Most identify a “good investment” by results
The Christmas-New Year period is always a great time to catch-up with friends that I don’t see regularly during the year. These fortunate people don’t suffer from me constantly providing gratuitous financial advice or challenging what I consider to be their “woolly” thinking on matters related to investment.
Inevitably, at least with the male friends, the discussions at some point turns to personal finance, but without becoming too specific. This year most people were pretty buoyant, with both share and property markets having performed well.
The only ones that didn’t seem to relish the conversations were those that were happy to tell everyone back in 2008 that they were cashed up going into the global financial crisis. Their inability to formulate and implement a sound investment strategy that saw them “luck out” in 2008 meant they were still cashed up through 2013.
But for those whose wealth had benefited from strong growth asset markets through 2013, little acknowledgement was given to the fact that provided you had a well diversified exposure to these markets you couldn’t help but achieve historically strong returns. Rather, the focus was on the stellar successes i.e. the successful initial public offerings (e.g. OzForex, Freelancer), the lucrative direct property foray or the clever private equity deal. These were considered the “good” or, more often, the “great” investments.
While I usually bit my tongue, I couldn’t help thinking that assessing investments as “good” or “great” by the results, rather than the process for selecting those investments, is the reason most people are poor investors. It also helps to explain why many people, including a number of my friends, who have been successful at accumulating wealth through personal exertion may not be well placed to protect and grow this wealth.
Their professional success and ability to save are the primary drivers of their wealth accumulation, rather than their investment acumen. For many, their investment blunders have been overshadowed by the sizeable, ongoing surplus cashflows generated over their working lives.
But once their reliance on that cash flow reduces and they have more time to focus on management of their wealth, an assumption that the “smarts” and hard work that resulted in professional success will translate to the type of investment success that now draws their plaudits sets them up for disappointment. Expecting to be investment “winners”, more often than not they will make decisions that increase the probability of being investment “losers”.
A “good investment” depends on the investment process
Rather than focus on results to assess a good investment, we pay attention to implementation of investment principles that have been derived from peer reviewed academic research and stood the test of time. The key principles are:
- Markets work – rather than trying to outguess the market (i.e. investment markets), let it work for you;
- Risk and return are related – Only take risks that research has shown to have been reliably rewarded in the past and can expect to be rewarded in the future;
- Diversification is key – Invest in broad based asset portfolios of every asset class where risk is rewarded over the long term in a strong and reliable manner; and
- Structure explains performance – Asset allocation is the key determinant of the variation in investment portfolio returns: the rest is “noise”.
To these are added disciplined cash flow management, a keen eye on costs and tax awareness. The aim is not to obtain the highest investment returns – an objective that can’t be reliably achieved – but to provide you with the best chance of being able to afford the lifestyle you want with minimum risk.
So the focus is on diligently managing the things you can manage (i.e. cost, risk and taxes) rather than the unmanageable outputs (i.e. returns) of your investment approach. Assessed against our framework, the “great” investments identified after the event by my friends are never even considered for selection.
Initial public offerings are rejected on the grounds that the research indicates that, on average, they underperform the overall share market in the first 12 months after flotation. We’d therefore rather wait until they are “seasoned”, before including in our clients’ portfolios. They also add to concentration risk, directly contradicting Principle 3 discussed above.
We have previously discussed our issues with direct (residential) property while participation in private equity funds involves a commitment to a high risk, high cost, concentrated and illiquid investment with a less than transparent return expectation. Both “asset classes” invalidate our Principles 2 and 3.
Relying on picking investment winners is more like gambling
The amateur investor views investment success as picking winners i.e. investments that outperform what they consider a relevant benchmark. Therefore, participating in a share float that immediately does better than the overall sharemarket is regarded as a “good” investment.
But in our view, this is like saying buying a ticket in a lottery or putting all your money on black when playing roulette at a casino are good investments. Even the mathematically challenged know that such practices, conducted repeatedly, will be loss makers despite the occasional spectacular win.
For us, good investment practice is doing sensible things repeatedly over time to bias the odds in your favour. It will not provide you with bragging material at a Christmas party but will increase the chances that you’ll be able to enjoy the life you want with considerably less anxiety than experienced by many results obsessed, rather than process focused, do-it-yourself investors.