The Life Solutions Team
Five investing truths – Getting a start in financial markets
Time is on your side
Three truths in long-term investing are the magic of compound interest, the power of volatility and the benefits of dollar cost averaging.
Get rich quick schemes are everywhere. Unfortunately, these schemes tend to make their promoters rich quickly — often at the expense of investors.
Like most things in life that are worthwhile, investing can take time — time to grow (compounding) and time to recover from downturns (volatility).
Albert Einstein is said to have called it the most powerful force in the universe, and John D Rockefeller named it the eighth wonder of the world. We call it compound interest.
Why do people regard compound interest so highly? Most of us studied compound interest at school, so we know how it works. But it’s not until you start looking at practical examples that you realise how powerful it can be.
As an example, imagine you are 21 again. You decide to invest $5,000 and then add to it at the rate of $1,000 a year — until you turn 30. Then you stop saving altogether and leave your nest egg alone until you turn 65.
Let’s assume you earn an average return of 8% pa (after fees and taxes) in received income (dividends) which you always reinvest. And for simplicity, let’s say inflation is zero (so your real return is that same 8%).
Now imagine an alternative scenario
In this version of the example, you don’t start saving until you turn 31. At 31, you put aside $5,000 and add another $1,000 each year until you turn 65. Remember, for simplicity, you are reinvesting income, inflation is zero and you’re getting that 8% pa average return. You figure you will more than make up for lost time by saving harder — i.e. for 35 years rather than 10 years.
Which is the better strategy? The ten-year saving plan, in which you will have invested a mere $14,000 (a $5,000 initial contribution then $1,000 a year for nine years) will reap $332,413. The 35-year plan, in which you will have invested $39,000 — nearly three times as much — earns you the considerably less amount of $227,077.
The power of compound interest – an example
Here are the hard numbers for you to check. The bold type represents those years when you contribute $1,000. The return, remember, is a constant 8% pa.
Time heals all wounds. It’s a common saying but one that’s very powerful in an investment context. Often it’s the investments that have the greatest risk of losing money over the short-term that produce the best return over the long term.
Consider Australian shares. Over the 20 years to 31 December 2016, Australian shares have lost money in three individual years. But over the full 20 years, the average annual return from Australian shares has been just over 10% (based on calendar year returns of the S&P/ASX 200 Accumulation Index). You can see in the following chart that most asset classes have lost money at various points of time and also experienced highs at other points.
Time in the market
That’s why many professional investors use the adage: ‘It’s time in the market, not timing the market that matters’. Investing for the long term can help you manage short-term losses. Timing the market means second-guessing; trying to choose the best time to buy and sell investments. This is extremely difficult. Many professional investors believe the risks of second-guessing market movements outweigh the benefits.
Consider the following chart. Over the 7 years between December 2009 and December 2016, the S&P/ASX All Ordinaries Index returned an average of 6.8% pa. It’s worth noting this period also includes some of the Global Financial Crisis. Deduct the 10 best days on the market from the 1,772 days in the period, and that return drops to 2.5%. And as you can see, the return falls more and more rapidly as you take away more of the best trading days.
Dollar cost averaging
Dollar cost averaging is a method used by investors to avoid trying to second-guess the market. You simply invest a set amount of money on a regular basis over a long period of time. By doing this, you automatically buy less units or shares when the market is up, but more when the market is down.
Let’s look at an example. Say you put $100 per month into a managed fund (buying units of the fund) that initially had a unit price of $10. Over the next few months, the market falls — causing the unit price to drop — before recovering to its original value. At the end of the five months you have 65 units each worth $10, so you have $650. You have invested $500, so your profit is $150 even though the unit price is the same as when you first invested.
Of course, dollar cost averaging does not guarantee a profit. But it can help to smooth out market ups and downs and importantly help reduce the risks associated with investing in volatile markets.
Diversify your investments
The more you spread your investments, the less chance you have of losing money. Let’s say you invested your life savings into a single company. If the share price soared, you could become very rich. On the other hand, if that company went bankrupt, you could lose your life savings.
