Investors are a worrisome lot. When markets are falling many can get upset. Should they sell? Should they buy more? When markets are rising, the questions are the same. Should they sell? Should they buy more?
It also depends on what asset is in the news. For a long time it was property, then gold, then bonds, then equities. What should I buy? What should I sell? Sometimes the easiest thing to do is to capitulate to the newsmongers and do whatever they are telling you. But who says that just because some guy on a TV program, radio column, newspaper or internet column advises on a particular course of action it doesn’t mean that they are right. More importantly, it doesn’t mean that what they are publicising is right for you.
There is one piece of investment knowledge that doesn’t change irrespective of what’s in or out of investment fashion and it is this. Good investment strategy is actually boring, sometimes tediously so as it requires diversification over a range of different assets with different time frames and different characteristics.
Constructing a well balanced investment portfolio is not sexy and it won’t make quick bucks. Indeed, it’s designed not to make you quick money by smoothing out asset volatility over the long term and if lucky over the short and medium term as well.
So if it’s so basic, what are the key components that investors need to pay attention to?
The first principle is don’t invest money for the long term if you are likely to need it in the short term. The definition of term depends on individual circumstances but the rule hinges on ensuring you have enough liquidity to meet your personal expenses. Sometimes this may necessitate keeping a few years cash available for living and emergency expenses. Sometimes cash requirements can be managed by receiving guaranteed income from the investments. But before you invest for the long term you need to get this issue sorted first.
Next, you need to decide on what way the assets are invested – shares, bonds, cash, property or even commodities.
This is probably the single most important decision any investor and their adviser can make. How much of any portfolio that is put into such constituent parts determines the likely future return. This process is labelled asset allocation. If a fund is held in cash at this point in time the likely return is very low especially after allowing for tax. Even then it also assumes that there is no credit risk with the underlying institution. A fund that is solely invested in shares has possibly great potential for growth long term but can see massive falls in the short term. The ideal portfolio for anyone will vary depending on their personal circumstances and the following questions need to be answered before a cent is invested:
- How much does the investor need?
- When will the investor need it?
- What investment rate of return does the investor need to obtain to make all this work?
Answering these questions should only be done from the perspective of using assets to meet investors goals. The exact allocation of asset types will then also depend on an investors willingness to take risk – their risk propensity and their ability to take investment losses – their risk tolerance. All of this is dependent on the investor and not on a reaction to some financial pundit in the media.
As a basic, investing should be minimal costs and well spread. An ideal way to approach this issue is to use index funds – this is referred to as passive investing. Investing by any other means (active management) requires fund managers to constantly make buy and sell decisions which incur ongoing higher costs as well as running the problem of making bad market timing decisions. If you need some encouragement to avoid active management just look at the long term statistical information on active managers over the last 50 years or so. Last years heroes invariably turn out to be this year’s zeros and even if they can string a good year or two together very few manage it for more than 5 years at most. Staying with them long term can be very expensive both in terms of returns and costs.
So what asset needs to be used and when? Each type of investment plays a different role in a portfolio. Shares provide growth and long term protection against inflation. Short and intermediate government bonds can offer safety and some income. Property is useful to counter inflation but Cash is only used for liquidity. Commodities are plays on economic demand. By blending these different investment types into a portfolio, an investor can reduce but not eliminate the risk of any individual investment. It’s the up and down theory of investing. As one investment goes down, it is a strong probability, but not a guarantee, that another can perform better. Again, statistical analysis of any investment period shows different asset classes at the top of the investment pile each year and rarely does one asset class have a monopoly of more than two years.
The key to successful investment lies in actually rebalancing the portfolio on a regular basis when one investment grows quicker than the rest or might even fall in value more than the rest. Either way a realignment to the original asset percentages helps store profits made while at the same time investing at fallen prices in areas that are likely to rebound over time. In short, sell high where growth has happened and buy low where losses have been suffered. On a behavioural basis this seems almost counter intuitive but it does actually work over the longer term.
These principles are necessary for a successful and worry free investment strategy. Once understood and implemented it makes it easier to ignore the media hype allowing us focus on the things we can control such as spending and enjoying life.