11 Dec The Foundation Stones Of Good Investing - Part 1: Five Lifelong Principles
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‘Successful investors operate with a coherent investment philosophy that they apply consistently to all aspects of the portfolio management process. Philosophical principles represent time-tested insights into investment matters that rise to a level of enduring professional convictions’
David Swensen, CIO Yale University Endowment
When investing money, it is often tempting to spend most of your time considering what to invest in rather than how to invest. If investors spent more time thinking about the latter, their investment experience would likely be a more fruitful one. Although investing is not easy, the following simple steps provide the foundations for success.
The challenge of investing
Investing is the process of delaying consumption from today to sometime in the future and in the meantime employing that money in the markets to grow at a rate at least in line with inflation but preferably more. Not scaring oneself to death along the way is also a key goal. As the old saying goes, investing is simple but not easy.
This post summarises what we believe to be a sensible and highly effective way to invest your money. Investing may never be easy, but it can be far less daunting if you adopt a systematic approach.
Start by building your investment compass
Investing money well requires a logical and robust framework on which to build a lifelong investment programme. It needs to be grounded in investment theory, supported by empirical evidence and enhanced with an insight into the behavioural traps and pitfalls which all investors face which can be costly.
Five lifelong principles
We start by looking at five guiding principles. These provide the backbone for how we should think about investing, rather than in what we should invest.
Principle 1: Have faith in capitalism and confidence in the markets
Capitalism is an adaptive and robust economic system which has delivered incredible developments for the benefit of mankind. For example, the wealth creation of capitalism has meant that over the last 25 years, around 2,000,000,000 (two billion) people are no longer trapped in crushing poverty[1] and child mortality rates have fallen by over 50%. Despite the apparent doom and gloom in the news, the world’s economy continues to grow year-on-year, which creates wealth and return opportunities for investors.
As investors, we need to keep faith in capitalism as a robust and resilient economic system and to recognise that free markets are an efficient mechanism for rewarding those who provide capital to those engaged in the pursuit of wealth creation. Despite current market challenges, the future looks bright from where we are sitting.
Principle 2: Accept that risk and return go hand in hand
An inescapable truth of investing is that to achieve higher returns, you must take on more risk[2]. That seems logical enough, but you might be surprised how many investors seem to think that it is possible to get high returns with low risk[3]. Yet risk should not be feared, because when appropriate risks are taken, they are the source of returns that investors seek.
The one thing we know for sure about risk is that if an investment looks too good to be true, it probably is. If you ever see such an opportunity and the risk is not obvious, you need to establish what the hidden risk is, as risk and reward are always related.
Principle 3: Let the markets do the heavy lifting
In investing, there are two main sources of potential returns. The first is the return that comes from the markets themselves. The second is the return generated through an investor’s skill in exploiting that return.
At its simplest, there are two main ways in which an investor – using their skill – can try to deliver a better return than the market. One is to time when to be in or out of the markets (market timing). The other is to pick (or find someone to pick for you) great individual stocks or sectors (stock picking).
Empirical evidence suggests that trying to beat the market – through either market timing or stock picking – is a tough game, with very few long-term winners. Our view – in line with both academia and many major institutional investors – is that it is a game not worth playing, particularly when costs are considered. Letting the markets do the heavy lifting on generating returns takes a great weight off your shoulders. You no longer need to worry about picking the right stock, the right manager or deciding if you should be in or out of the markets. As you cannot control the returns of the markets, the structure of your portfolio becomes key.
Principle 4: Be patient – think long-term
One of the great challenges that all investors face is that there is no easy or quick way to investment success. Aesop’s fable of the tortoise and the hare is a useful metaphor. You must use the time on your side – which could be over multiple decades – to capture the returns of the markets effectively but often slowly. In the short-term, market returns can be disappointing. The longer the period for which you can hold an investment, the more likely it is that the returns you will receive will be at worst survivable and hopefully far more palatable. It is time that allows small returns to compound into large differences in outcome for the patient investor. The reality is that markets go up and down with regular monotony but not to such an extent that those movements can be reliably predicted.
If you want to be a good investor, you must be patient. On your investing journey, you will spend a lot of time going backwards, recovering from a setback and then surging forward again, often in short, sharp bursts of upward market movement. You just have to stick with it. Remember that you have to be in the markets to capture their returns. Impatient investors tend to lose faith in their investments too quickly, with often painful consequences.
Principle 5: Be disciplined
Patience and discipline are close bedfellows. Once you realise that to generate good long-term returns takes time, patience and belief in the markets, it is essential to put in place the discipline to stop yourself succumbing to impatience and ill-discipline. Discipline comes in many forms: sticking to the principles above. Constructing well-researched and tested portfolios that should weather all investment seasons relatively well. Not chasing investments that have gone up dramatically but sticking with the logical reasons for not owning them in the first place. The discipline not to become despondent about unimportant short-term market noise and to focus on your long-term strategy.
We know from research in the field of behavioural finance that we tend to feel at least twice the pain from losses compared to the pleasure from gains of a similar magnitude. Consequently, every time their portfolio falls, investors feel glum. The key to this discipline is to understand the very ordinariness of these market falls and not to look at your portfolio too often. If you look at your portfolio every day you have about a 50/50 chance of seeing a loss, yet if you only do so once every five years that drops to around a 1-in-10 chance, falling further to around a 1-in-20 chance over 10 years[4]. Time is your friend.
Next week, five key investment practices on which the evidence and theory suggest we should focus.
Carolyn
[1] Human Development Report 2015: ‘Work for human development’, United Nations.
[2] Sharpe, William F. (1964). ‘Capital asset prices: A theory of market equilibrium under conditions of risk’, Journal of Finance, 19 (3), pp. 425-442.
[3] Sharpe, William F. (1964). ‘Capital asset prices: A theory of market equilibrium under conditions of risk’, Journal of Finance, 19 (3), pp. 425-442.
[4] Albion Strategic Consulting – internal research 2016.