themes and specialist areas which I believe have growth potential. In the next article, I’m going to explore further methods to focus and build an investment idea generation process to start generating individual ideas for investment, including conducting fundamental research on them and narrowing down the pool of thousands of assets to hundreds and eventually a ‘watchlist’ of ideas.