You might be better off spreading your money around.
This concept is a simple one, but often overlooked by even the most experienced investors. Diversification is a powerful way to help to reduce risk. It can do this in two ways. Firstly, if you have a well-diversified investment portfolio and an individual stock (or even an entire asset class) loses ground, your losses may be reduced.
Secondly, the various types of investments will perform better at different times. For example, shares tend to perform well at the upturn in the economic cycle, while fixed interest investments tend to perform better in the latter parts of the cycle. So diversifying across all the asset classes gives you a better chance of achieving a sound overall return.
There are three main levels of diversification — by asset class, investment shares and investment manager.
a. Asset class
This refers to the type of investment — generally shares, property, fixed interest and cash. As you can see from the following, each asset class typically has its time in the sun. By investing across all the major asset classes, you will always have exposure to the best performing asset class every year.
Obviously, you will also be invested in the worst performing asset class. However, the strategy is that this performance will at least be partially offset by the performance of other assets.
b. Individual investment securities
This refers to individual shares, fixed interest securities or properties. Once you have diversified across asset classes, it is time to start thinking about diversifying within asset classes. There are three major ways to do this:
Certain market, economic or political conditions could spell trouble for one company and success for another. Investing in a number of companies reduces the effect if an individual share falls. 7.8%
All companies operating in a particular industry can be affected by a change in government policy or economic conditions. But these same changes may have no effect on another industry — they may even make things better! So diversifying across industries might help to balance out the effect of these industry specific changes. The same principle applies to sectors of the property market, such as office blocks, houses, warehouses and shopping centres.
Australia’s share market is among the world’s 15 biggest, but as the graph below shows it still only makes up less than 3% of the value of the world’s share markets. This means that if you only invest in Australia, you might be missing out on the diversification benefits of investing in different economies, markets and industries.
c. Investment manager
One of the easiest and most effective ways to create a diversified investment portfolio is through multi-sector diversified managed funds. Share funds and single sector managed accounts, for example, might invest in more than 30 individual companies, while diversified multi-sector funds and managed accounts will generally invest across shares, fixed interest, property, alternatives such as commodities and cash.
If you choose to invest through managed funds, many of these funds diversify across different investment managers. If one investment manager performs poorly, you only have part of your investment with that manager.
Further to this, most investment managers follow a particular investment style that may perform better under certain market conditions. The most common investment styles are growth, core and value. By combining different investment management companies with different investment styles, you can help to reduce your risk and smooth out returns over time.
Look ahead when deciding where to invest – avoid chasing returns
It is important to understand the past but don’t rely on it to give you guidance on the future. One of the greatest temptations when deciding where to invest your money is to choose the investment that had the best return last year. You see a return of over 30% and curse that you weren’t invested a year ago. So you decide to put your money in that investment in the hope that it will do the same thing in the year ahead.
Chasing returns like this is one of the most common mistakes made by investors. It is akin to driving using the rear-view mirror. You can see clearly what is behind you — but not what lies ahead.
It is very tempting to get caught up in the excitement of a bull run on the share market. The same is also true in other asset classes such as property and fixed interest. However, it can also be dangerous to get caught up in the hype.
Asset class returns
The table following shows the main asset classes and their percentage return each year between 1995 and 2016. The asset class that had the highest return each year is at the top. While there are occasions when the top performing asset class of one year has also been the top performer in following years, this is not always the case and depends on a range of influences in the market. The worst performing asset class is not always the worst in subsequent years either. Rather than going by performance in one particular year, it is important to look at the complete picture influencing the asset class, ranging from geopolitics and economics to the dynamics of investments in the asset class, for example, oil prices may have been high in a particular year due to scarcity but if a new supply was just found, it may lose some of its value.
There is an old saying: ‘today’s rooster is tomorrow’s feather duster’. Today’s best performing investment manager might be relegated to the middle of the pack or worse in years to come. In other words, it is very difficult for one investment manager to consistently produce the best results.
