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The 10 most important guidelines to investing

 
24 | Mark | 2010/10/08 | Print |
 
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The 10 most important guidelines to investing

Look, lists are lists. List on blogs are even more so: they tend to add to suspiciously neat numbers. They often fail to balance having a sufficiently rigorous discussion of each point with the quantitative urge to complete the list before your attention runs out. They tend to sound like a manifesto.

That said, you know a list is coming. We happen to think the topic is deserving of a list – in fact has to be a list – but apologise in advance both for any failures of the article in the above areas...

Here follows our opinion on the 10 most important things you should remember about investing and building your investment portfolio (in no particular order):

1.    Focus on asset allocation

Virtually every single piece of research into portfolio construction concludes that asset allocation decisions determine around 90% of performance. It’s kind of like the universal acid of investing. Clearly, a focus on determining the right asset allocation for you is the most important part of investing. For a refresh, read up on asset classes, asset allocation and portfolio construction.

2.    Invest globally

Do you think the world will look like it does today in 10, 20, 40, 60 years time? Do you think that the US and Europe will occupy the same economic positions as they currently do, and that the stocks currently touted will still be around? We don’t and nor should you. So, if you think you’ll live another 60 years and want to retire in 30, be sure to think globally when building your investment portfolio.

It should be clear to you that your long term investment thinking should take into account how the world’s economy is changing, and this probably means investing some portion of your capital with exposure to markets outside of mature traditional markets like the US.

There is a line of thought that says that as US / Euro companies expand their exposure to new or growing markets like Asia, owning their stock has this exposure built in. While this is true to some extent, it is not sufficient. From an investment perspective, you’re effectively hoping that management in those companies makes decisions in their business to support the global market growth and exposure you need. From an asset allocation perspective, you’re hoping they do in a way that exposes your capital to meet what you might want from these economies. Not ideal and not likely.

Happily, with the rise of new financial products you can easily get access and exposure to all kinds of markets and assets, so investing directly for global market exposure is easy.

3.    Think broadly: your portfolio is bigger than you think

For most people their personal ownership of real estate (a house, apartment, etc.) represents a sizable proportion of their wealth. So too might ownership of a business. These should all be incorporated into your overall view of your wealth when planning your finances. (But, err on the side of conservatism, as most of these holdings tend to be illiquid, very localised and usually quite risky.)

We’ve dealt with this in more detail here but it’s important to remember that these assets should be considered when building your portfolio, with your allocation to equity, bonds and other asset classes taking these exposures into account. 

4.    Rebalance your portfolio

Depending on how big market moves have been, about once a year is usually ok. Any more often and you’ll pick up unnecessary trading costs, any less and your portfolio performance will start to look like someone else’s. Just try to keep your portfolio reflective of your strategic asset allocation.

5.    Invest efficiently (1): Minimise tax

Invest your capital as tax efficiently as you can. While not all portfolios are retirement investments, retirement vehicles such as  401(k)s and ROTH IRAs in the US and ISAs in the UK offer tax advantages (to say nothing of other benefits like possible employer contributions) whose value, especially over long periods of time, is significant.

Additionally, depending on your particular situation, some offshore products and bonds may offer additional tax benefits.

6.    Invest efficiently (2): Minimise costs

The debate between active management and so-called passive investing, such as through index funds, ETFs or low cost funds offered by the likes of Vanguard, has received a lot of press. While you may have strong feelings or good reasons for a position either way, you should look to keep transaction and management costs to a minimum.

These are costs that effectively cut directly into your returns, and over time could result in significant forfeited capital growth. Invest as efficiently as you can to reap the maximum upside.

7.    Understand emotions and behavioural finance

Think about risk in the larger sense: Are you working in an environment where your earnings fluctuate a lot? Have family or health issues? You should think about how these aspects might affect your thoughts and feelings about investing and influence your behaviour.

If you feel like you’ve cut your living income too much for the sake of investing, or don’t have sufficient funds to cater for emergencies like losing your job or health issues, then you may want to reconsider your investing goals.

In the investing world, ‘behavioural finance’ is the study of irrational behaviour where investors act on emotions that aren’t consistent with their investment plan and rationale. A significant part of investing success comes from avoiding making irrational decisions. While a relatively new field of study, behavioural finance is in some quarters believed to eclipse traditional financial theory in its importance.

Theoretically, the ultimate investor would be hyper-rational and avoid all emotional influence. But as humans we are emotional beings not always in control. The trick is therefore not to eliminate emotion – which is impossible and perhaps also undesirable – but not to let yourself be led emotionally. Don’t make quick decisions based on your emotions.

The best way we know how to do this is by being as comfortable with your investments as you can, inform yourself as far as possible about your investment portfolio’s likely behaviour and ensure you are happy in the context of your larger situation. Forewarned is forearmed, as it were.

8.    Get the power of time on your side

Einstein was purported to have said that the most powerful force in the universe is compound interest, but even without his weighty support the message is clear: compounding growth over time is by far the best ally to building wealth.

What does this tangibly mean? Mostly, earlier you start to invest, and the longer you’re able to remain invested, the better. For pure capital growth, reinvest your dividends. Don’t make withdrawals that cripple growth.

Another advantage to time is that it increases the certainty with which you will achieve a certain return. Over a longer time period, short term market fluctuations and volatility expresses itself in a more predictable way. The range of returns of a portfolio invested for 20 years is much, much smaller than the range of a portfolio invested for 3. Ergo, the certainty of that investment is significantly higher and your goals (what you want to do with that money) more secure.

9.    Noise: there to be ignored

Noise tends to come at us in two forms: short term market price fluctuations and general information noise. We think you should learn to ignore both.

Don’t worry about short-term market vagaries: successful investing is about making and sticking to long term goals. You know that over time asset classes have a characteristic volatility and return. Acting on what happens in the interim is not going to help you and will probably only hurt, especially if you try to time the market! Besides, detecting meaningful trends or patterns in market fluctuations are impossible, and making money out of it is best left to occupations like currency traders.

Pascal said “all man's miseries derive from not being able to sit in a quiet room alone.” While this is probably a little extreme, it does illustrate the ill effects general information noise has on us, especially in the era of the internet where its volume is increasing and distribution is essentially free.

There is just so much noise – financial and business news, market performance feeds, opinion and “analysis” – that knowing what is important is nigh impossible. What does seem to be true is that mostly it just does not matter.

Noise distracts us, makes us think somethingelsesomethingbetter is just around the corner, that there is a hot new tip or insight. And you know what, there may be. Who knows? But the downsides to listening to that noise and acting on it far outweigh any possible upside in return.

Besides, even if you do find that hot tip that beats the market:

10.    Remember that more important than beating the market is meeting your needs

For most people, furiously trying to beat the market is like tying a fly to a moving bus with an elastic band and hoping the fly will go in a different direction to the bus – it can be done, but doing it repeatedly, over years and years and within your risk profile is really very difficult. Additionally, it generally violates investing efficiently.

In a portfolio context it’s even worse! This means that 99% of the time you will not beat the market and will be worse off. (In this case you’re hoping for a swarm of flies, but you get the idea).

The statistical improbabilities of beating the market aside, there is little reason to do so. Perhaps is has more to do with the psychology of relative versus absolute performance? 

The truth is that beating the market is the wrong thing to focus on; it’s asking the wrong question. Worry about building something that meets your needs, not beats a benchmark.

 

 
24 | Mark | 2010/10/08 | Print |
 
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