18 Jan The 10 Commandments of investing
Image by Jondolar Schnurr from Pixabay
- Define how you would like to live your life and create a financial plan to meet the expenses that will entail
Not having this is a bit like taking off in an aeroplane without a destination in mind.
It is however important to build flexibility into your plan (and to be flexible in your expectations) as reality will never go (exactly) according to plan.
Moreover, it is important to be conservative in your financial planning and investment portfolio return assumptions and to think in terms of a range of possible outcomes.
It is best to err on the side of caution as you can’t be sure that your investment portfolio returns (or inflation, for example) will meet your expectations or hopes and you are better off leaving money on the table for the next generation than running out.
- Work out your risk profile
There are three inter-linked components to consider here:
- Your risk tolerance (psychological)
How nervous are you going to be if your portfolio goes down by 25% – or more? Are you going to be able to stay the course or want to sell? Are you going to sleep at night? Your emotional reaction in these circumstances is the key to determining the risk level that your portfolio should have.
A lower risk portfolio is likely to generate lower long-term returns but should decline in value less in a downturn, making it easier to stomach. A higher risk portfolio is likely to generate better returns in the long term but could leave you feeling queasy in down markets when the mood is negative and the media are spreading alarm.
- Your risk capacity (financial)
Another important component to consider is your capacity for loss, which can be assessed by stress-testing your financial plan. This is an assessment of the impact of a temporary or permanent loss of income or capital on your standard of living. Would either affect your ability to achieve your goals? If so, what is the size of the loss that you could sustain before your goals would be compromised?
- Your risk required (financial)
Where you have specific investment objectives, whether for growth and/or income, there will be a risk required. This is the amount of risk that you will need to take in order to have a reasonable chance of achieving your objectives.
It is wise to err on the side of caution until you experience a severe market downturn with your capital at risk. It is only then that you are likely to truly understand your risk tolerance.
Simulating the experience, albeit a worthwhile endeavour, does not really come close to experiencing the real thing.
- Create a portfolio asset allocation which aligns with your risk profile
Asset allocation is the biggest driver of the variation in investment returns between different portfolios.
Your asset allocation refers to how much of your money you place in different types of investment categories to ensure that your overall portfolio has sufficient diversification and is consistent with your risk profile.
The main investment categories are shares, real estate (property), bonds and cash. However there are others, including private equity and hedge funds of various types, although some can be considered sub-classes of the main four.
Your time horizon is a key factor to consider here, meaning how soon you will need funds for expenses and how much. If the requirement to draw on the portfolio is a long way into the future, a longer time horizon can be accepted as well as potentially a higher level of risk since you have no urgent need to draw on the funds.
According to Roger Ibbotson, who has spent a lifetime measuring returns from multiple portfolios, more than 90% of an investor’s total return is determined by the asset categories that are selected and their overall representation within them.
You should aim to create an asset allocation that you would be comfortable holding in any market environment.
- Think about risk management
Preservation of capital is important and for most people can be more important than maximising returns (which generally entails taking a higher level of risk).
Loss aversion is hardwired in human beings and numerous studies have shown that for the typical investor the pain of losing money is psychologically twice as powerful as the pleasure of gaining more money.
Some sensible ways to reduce risk are:
“Diversification is the only free lunch in investing” (Harry Markowitz – Nobel Laureate and the father of Modern Portfolio Theory)
- Insist on a margin of safety
The unexpected happens more often than you think. A margin of safety gives you flexibility, resilience and freedom.
‘Plan on the plan not going according to plan’. Our assumptions, whilst reasonable, will be inaccurate. Think in terms of probabilities and a range of possible outcomes.
Cash and/or short-dated high-quality government bonds provide liquidity and safety of capital, thus enhancing your financial resilience in the face of a market downturn. This also gives you the ammunition to buy other assets when they are likely to be at much more attractive valuations.
Have a disciplined process for rebalancing the portfolio to maintain your risk exposure over time at the desired level. Doing this properly is a systematic way of buying low and selling high (in a modest way).
- Avoid market timing
History shows that even the most experienced professional investors are unable to judge consistently when the market is at a high or low point. When they get it wrong they lose much of the return that they made when they got it right. Amateurs are much more likely to get it wrong more often than they are to get it right.
The emotional response of many is to buy when markets are rising (and everyone feels confident) and sell when markets are falling (and everyone is worried). This invariably leads to buying high and selling low, which is a disaster for investment returns. It is much better to do nothing and hold your nerve through the market cycles.
- Pay attention to valuations
Valuations matter. Avoiding bubbles is critical if you are going to be a successful long-term investor.
Equally it is critical not to panic and sell when prices are severely depressed.
