Rule Book: 5 Investing Principles
1. Investing is not a 'bet' and vice versa
‘Gaming’, ‘short-term bet’, ‘timing’ -- these terms are gambling ideas. If you treat markets like a casino, you are opening yourself up to having to be doubly right. If you are looking to “buy low and sell high” you need to be right timing the buy and right timing the sell – ‘right twice’. Research shows that most can’t do this more than once, making the probability of capital loss high. In short ‘timing’ isn’t investing, it’s betting as ‘time’ and ‘picking’ are odds that are against you, not for you.
Investing, on the other hand, is long term by its very nature. All investment asset classes have risk, from term deposit through to equities. But there are options you can take as a long-term investor to manage those risks and be prepared, something you can’t with short-term positions. The simplest option is diversification, spreading your investment capital across the risk spectrum of asset classes and holding these for a longer time period. This smooths out your investment risks and give you time for the likes of compounding interest to take effect.
2. Expect the unexpected
COVID-19, the Global Financial Crisis, the Euro crisis, the Asian Financial Crisis, 9-11, China’s ‘hard landing’ the list goes on. These are events of the past 25 years that have created the unexpected.
Yet if we look at the average return of markets like the US S&P 500 or Australia’s ASX 200 the average total return is 10 per cent and 8 per cent respectively per annum. But neither have really ever registered a 10 per cent and 8 per cent return in any given year. It is the same in pretty much every developed market on the planet.
The behaviour of equity markets (in fact almost any asset market you can point to) has uncertainty, something we experience all the time in our everyday lives. No matter how hard we try we can’t make uncertainty disappear. We can however deal with it thoughtfully, making sure we treat uncertainty as a given and thus invest accordingly. This will make all the difference in our investment returns, and even more importantly, our quality of life.
So how do you deal with uncertainty thoughtfully? You prepare for it. We would point out that that there are two sides to uncertainty, a downside and an upside. If you want next to no uncertainty, then a money market return is all that you can consider. But that will mean your returns will suffer from chronic underperformance. That’s because risk (uncertainty) and returns are related: the more risk you take, the better your long-term returns will be. But again, having just a ‘risk’ asset will also lead to problems as the gyration in the market can lead to investment mistakes.
That is why, if you diversify across the “risk-return” scale you will have some ‘risk-less’ exposure, some ‘risk’ exposure, with the rest somewhere in between. Thus, you have prepared for the unexpected, both the upside and the downside.
3. Excute Discipline
Financial science tells us that things like diversification, long-term investment, compounding returns and dollar-cost averaging are the difference between below or above average returns. Yet, despite the science, so much can be lost in application because of poor discipline. Think about times you have broken your strategy because of ill-discipline like buying something on a whim, being influenced by events or persons or selling something before you were suppose too – this all leads to underperformance.
Think about it in terms of a contest: Some sides consistently execute their strategies better than others. It’s the same with investment professionals: some consistently add value by dealing with the market mechanics and staying disciplined to financial science rules.
4. Cancel the ‘noise’
Noise from the outside your investment world is one of the leading causes of breaking Rule 3 – your discipline.
Noise in the investment world sounds and looks like this:
- If an investment sounds too good to be true, it probably is.
- A Shiny new investment nearly always turn out to be fads and failures.
- A friend of friend invested in this and it made them rich. This is luck more than anything.
This noise can lead people to break their discipline and/or induce people to think that they can time markets, find the next winning ‘thing’ or appoint people they believe can.
Study after study shows there is no compelling evidence that professional stock pickers can consistently beat the markets. Even after one outperforms, it’s difficult to determine whether a manager was skilful or lucky.
Constantly finding big “winners” is difficult, but if you are diversified these winners are baked into your holdings. That means those high fees from a stock picker are surplus to requirement as a low-cost portfolio can generate similar returns over time.
5. Find your strategy and stick to it
As Rule 2 and 3 state, markets are unexpected so you need to have discipline. However, this can be tremendously difficult during periods of extreme market volatility. Look at the 20 days between late February and mid-March 2020 when COVID-19 first hit. Record amounts of money exited equity funds flow into money markets. The ASX 200 at one point lost over 29%.
However, those that stayed true to their strategy and didn’t panic saw a subsequent 60% gain in the ASX 200 over the next 6 months from the bottom of the COVID crash. 2020 will be a year we will never forget for many, many reasons. We think you should add one more reason to why you won’t overlook how important it is to maintain discipline and stick to your strategy of diversified long-term investing.