Long-term agenda

Most long-term UK retail investors prefer cash deposits to equity investment, which they regard as too risky.

However, they are confusing short-term risk with long-term risk. The risk in investment is that of achieving a poor return. Long-term investment in cash is far riskier than long-term investment in equities. Over the last 10 years the real annual return on UK cash deposits has been negative, at -0.7 per cent, whereas UK equities delivered a positive real annual return of 4.1 per cent, beating the returns on any other non-physical asset class. The story is the same for longer investment periods such as 20 or 50 years. Cash deposits always massively underperform equities, according to a Barclays 2015 equity gilt study.

There are three main options for long-term UK equity investment:

Individual UK shares. Running a share portfolio requires effort and involves significant risk.

Share funds. Only a handful of funds consistently outperform the market and there is no guarantee that they will do so in future. Poor performing funds can sour the relationship between client and adviser.

Index funds, which replicate the performance of an index such as the FTSE 100 or FTSE 250. I believe that these tracker funds are the most suitable option for a novice retail equity investor. An investment adviser can help the investor with the choice of funds and with the timing of the investment.

Two systems can be used to boost returns from index funds:

1. Market valuation system

This system values the FTSE 100 in comparison with its market price. A valuation over 100 per cent indicates the value is greater than the price; below 100 per cent indicates the reverse. These percentage valuations can be used as signals for entering and exiting the market. A proven strategy is to buy the FTSE 100 when the valuation reaches 105 per cent and sell when the valuation falls to 95 per cent.

These timing signals can also be used for the FTSE 250, as the market turning points for the two indices are very similar (Chart 2).

Using these buy/sell signals since the start of each index, every buy/sell pair has produced a profit.

Total points gained when in the market have been 6,138 (17,382) and total points lost when out of the market have been 380 (1,166) ? with FTSE 250 figures shown in brackets.

2. Market momentum system

There are times when the market gets gripped by panic and prices go into freefall, irrespective of the market valuations. This system is designed to give protection against the impact of these crashes. The system uses the simple 100 day and 200 day moving average prices of the FTSE 100 (or FTSE 250), which show the underlying momentum of the markets. If the 100 day moving average crosses below the 200 day and the market price falls a further 10 per cent from this point, you exit the market. You re-enter the market when the 100 day moving average crosses above the 200 day and the market valuation is above 105 per cent.

Chart 1 shows the system in action for the credit crunch crash. The moving average lines are the smooth lines and the jagged lines are the actual market prices. The market exit occurred on 21 January 2008 at a price of 5578.2. Market re-entry occurred on 28 July 2009 at a price of 4528.8. The system therefore avoided 1049.4 points of the crash.

The system has been triggered only three times in the history of the FTSE 100 since other crashes occurred when the market valuation system had already triggered an exit.

Table 1 shows the annual returns achieved by the four simplest strategies I advocate for those looking to start investing in index funds ? from the start of the indices to the end of September 2014. All returns include reinvested dividends and take into account all costs, including basic-rate tax.

The first two index strategies are extremely simple: buy and hold a tracker fund long-term and reinvest dividends. It is essential that the investment adviser checks the market valuation before advising the client to invest.

An investment at the end of 1999, when the FTSE 100 valuation was only 56 per cent, would have taken seven years to recover its original value, including reinvested dividends.

The last two strategies use my market valuation and timing systems to switch investment between the index and cash. This approach increases long-term fund values by over 30 per cent and also reduces risk.

The long-term returns from all the strategies have been strong and it is striking how much better the FTSE 250 performs than its big brother, the FTSE 100.

Investment Strategy

Annual return %

Investment value of £1,000

Cash up to:

4.1

3,338

1. Buy and hold FTSE 100 ? get valuation first

9.2

14,017

2. Buy and hold FTSE 250 ? get valuation first

11.2

24,162

3. Market timing FTSE 100

10.3

18,935
4. Market timing FTSE 250 12.2 31,607

To maximise long-term returns, it is essential that the retail client is correctly advised on the choice of fund. Unit trust or Oeic funds should be avoided, as they will incur an annual platform fee of around 0.3 per cent. ETFs are a much better bet. Consider those with low management fees, physical inventory and good tracking performance, for example, i-Shares FTSE 100 (ISF). Vanguard introduced a FTSE 250 tracker with very low fees last year (VMID) and its FTSE 100 tracking performance has been good.

Glenn Martin is author of Seven Successful Stock Market Strategies

Key points

The risk in investment is that of achieving a poor return.

Two systems can be used to boost returns from index funds ? market valuation and market momentum.

The long-term returns from all the strategies have been strong.