Rather than relying on one-year performance figures, it makes more sense to do some research on investment managers to find one that consistently produces good returns. We give you a few ideas on how to get started in the section ‘Do your research’ on the following page.
In the years leading up to 2000, technology shares made many people rich. In the two years following, many people lost a lot of money investing in the same shares. The people who lost the most money were those who invested at the height of the technology share boom. They made the mistake of buying based on the past performance of the best performing shares. Many highly successful investors do exactly the opposite, buying laggard shares when they believe the market has not understood the true potential of these companies which are therefore priced cheaply.
How to avoid the trap
So what does this mean for your investing? If you shouldn’t base your investing decisions on past performance, what sort of criteria should you use?
One way is to think about the driving analogy mentioned earlier. Avoid spending too much time looking in the rear-view mirror — concentrate on the road ahead. Another way is to think about a weather forecast. You wouldn’t base a weather forecast on what happened yesterday. Instead you would look at high and low pressure systems, cold fronts and long-term climatic conditions. It’s the same with investments — the manager’s investment process and the resources and experience they can deploy are at least as important as past performance.
Practical Steps There are also a few practical steps you can take.
This is discussed in more detail in section 2 of this guide.
2. Stick to your guns
Don’t chop and change your investment strategy every year. Instead, spend time developing an investment strategy that suits your circumstances and goals, and give it time to work. Past performance can be useful when you consider longer time periods. For example, Australian shares was the top performing asset class in the 20 years to 31 December 2016. But Australian shares also lost money in three of those 20 years.
3. Do your research
Rather than simply relying on past performance to select your investment, take advantage of the many resources available through newspapers, the internet, online investment tools like BT Invest or professional financial advisers. These can help you track true long- term performance and build up the information you need to make the right investment decisions.
You can check out the long-term performance of managed funds and their research company ratings at sites such as www.morningstar.com.au or through newspapers such as the Australian Financial Review or magazines such as AFR Smart Investor. The Australian Securities Exchange has a wide variety of information on individual shares at www.asx.com.au. Or try the research facilities offered by programs like BT Invest.
4. Seek advice
Finally, and most importantly, financial advisers can help you develop a disciplined approach to investing which will take into account all the issues outlined above. They can also help to tailor your investment to your circumstances and goals.
Keep your eye on the prize and don’t panic
Maintain your composure and keep the end goal in sight.
We live in an uncertain world. Events such as Cyclone Debbie in Queensland remind us that natural disasters can strike at any time. And the threat of terrorism continues to be a concern.
Economies and markets are often affected by sudden tragedies. Every now and then, they have crises of their own. The losses sustained in events like the global financial crisis will undoubtedly remain in the minds of investors for some time yet.
So how should investors approach these events — unexpected economic, political or natural calamities — that strike at the value of investment markets?
As said above, don’t panic. History tells us that events — however catastrophic — are soon swamped by the longer-term trend.
The following chart shows the performance of international share markets since June 1985. As you can see, a whole range of events have all been blips on the long-term ascent of share markets.
The chart illustrates how important it is for investors to think long-term when a crisis strikes. There is compelling evidence that panic selling might be bad for your wealth in the short term as well.
Plunge then bounce
Share markets do react, often sharply, to crises. Yet they tend to snap back quickly as investors reassess the real economic impact of these events. For example, on the news of a ‘Brexit’ outcome on 23 June 2016, the British stock exchange (FTSE 100) lost 8.7% of its value in the following two trading days but had recovered to its pre-election level four trading days after the election result.
Coping with crisis
There are still sensible precautions any investor can consider taking to deal with a market crisis. The most important is to have a financial plan — a written document that reminds you why you’re investing, what your objectives are and for how long you plan to invest. Such a plan is the perfect antidote to the tendency to panic, a reminder that long-term investors have nothing to gain from short-term reactions.
