It is simple to say that the decision to invest in the first place provides an opportunity to protect hard-earned savings from inflation and perhaps grow further. It is not easy, however, to have the foresight and discipline to deny oneself spending today for the opportunity of a better tomorrow.
It is also not easy to work out how much one might want, need, and be able to invest in stock markets to help fund future spending goals.
Getting this right is key and where good financial advisers can add value.
It is simple that stock markets act as a core driver of returns in an investor’s portfolio and that a good place to start for stocks is the structure of the global markets, which defines the basic country, sector, and company weights and offers broad diversification.
It is also simple that high-quality bonds act as protection from economic turmoil and help to smooth returns.
However, it is not easy to know what evidence to look for to understand what types of long-term investments typically improve a portfolio’s structure. This requires understanding the risks one wants to be exposed to over time.
It is also not easy to decide which bonds are defensive enough to be considered insurance against the uncertainty inherent in stock markets.
Finally, it is a simple concept that a low-cost fund structured to capture the target strategy gives investors a better chance of achieving their investing goals than a high-cost one.
However, it is not easy to regularly screen for which funds might be best positioned to capture the returns of each part of the market or to understand the trade-off between a fund’s management costs and the opportunity cost (i.e., what could have been) of omitting an investment.
Implementing a thorough and regular investment oversight process is even harder but is essential to maintaining confidence in the approach.
Figure 1: Investing can be simple, but that does not mean it is easy to do
The figure below shows a simple formula for describing what we expect from an investment outcome.
Figure 2: A simple formula to describe an investing outcome
Starting with taking on sensible risks, such as owning a diversified portfolio of investments, we expect a market rate of return.
Depending on how different a portfolio is from the broad market, the portfolio return will be higher or lower than that of the market. This is what is known in the investment industry as ‘alpha’.
To achieve a return above the market portfolio (a positive alpha), an investor must own a portfolio of stocks and bonds that returns higher than the corresponding market. This can be done through picking stocks, timing markets – neither of which are expected to deliver reliably positive outcomes – or it can be more reliably achieved by overweighting areas of the market the academic evidence would suggest reward investors for owning them over the long term, such as tilting to value and smaller companies.
Next, the financial cost of accessing the desired solution is taken away from the outcome achieved. Controlling financial costs makes good sense.
Finally, there is also a cost associated with bad investing behaviour, such as falling foul to biases or illusions or acting on inadequate information. Good process and discipline and having a good financial adviser for additional support can ensure such a cost is eliminated.
Investing using a well-thought-out, evidence-based, and systematic process helps reduce the emotional pressures involved and ensures the highest probability of a successful investment outcome.
It does not guarantee that the outcome will always be favourable; it cannot, given the uncertainty of the markets. What it does is help us make strong, rational decisions and avoid the silly mistakes that prove to be costly so often.
In particular, chasing markets and managers in search of market-beating returns and being sucked into the latest investment fad by recent trends, plausible marketing stories, and press coverage.
A bad process, or a lack of process, has an upside outcome that is down to luck rather than judgement.Best avoided.
Wise words to leave you with
Perhaps reflect a while on these wise words written by Charles D. Ellis in his excellent book ‘Winning the Loser’s Game’:
‘The hardest work in investing is not intellectual, it’s emotional. Being rational in an emotional environment is not easy. The hardest work is not figuring out the optimal investment policy; it’s sustaining a long-term focus at market highs or market lows and staying committed to a sound investment policy.
Holding on to sound investment policy at market highs and market lows is notoriously hard and important work, particularly when ‘Mr Market’ always tries to trick you into making changes.’
It’s simple but not easy. The keys to success are a systematic process and a guiding hand from your adviser at Capital.
Ben Edwards
Albion Strategic Consulting.
