Eight top tips for a good investment philosophy
By Darren Higgs
Over the last year, the Australian share markets is up by around 22% and the listed property markets is up by around 30%. Even the less volatile, more conservative bond markets are up by around 7%. These return numbers are certainly high. However, are they the highest numbers I have seen over the last 12 months? No, not even close. So what are?
The highest number I have seen is 180. No, that is not the return on an individual investment, although I am sure I can locate a few investments that have achieved this number. 180 stands for 180 degrees, which is the switch in investor's attitudes and risk appetite since the markets have been on the rise! Far more people are willing to take risks now than they were when the markets were lower. This is predictable, however is a poor (pardon the pun) strategy for long-term wealth creation. I am sitting next to my library of financial books while I write this and I cannot see one book titled 'Buy High and Sell Low'!
This is classic emotive investing. The diagram below displays this phenomenon perfectly, where we often see more money invested when people are feeling optimistic to euphoric, which is where the maximum financial risk is) and most of the withdrawals occurring when people are feeling fearful to despondent, which is when there is maximum financial opportunity. You would be far wealthier if you did the opposite to the crowd!
You can avoid emotive investing by having an "investment philosophy" that can guide you through good times and bad. As a starting point, I would suggest the following key tenets for a good investment philosophy:
1) Cashflow is the centre of the financial universe
Cashflow is the key to improving your financial position. Salary or investment income must always be putting money into your pocket. Capital growth is also important, as you need your investments to be growing at least in line with inflation (which is the biggest enemy for investors). However, if you are earning $100 but spending $200, the world's best investment philosophy is not going to save you. You need to understand cashflow before you can have a profitable investment outcome.
2) Markets work
Investment markets are not perfect, but they do work. In previous centuries, ships sailed from one country to another to provide goods and resources that the other country did not have. Today, financial markets work in the same way. Companies, sectors, industries and countries need investment capital from investors, and investors need cashflow and/or capital appreciation from these entities. Financial markets provide a place for investors and these entities to meet and provide what the other wants…almost a 'you scratch my back and I'll scratch yours". Because there are so many investors and entities in the market, all buying and selling, it also means that assets are generally priced correctly. Investors will get a successful investment experience over time if they embrace this principle.
3) Risk and return are related
As a general rule, you do not get a higher return over time without taking on higher risk. However, we do not want to run away from risk for that exact same reason, that is, you do not get a higher return without taking on higher risk. Racing to your computer to read this blog is a risk as so many bad things can happen, however the benefit you get will outweigh the risks (ha ha!). Therefore, it is important to do your budgeting and cash flow modelling to determine what return you need to meet your goals, and then take only the level of risk to needed to obtain that return. Furthermore, you should only take risks that you get rewarded for, which segues nicely into the next point.
4) Portfolio structure determines performance
This is quite a detailed point and could be a blog all unto its own. Suffice to say, history tells us that there are some key points that can be used to enhance portfolio structure:
- Have exposure to both Australian and international assets. All things being equal, international assets should provide a similar return to Australian assets over a full economic cycle. However, by combining both Australian and international assets, you can significantly reduce the risk and volatility within your portfolio;
- Smaller companies provide a higher return than large companies, albeit with higher risk. I suggest you tilt some of your portfolio to smaller companies for both Australian shares and international shares;
- Cheaper value companies provide a higher return than more expensive growth companies, albeit with higher risk. I suggest you tilt some of your portfolio to value companies for both Australian shares and international shares;
- Use cash and fixed interest investments as a way to reduce the risk and dampen the volatility within the portfolio, rather than as a way of chasing returns. Shares and property will provide you with the higher returns over an economic cycle. Cash and fixed interest investments will provide you with risk/volatility management over an economic cycle. All asset classes have their place, so long as they are matched to your goals;
5) Diversification is essential
This is absolutely essential and is the only free lunch you get with investing. Diversification is the number one way to reduce risk in a portfolio. You have heard the saying 'spread your eggs across many baskets', but this is a generalised statement that is only the tip of the iceberg. Diversification means considering all of the major asset classes, be it cash, fixed interest, property, shares and alternative assets. It includes having Australian and international exposure to each of the major asset classes. With shares it ensures having the right mix between large companies, value companies and small companies. With property securities it ensures having the right mix between commercial, industrial and retail property. With fixed interest it ensures having the right mix across varying maturity dates and varying credit ratings.
When you get the entire mix right, which isn't easy, you can then use diversification as a way to either increase your return while keeping your risk the same, or keep your return the same while lowering the risk. Investors should never forget the importance of diversification, irrespective of what you may hear from some so-called 'experts'.
6) Investing is not speculating
Whilst many will tell you that investment professionals can time markets, predict events or pick the perfect product to invest into at exactly the right time. It just ain't true. I often tell my clients that if I ever pretend to have a crystal ball that they should run out of the room as quickly as possible and give me a clip behind the ear while they are doing it.
The world is complex. Nobody can predict the future. All we can do is employ the proven investment philosophies detailed above, and review the strategy on a regular basis. Plus, why do you need to speculate? The capital market rates of return are clearly out there. All you have to do, to get these returns, is accept that markets work over time, use diversification in a way that suits your goals, and then invest in a cost and tax effective manner, which leads me to my next point.
7) Costs and taxes matter
Higher costs and inefficient tax structures obviously affect the returns you receive, so we want to keep both costs and taxes as low as possible. However, we need to be sensible about how we implement this. As an example, I can get the investment management costs down to 0% by investing directly into term deposits, hybrid securities and shares (which I do for a number of clients who prefer this method). However, unless you have around $50,000,000 to invest…and I will try to get you there…you cannot achieve adequate diversification. Remember, diversification is the number one way in which to reduce risk. Therefore, you may need to ask yourself whether you want lower risk or lower cost.
I like to use your home insurance policy as an analogy. You have your home insurance policy, although you hope to never claim on it, as it usually means that something bad has happened to your home. However, you still pay the premiums each year, as you cannot afford to take on the risk yourself and insurers provide better risk management through both assessing individual risks and diversifying risk across multiple insureds. I look on fund managers in a similar way. Fund managers can provide you with proper diversification and better risk management, however there is a cost for investing in a managed fund. Therefore, managed funds can play a vital role in providing the diversification needed for a portfolio. However, some managed funds efficiently manage their portfolio from a tax perspective, while others do not. Therefore, do not be fooled by the returns some fund managers promote. That return does not mean much if their costs and taxes are significantly reducing the return you actually receive.
8) Discipline is important and is ultimately rewarded
You cannot achieve a successful investment experience if you lack discipline. It just does not happen. If you ask the really successful people in life what their secret is, it always comes down to having faith in a sound plan, having a strong support network around them, and then having the discipline to stick with the plan. They do not get distracted by short term distractions, as their eyes are on the prize. It is not easy to maintain discipline, especially when you, your friends and the media doubt the plan during the bad times. This is where a strong support network helps. In my role, sometimes the real value isn't what I do, but what I stop clients doing. If I can help clients avoid deviating from a good plan at the wrong time, this will contribute more to their wealth over the long term than they realise. With the way that the investment markets have rebounded recently, it is the disciplined investors who are now being rewarded. Those who panicked and deviated from the plan halfway incurring losses, are now being rewarded with historically low term deposit rates.
There is no one perfect investment approach that suits everyone. There are a number of approaches that can be utilised to achieve each individual's objectives. However, it is always important to have a sound investment philosophy to fall back on. A successful investment experience is yours for the taking if you follow these eight investment tenets over the long term!
Please call or email me and I will forward a copy of Shadforth's investment philosophy booklet to you.
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