Coping with events such as those outlined above should form part of your risk management plan. By understanding risk, you will be in a better position to manage it in times of calamity — plus benefit from risk over the long term.
To understand more managing risk in your portfolio, review section 2 and section 3 of this guide.
The good news about investing is you don’t have to do it all yourself. You can employ experts to help you understand your financial position and some of the options available to you to reach your goals. Financial advisers can act like a coach to help you and guide you through the decision making process behind investing. And when it comes to investing money, there are many fund and asset managers who can help you.
What you get from your financial adviser
So what are the most important services you might access with a financial adviser?
1. A holistic approach
A financial adviser can help you take a holistic approach to your finances. They help you understand your existing financial position, clarify your goals and devise a strategy to help you achieve them. They can work with you to build a financial plan that’s about you – your age, your plans, your investment experience, your risk tolerance and your lifestyle.
2. Asset allocation
Asset allocation is the art and science of allocating your investment between shares, property, fixed interest, cash and other asset classes.
Your financial adviser can work with you to devise an asset allocation structure that suits you, helping you use the mix of growth and defensive assets that meet your needs. Ongoing consultation with your adviser also helps you to stick with your asset allocation strategy in the face of short-term events — such as the tendency to become too defensive when markets are falling or too aggressive when they are rising (see section 4 of this guide).
3. Share selection
There are thousands of shares, managed funds, trusts and super and retirement income products to choose from. Which are best for you?
Your financial adviser has access to the latest professionally-compiled research that allows them to compare these products against each other. This helps them to select the products that are most likely to suit you and your goals.
4. An education
An important and often underestimated role of a financial adviser is to help you learn more about investing. They can help you understand types of investments and how they might fit with your financial strategy, especially as situations change through your life.
What a fund manager can provide
The methodical, systematic approach taken by many fund managers can help them to avoid many of the mistakes individual investors often make.
Since the 1980s, investment experts have paid increasing attention to a field called behavioural finance. It’s a science that investigates whether individuals behave rationally when they invest. Unfortunately many individuals don’t — and that can prove expensive. According to academics like Nicholas Barberis and Richard Thaler of the University of Chicago, we exhibit a number of irrational behaviours when it comes to investing1.
Research quoted by the two Chicago academics says individuals often have an inflated sense of their own competence. For example, around 90% of us believe we are above average drivers. Carry this approach into investing and it’s easy to see why some investors take excessive risk given their level of investment expertise.
Researchers have identified other biases. ‘Self-attribution bias’ is the understandable, but unfortunate, tendency to claim success as a result of our talents and failure as a result of bad luck. An investor might regard a good year in the share market as proof of their stock picking prowess. However, a poor year is the fault of a bad market.
‘Hindsight bias’ is our tendency to believe (often falsely) that we predicted an event. And if we think we successfully predicted the past, we may have an inflated sense of our ability to predict the future.
It is because of these irrational behaviours that fund managers often outperform individuals. Their investment approach is more structured and they are trained and managed to avoid poor investment behaviours.
Of course, managed funds have other advantages.
Safety in numbers
By investing in just a few shares (or other investments), you carry more risk because your whole portfolio can suffer from an event that affects just one or two assets. By diversifying your portfolio, you can help to reduce risk without sacrificing too much return. Managed funds make it easier to diversify — because you pool your money with that of other investors you have the capital to invest in a wider range of assets.
Choosing investments — and when to buy and sell them — means gathering a lot of information, processing that information and being able to act upon it quickly. Economies of scale means managed funds and managed accounts typically have the technology, people and research capacity to invest more successfully than most individual investors.
More convenient investing
Those economies of scale — and the power of modern technology — also allow managed funds to offer you services, choices and investment information that make investing easier. For example, most modern managed funds can be accessed via the phone and the Internet and offer a range of investment choices to suit different needs. Regular statements and investment information also make it easier for you to monitor your portfolio and fill out your tax return.
Originally published by BT, October 2017.