If you’re reading this, there’s a good chance that you’re above average when it comes to financial literacy. You’re probably a good saver and have money invested in stocks or other growth assets.
The bad news is that loads of investors with those qualities still fail to get rich by retirement. Almost always it’s because they shoot themselves in the foot by overcomplicating things. They speculate on the price of gold or – worse – crypto-currencies. They buy dicey ‘lottery ticket’ stocks, small-cap miners and biotech startups. Or they invest in complex products with opaque risks, such as bank hybrids and derivatives.
What’s more, they love to shuffle their portfolios around chasing various ‘exposures’ and, in the process, clock up extra fees and taxes that bite into returns.
When investing, it pays to keep things simple – both in terms of the businesses you are buying and the way your portfolio is constructed. Simplicity isn’t so much about doing particular things, it’s a consequence of not doing things.
Our Buy recommendations have returned 14.1% a year on average over the past 16 years, outperforming the S&P/ASX 200 Index by 5.0% a year. That record wasn’t built by picking winners alone; avoiding losers was just as important. And, to do that, we had to be willing to pass on the vast majority of stocks and accept that it would mean we missed a few big winners.
In his 1996 letter to shareholders, Warren Buffett said: ‘What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.’
Sometimes, all you need to do is look at the industry a company is in to know you’re out of your depth. For example, technology and mining stocks – as well as most startups – get an almost immediate pass from me, not because there won’t be great opportunities in these sectors; I just have no confidence in my ability to spot them. Companies with untrustworthy management, loads of debt or other bankruptcy risks are also in my no-go zone.
If you can’t explain to a 10-year-old what a certain business does, its customers, suppliers, and how it makes money, then it’s probably outside of your circle of competence. Even then, watch out for industries characterised by rapid technological change because there’s a greater risk of obsolescence, which makes future profitability hard to predict (see A quick investment checklist for selecting stocks).
As a general rule, it’s better to be certain of a company’s outlook and pay a fair price, than to be uncertain about its future and pay what seems to be a cheap price.
Stay the course
Finally, embrace simplicity for your portfolio as a whole; don’t try to time the market.
Cash feels safe but it’s a depreciating asset. Stocks bounce around a lot but, over the long term, they’re hard to beat. Over the last 30 years, the All Ordinaries Index has gone up almost fivefold, whereas the dollar has lost roughly half its value.
Despite this, investors often sell equities to increase their cash holdings because they think a market crash is around the corner. Unless you need the money to fund a necessary expense, swapping a growth asset for a depreciating one is a losing strategy. The big picture matters far more to long-term investors than current headlines.
A 2015 study found that over the previous 20 years, the average US mutual fund investor earned a return of 4.7% compared to the market return of 8.2% – a gap of 3.5%. Curiously, though, almost half the underperformance was due to ‘voluntary investor behaviour’ – panic selling, exuberant buying and attempts at market timing.
‘No evidence has been found to link predictably poor investment recommendations to investor underperformance,' the study said. 'Analysis of the underperformance shows that investor behaviour is the number one cause, with fees being the second leading cause.‘
The bottom line is that if you’re adding complexity to your portfolio – either by stepping outside your circle of competence or by trying to time the market – then you’re doing yourself a disservice.
Buying a diverse group of high-quality companies when they’re undervalued, and holding them for the long term, is a much better approach. As Benjamin Graham put it: ‘To achieve satisfactory results is easier than most people realise; to achieve superior results is harder than it looks.’