19 Nov A successful investment experience
There’s always something to read about how to beat the market or to achieve better than average returns and you can find countless articles, podcasts, books or even go on weekend trading courses to learn how to invest in the stockmarkets of the world. Like a lot of things since the internet and search engines arrived, the problem is not finding the information but working out what is relevant, doable and that actually works for you.
In my opinion, most of these investment strategies at best have some basis in financial theory but at worst the same as having a ‘system’ for horse racing. Either way, they are extremely difficult for most people to implement and stick to. We all have behavioural biases that get in the way of the best intentions.
So, before you order several books from a leading online bookseller or go on that course, try starting by understanding the following simple concepts.
The two main risks that most investors face are living too long for the wealth that they have (longevity risk) and of inflation eroding the purchasing power of this wealth (inflation risk). Therefore, most people need their personal wealth to generate annual returns which are higher than inflation.
In investment terms, risk and return are related. The more return you want, the more risk you have to accept. There are no low risk and high return investments. Accepting the potential for loss of capital and daily fluctuations in the value of your investments is the price you have to pay for trying to avoid longevity and inflation risks.
This leads to the following key and simple investment principles:
- Capitalism works well enough – the free market is the best mechanism for valuing assets.
- Stockmarkets are an effective enough pricing mechanism and market prices are the best guide to the fair value of traded assets as they are based on the expectations of all investors; changes in those expectations are rapidly reflected in prices.
- Diversification (not putting all your eggs in one basket) is the only ‘free lunch’. The market does not know if you are not diversified. And it doesn’t care.
- Asset allocation determines the majority of the variability of investment returns. The factor which will have the greatest impact on achieving your goals is the mix of assets that you own (e.g. cash, fixed interest investments and shares).
- Costs, especially ongoing costs, matter and they are something tangible which investors can control. Trading always adds costs (including, potentially, taxes) but only sometimes adds value.
If you understand and try to follow these then you are much more likely to have a successful investment experience than trying to follow a complicated trading strategy or by trying to identify in advance who is going to be the best investment manager of the future.
You then need to consider your own risk profile, i.e. what level of risk you should be taking and therefore what overall asset allocation does this suggest.
Your risk profile comprises three elements:
- Your emotional tolerance to risk. This is best measured by using a psychometric risk testing tool (some are better thsan others) and is an assessment of how you emotionally react to financial loss and gains.
- Your financial capacity to adapt your lifestyle in the event of a permanent loss of capital and/or investment returns being lower than anticipated.
- The investment risk you need to take to achieve your goals, i.e. the annual rate of real return that you need to maintain your lifestyle and other goals.
A financial planner can help you to ascertain the annual rate of investment return that you need in order to meet your goals and also whether this is realistic given your emotional tolerance and financial capacity for risk. If the required real rate of return is too high, then your future goals or other planning assumptions about current spending, earning, saving and how long you want to work may need to be changed. A financial planner should also be able to run various scenarios and stress test your financial plan in order to agree your financial capacity to risk.
However, if you don’t have a financial planner then trying to understand your own risk profile is still the starting point of any investment strategy.
The secret to a successful investment experience is not how complicated your trading strategy is or whether you can read tea leaves. It is to have the context and clarity of a well-structured financial plan which takes into account why you are investing, how best to achieve your life goals and the risks that are most likely to be compensated in the form of long term investment returns.
The long term cost of getting your investment strategy wrong and making bad decisions when things don’t go to plan is likely to be far higher than the fees that a financial planner will charge for their knowledge and experience to help you to have a successful investment experience.