The upside to spreading your investment is that it can reduce risk. So what’s the downside?
When it comes to your SIPP, spreading your investment comes at a cost. Arguably, two costs.
- 1. Spreading Your Investment Increases Your Charges
- 2. Spreading Your Investment Can Reduce Your Return
Let’s Consider This With An Example
- You have £100,000 to allocate from within your SIPP
- You’ve chosen to invest for a five year period
- You want the annual interest paid into your SIPP
1. Spreading Your Investment Increases Your Charges
You’ve heard that ‘putting all your eggs in one basket’ is a bad thing. So instead of putting it all into the one investment, you consider spreading it across five investments, putting £20,000 into each.
For the purposes of this illustration, each of the five investments is exactly the same, earning you 13% per year.
Your SIPP operator will normally charge for each investment you make. Here’s a typical set of fees:
- You’ll pay a set-up fee of £300
- You’ll pay an annual fee of £200 to receive the interest, check it’s correct and bank it
The following tables compare a single investment with spreading it equally across five investments.
Single Investment Of £100,000
Interest Received: £65,000
SIPP Charges: £1,300
A set-up charge of £300 and five years of handling the interest at £200 per year.
Your Net Interest Is £63,700
Five Investments Of £20,000
Interest Received: £65,000
SIPP Charges: £6,500
It’s the same charges as the single investment, for each of your five investments.
Your Net Interest Is £58,500
Spreading your investment has cost you £5,200. It’s reduced your overall income by more than 8%.
2. Spreading Your Investment Can Reduce Your Return
In the real world, it’s almost impossible to find five SIPP approved investments that pay exactly the same return. What’s more likely is that you’ll have to accept a range of returns.
Let’s assume you find five similar five year loan notes paying 9%, 10%, 11%, 12% and 13%. Like most people, you’d be willing to accept what seems like a smallish reduction in interest rate, because if one of them goes wrong, you won’t lose everything. It’s a small price to pay. Or is it?
Here’s a summary of the calculation for each loan note, over the five year term.
By accepting what feels like relatively small reductions in interest rate, it’s reduced your net income from £58,500 in the pink box above, to just £48,500. That’s 17% less income.
When you compare it to selecting one investment at the best rate in the blue box above, you’re almost 25% down. From £63,700 to £48,500.
Spread your investment in the real world, and more often than not, you’ll find charges and compound interest will work massively against you.
What’s more, it could be argued that you’ve increased your risk. For now you’re hedging your bets on five loan notes rather than one. You see, there’s absolutely no guarantee that a loan note paying 9% is lower risk than a loan note paying 13%.
Here’s the point. If the highest earning loan note ‘does what it says on the tin’ and pays you all the interest due, yet one of the others fails, you’ll significantly lose out.
What Do The World’s Most Successful Investors Do?
Ben Graham, author of The Intelligent Investor, is known as “the father of value investing”. He excelled at making money in the stock market for himself and his clients without taking big risks.
Graham created and taught many principles of investing safely and successfully that modern investors continue to use today. His investment choices were always based on diligent, almost surgical financial evaluation. In short, he used to ‘invest by the numbers’.
Warren Buffett credits Graham with providing the foundation for his career. But Buffett often became frustrated with Graham’s insistence on focusing on ‘just the numbers’, and disregarding management evaluation or other qualitative analysis.
Diversification was another key area on which they disagreed. Graham was a staunch advocate of diversification. He believed it was necessary to allocate relatively equal amounts to a large group of stocks with similar characteristics. Whilst some might die, in aggregate, the insurance bet would pay off.
Buffett on the other hand, analysed qualitatively, feeling he could gain an edge by doing more in depth research. He visited companies, talked to management and considered the actual prospects of the business. But he did this alongside Graham’s technique of analysing the numbers. And when he invested, he invested big, rarely spreading his investment.
History shows both men were incredibly successful investors. But Buffett was spectacularly more so.
“You Pays Your Money, And You Takes Your Choice”
Whether you follow Graham or Buffett or someone else is largely academic. What won’t surprise you to learn is that throughout history, successful investors all do one thing very well. Detailed due diligence!
And a big part of due diligence is knowing the true effect that compound interest has on diversification and on charges.
Please Share This
Sharing this article with your friends could really help them understand how to minimise the effect of diversification and charges when it comes to compound interest. Thanks.