09 Jul Ten Steps To A Better Investment Experience
I think most investors would agree that 2020 has been a remarkable year so far. As the global pandemic took hold and spread from Asia to Europe and the US there was a brutal reaction by world stock markets, which recorded some of the biggest one day falls in almost 100 years.
The markets’ reaction made total sense. In the wake of a highly contagious virus, for which there is no cure, and an environment where most of the developed world basically shut down their economies, the markets’ reaction surely could have surprised no one.
What did catch investors by surprise was the speed at which markets recovered, with many now close to their previous highs.
The pandemic continues to exercise a strong grip in many countries – including the US, the world’s largest economy. A vaccine doesn’t look likely to be available in the short term and as we are trying to kickstart economies again, it looks as though it’s going to be a slow road to recovery, with massive unemployment numbers likely in the coming months.
What’s the average investor to do? Well, there are numerous options available. Our view is that there are ten sensible steps which, when employed as your investment strategy and philosophy, should help you to avoid many of the mistakes investors typically make.
Embrace market pricing
Accept that the market is generally an effective information-processing machine. In 2019, the daily average trading in world equity markets totalled $443.3B. With each trade, buyers and sellers bring new information to the market, which helps set prices. No one knows what the next bit of new information will be. The future is uncertain, but prices will adjust accordingly. The market may not price assets correctly 100% of the time but accepting the ‘wisdom of crowds’ has proven to be a successful strategy.
Don’t try to outguess the market
Many fund managers believe they can identify “mispriced” securities and convert that knowledge into higher returns. But fair market pricing works against such efforts, as indicated by the large proportion of mutual funds that have underperformed their benchmarks. Research shows that over both short- and long-term horizons, the deck is stacked against mutual funds that attempt to outguess the market.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.
Source: Dimensional Fund Advisors. The sample includes funds at the beginning of the 20-year period ending 31 December 2019. Each fund is evaluated relative to its respective primary prospectus benchmark as of the end of the evaluation period. Surviving funds are those with return observations for every month of the evaluation period. Winner funds are those that survived and whose cumulative net return over the period exceeded that of their respective primary prospectus benchmark. Loser funds are funds that did not survive the period or whose cumulative net return did not exceed that of their respective primary prospectus benchmark.
Resist chasing past performance
Some investors select mutual funds based on their past returns. Yet, past performance offers little insight into a fund’s future returns. For example, most US-domiciled mutual funds in the top quartile of previous five-year returns did not maintain a top‐quartile ranking in the following five years.
Let markets work for you
The good news is that the capital markets have rewarded long-term investors. The markets represent capitalism at work in the economy—and historically, free markets have provided a long-term return that has offset inflation.
This is documented in the growth of wealth graph below, which shows monthly performance of various indices and inflation since 1956. These indices represent different areas of the global financial markets.
The data illustrates the beneficial role of stocks in creating real wealth over time. UK Treasury Bills covered inflation, while UK stock returns have far exceeded inflation and significantly outperformed the UK Treasury Bills.
Another key point to note here is that not all stocks are the same. A pound invested in the UK market in 1956 would be worth £1,265 in 2019, compared to £7,068 for UK value stocks and £11,534 for UK small-cap stocks.
Keep in mind that there’s risk and uncertainty in the markets. Historical results may not be repeated in the future. Nevertheless, the market is constantly pricing securities to reflect a positive expected return going forward. If they didn’t, people would not invest their capital.
The graph is for illustrative purposes only; figures presented are hypothetical and not indicative of any investment. Past performance is no guarantee of future results.
Source: Dimensional Fund Advisors. In GBP. UK Small Cap is the Dimensional UK Small Cap Index. UK Marketwide Value is the Dimensional UK Marketwide Value Index. UK Market is the Dimensional UK Market Index. UK Treasury Bills is UK One-Month Treasury Bills. UK Inflation is the UK Retail Price Index. The Dimensional and Fama/French indices reflected above are not “financial indices” for the purpose of the EU Markets in Financial Instruments Directive (MiFID). Rather, they represent academic concepts that may be relevant or informative about portfolio construction and are not available for direct investment or for use as a benchmark. Their performance does not reflect the expenses associated with the management of an actual portfolio. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower.
Consider the drivers of returns
There is a wealth of academic research into what drives returns. Expected returns depend on current market prices and expected future cash flows. Investors can use this information to pursue higher expected returns in their portfolios.
Dimensions of Expected Returns
Relative price is measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios. Profitability is measured as operating income before depreciation and amortisation minus interest expense scaled by book.
Practice smart diversification
Many investors prefer to invest with a ‘home bias’ and / or in a small number of stocks. A large number of US investors never invest outside the US. This has served them well in recent years, but, from a global perspective, limiting one’s investment universe to a handful of stocks, or even one stock market, is a concentrated strategy with possible risk and return implications.
Avoid market timing
It is impossible to know which market segments will outperform from year to year. By holding a globally diversified portfolio, investors are well-positioned to seek returns wherever they occur. Tempting as it might be to think a portfolio containing just the FAANG stocks could be the best strategy to employ given their spectacular returns in recent years, it would be a high-risk one to execute. There is no discernible pattern to returns year on year, which is why diversification is often referred to as ‘the only free lunch’.
Annual Returns by Market Index (top row highest returns, bottom row lowest returns)
Past performance is not a guarantee of future results. Diversification neither assures a profit nor guarantees against loss in a declining market.
Source: Dimensional Fund Advisors. In GBP. UK Equities is the MSCI United Kingdom Index (gross dividends). Developed Markets ex UK is the MSCI World ex UK Index (gross dividends). Emerging Markets is the MSCI Emerging Markets Index (gross dividends). Global Real Estate is the S&P Global REIT Index (gross dividends). UK Treasury Bills is UK One-Month Treasury Bills. Government Bonds is the FTSE World Government Bond Index (Hedged to GBP). Short-Term Government Bonds is the FTSE World Government Bond Index 1–5 Years (Hedged to GBP). Global Credit is the Bloomberg Barclays Global Aggregate Credit Bond Index (Hedged to GBP).
Manage your emotions
The 2008–2009 global market downturn was an example of how the cycle of fear and greed can drive an investor’s reactive decisions. Some investors fled the market in early 2009, just before the rebound began. They locked in their losses and then experienced the stress of watching the markets climb.
Staying disciplined through rising and falling markets can pose a challenge, but it is crucial for long-term success.
Look beyond the headlines
News and financial commentary can influence people’s view of investing. Without a strong investment philosophy to guide them, they also may follow the advice of friends, neighbours or family, especially if the “insight” promises a fast, easy return.
The media uses provocative headlines to drive clicks and views. Their interests are not aligned with yours.
Growing your wealth has no shortcuts. Success requires a solid investment approach, a long-term perspective and discipline to stay the course. Getting wealthier is supposed to be boring.
Focus on what you can control
This starts with creating an investment plan based on market principles, informed by financial science and tailored to your specific needs and goals. Focus on actions that will add investment value, such as managing expenses and portfolio turnover while maintaining broad diversification.
And lastly, stay disciplined through various market conditions.