There’s no shortage of books, articles, and academic research exploring the investment universe.
So what works?
In today’s post, I attempt to distil the key elements that you need for investment success.
Short, sharp and to the point – that’s what we do here at Financial Autonomy!
The starting point must be clarity around your goals. Most importantly, your goals determine your investment time frame. They also dictate whether your investment should have as a priority growth, or income.
If your goal is having the option to retire in 15 years time, then you can invest in assets that experience high levels of volatility. You could also hold assets that are fairly illiquid – that is, not quickly sellable.
Some examples. On the volatility side, as I write this piece, the Asian Share index is the best performer over the past 5 years. It is however also more volatile than the developed markets such as the US and Australia. If you wanted maximum returns 5 years ago, you got the best result through buying the Asian share index. But you only enjoyed those gains if you stuck to your investment and rode out the significant ups and downs. Now with a 15 year time frame, you can do that. If your time frame was 3 years though, an investment in the Asian share index was likely to lead to a disappointing investment outcome.
The most liquid of investment assets is cash. Not far behind is shares – you can sell and have your money in just a few days with little cost. Residential property is far less liquid. In an emergency it’s very unlikely you could get a property sold in under 30 days, and 3 or 4 months is far more typical. At the really illiquid end of the scale is commercial property, where it can at times take years to find a suitable buyer.
For someone with a long time frame though, illiquid assets can work well. Australia’s sovereign wealth fund, the Future Fund, holds significant illiquid assets, mainly infrastructure assets such as toll roads and airports. Its goal is to fund the federal government’s retirement obligations to former employees, and so it can prioritise long term growth and income generation over an ability to sell up at short notice.
So to circle back, the key first step to successful investing is having clarity around your goals.
Understand asset classes
A working understanding of the asset class options available is an essential for successful investing.
Asset classes are broad groups of investments that have a consistent risk relationship. The most common asset classes that we think about are shares, bonds, property, and cash.
Within each of these there are all sorts of sub-categories. So when considering shares, there are Australian or Global shares, Small cap vs Large cap, or resources, financials, and healthcare.
There will be variation amongst the individual assets within each asset class, but as an investor you will have a sense of the return and volatility characteristics to be expected from each asset class.
As an analogy, think of cats and fish. Within the cat group, you’ve got lions and the tabby that sleeps on your couch – huge individual variation. And when we think of fish, you’ve got goldfish and sharks.
But despite the wide variations within each group, we know that cats will all be four legged, have soft fur and sharp claws. We know that all fish will be in the water, will have fins and a tail. If we went for a hike in Tanzania, we could be confident that we need not worry about attack from fish.
So why is it so important to understand asset classes? Research by Vanguard looked at the explanation for the difference in returns from one fund to another. They found that roughly 90% of the explanation came down to asset allocation. This finding was consistent across multiple countries, including Australia.
In other words, if you made the right call on the asset classes you invested in, other decisions you make, like which specific shares to buy or when to buy, are not really very important.
It’s worth emphasising that because to most people it’s not intuitive. Individual stock selection and market timing, whilst not completely unimportant, are not very important at all.
If your goal is to X amount of dollars in 10 years time, and you determine that your savings need to earn 8% per year to get you there, then what’s crucial is getting enough growth assets like shares and property in the portfolio to make an 8% annual return possible. If you hold all cash or bonds, your chances of achieving your goal is practically zero. Within the share portion of your portfolio though, whether you chose one bank over another really makes little difference, just so long as you are appropriately diversified. This is why so much money is flowing into ETF’s. They give you market exposure, and when it comes to achieving your goals, it is exposure to the broad market – the asset class – that you’re searching for.
Avoid the bling
Most people wouldn’t build their investment strategy around a weekly trip to the casino. Yet only 12 months ago there were millions of people willing to punt plenty of their hard earned savings on BitCoin and its siblings.
Now blockchain technology and even crypto currencies themselves may well have a long term future. But when it comes to building an investment portfolio with the highest likelihood of delivering on your goals, speculation of this kind makes no sense.
Your investment portfolio is not the vehicle for you to experience excitement. In fact your investment portfolio should be boring. If you need more excitement in life, find a new hobby.
FREE DOWNLOAD – Don’t miss our free download – Investing – How to get Started.
Investment risk should be your friend. The reason you earn 8-10% on your share investments but close to zero on your cash is because you are getting compensated as a share investor for putting up with the volatility associated with shares.
It’s the taking on of risk, that leads to you getting returns.
Given the iron clad link between risk and return, you can determine the level of risk you need to take to achieve your goal.
So if for instance you wanted your portfolio to enable 5% income drawings each year, you don’t need to be entirely invested in shares. Probably something like an allocation of 60% shares and 40% bonds, would see you hit your goal.
Don’t take on unnecessary risk. The more risk you take on, the wider the potential range of outcomes. You want to achieve your goals with the highest level of certainty possible. That being the case, take on the minimum risk required to secure that outcome, and no more.
When thinking about the essentials for successful investing, human behaviour could be easily overlooked. That would be a huge mistake.
For the 20 years ending 2015, the S&P500 index averaged 9.85% return per year. Yet the average investor earned only 5.19%.
Why the difference? Behaviour.
Selling when markets drop is the biggest destroyer of value.
Develop your plan – one that will achieve your specific objectives – and then stick to it!
Markets will go up and down. The down periods are normal. They are the risk – the reason you get that higher return that you are seeking.
Be patient, stick to your plan.
Well, there you have my 5 essentials for successful investing. To summarise, they are:
- Understand Asset Classes
- Avoid the bling
I hope they help you gain the choice in life that you deserve.
PS: If this topic interests you, be sure to give my interview with Brian Portnoy a listen. He is a guru when it comes to successful investment strategy. It’s episode 64 – Money & Happiness.