“Be fearful when others are greedy, and greedy when others are fearful” (Warren Buffett)
Contrarianism is often a trait associated with the most successful investors but is best left to the few experienced investors who are good at it.
- Remember that risk and return are related
It is safe to assume that there are no low-risk and high-return investments. If an investment seems too good to be true then it probably is.
The higher the risk of an investment, the wider the possible range of outcomes.
- Conviction is key when investing
To invest successfully, you must have conviction in your investment approach. Focus on an investment portfolio that corresponds to your risk profile and with which you feel comfortable. Make sure that you understand what you own and why you own it. Do not invest in anything that you do not understand.
This will help you to stay the course when the going gets tough.
Simplicity tends to trump complexity, although complexity often ‘sells’ better. This is especially true for non-professional investors, who can fall victim to sophisticated-sounding products which may be designed more to meet the provider’s interests than theirs.
- Define your circle of competence and competitive advantage
Stick to the former and leverage the latter.
A truly long-term time horizon, for example, can be one of the biggest competitive advantages of the private investor in the same way that endowments can take a very long-term view.
‘Time in the market’ is more important than ‘timing the market’, which should be avoided in any event.
- Focus on the things within your control
These are things like saving, spending, costs and taxes. Investment performance is not one of them.
Or better yet,
Do not worry about the things which are outside of your control
“God, grant me the serenity to accept the things I cannot change, the courage to change the things I can and the wisdom to know the difference.” (The Serenity Prayer)
- Considering the long-term evidence, approach active management with a high degree of scepticism
Over a 20-year time frame expect c.90% of active managers to underperform the market in which they invest (before taxes).
As there tends to be far less trading activity with a passive approach, the net after tax results look even worse for investors who favour an active management approach. More than 90% end up with an inferior result.
In The Little Book of Common Sense Investing, John Bogle quotes David Swensen, chief investment officer of the Yale University endowment fund:
“A minuscule 4% of funds produce market-beating after-tax results with a scant 0.6% (annual) margin of gain. The 96% of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8% per annum.”
Sound investing is all about tilting the odds of success in your favour.
- Be wary of the media and of market forecasts
Be sceptical of what you see/read in the news. News organisations are incentivised to capture eyeballs or sell newspapers. They prey on fear and greed. The news media is not there to help you to make long-term decisions about your finances.
The news highlights a fresh litany of woe on a daily basis, with stories ranging from political corruption through natural disasters to forecasts of impending doom. Human beings are hardwired to be on the lookout for threats, so these broadcasts attract eyeballs – and, more to the point, advertisers.
The reality is that the world is getting better for most people in most places in most ways, as demonstrated by all the positive, long-term trends which tend not to feature in the news media.
Why is this important?
If we are truly living in a rotten world at a terrible time and are on the wrong track then why would you risk any of your money in the stockmarket?
It is due to this pervasive media bias that most people have a negative view of the world. Their investment returns suffer as a result.
“The only value of stock forecasters is to make fortune tellers look good. Short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children” (Warren Buffett)
- Successful investing requires good investments AND GOOD INVESTORS
Managing your investment behaviour (i.e. your emotions) is key.
“The investor’s chief problem – even his worst enemy – is likely to be himself” (Ben Graham – Warren Buffett’s mentor)
“If I have learned anything from my 52 years in this marvellous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns than the economics of investing have ever dreamed of destroying.” (John Bogle – founder of Vanguard)
- The ‘behaviour gap’:
Since 1984, independent investment research firm Dalbar Inc. has published its annual Quantitative Analysis of Investor Behavior report, or QAIB. This research series studies investor performance in mutual funds. Its goal is to shed light on how investors can improve portfolio performances by managing behaviours that cause them to act imprudently.
Most common behavioural mistakes:
- Market timing
- Performance chasing (i.e. buying investments that have done very well in the recent past)
- Overconfidence (in their own abilities to outperform the market, time the market etc.)
- Following the herd (and succumbing to greed/fear during bubbles/downturns).
Perhaps the most important lesson Warren Buffett teaches investors — and certainly the one he focuses on the most — is the importance of developing the right temperament.
“You’re dealing with a lot of silly people in the marketplace; it’s like a great big casino and everyone else is boozing. If you can stick with Pepsi, you should be OK.”
“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”
“What investors then need is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period — or even to look foolish — is also essential.”
…when markets fall
“You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.”
“There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
…and when they rise
“Equities will do well over time — you just have to avoid getting excited when other people are getting excited.”
“Nothing sedates rationality like large doses of effortless money.”
This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person. Your capital is at risk when investing. Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.
Please note that this does not constitute tax advice and any comments or observations on taxation are merely to provide general guidance. You should therefore take appropriate tax advice from a qualified tax adviser as tax treatment depends on an investor’s individual circumstances and may be subject to change.