A very wise man once told me, ‘If you want to test the veracity of your argument, put it out in the public domain. If it gets shot down by facts you have new information on which to re-evaluate your opinion. If it doesn’t, then your argument may be valid.’
Yesterday’s Markets and Money article was an exercise in ‘testing the veracity of my argument’. My sincere hope was someone would turn my solid theory into a sieve.
But not one person has been able to refute the historical facts and mathematical calculations.
Why would I want to be proved wrong? Because being in cash while markets are posting double digit gains can really test your patience.
Your investment strategy must be well reasoned, suit your tolerance for risk and reflect what stage of life you are at.
My investment motto is ‘winning by not losing’. Sounds simple, but it took years to figure this out.
As yesterday’s article showed, the ferocity of a historic bear market can wipe out years, even decades, of gains in the blink of an eye.
For me, successful long-term investing is more to do with avoiding catastrophic losses than it is do with capturing unrealised gains. This is where I am at in life.
Here’s the math to support the ‘winning by not losing’ premise:
% GAIN REQUIRED TO OFFSET LOSS
Every 10% of losses requires an exponentially higher gain to recover. It can reach the point where the losses become so great, recovery will never happen in your lifetime.
In the space of 18 months, the GFC wiped over 50% from the Australian share market. The All Ords is still languishing some 20% below its 2007 peak. Seven years and still not back to break even. You have to wonder how many more years it will be before the 50% loss is finally recouped.
If you think that’s a tough question to answer, then try contemplating how long it would take to recover from a 90% fall? My guess is several decades.
Therefore, the preferred strategy is to sidestep the fall and buy the recovery. Easier said than done. That’s why having well defined investment guidelines is essential. When formulating my long-term investment strategy, the wisdom of Ray Dalio has been invaluable.
Ray Dalio is the founder of Bridgewater Associates (the world’s largest hedge fund, managing US$150 billion). Forbes estimates his net worth at US$15 billion.
In 2011, Dalio released a 123 page paper titled Principles,which outlined the principles that have guided his tremendously successful life.
The Introduction commences with:
‘Principles are concepts that can be applied over and over again in similar circumstances as distinct from narrow answers to specific questions. Every game has principles that successful players master to achieve winning results. So does life. Principles are ways of successfully dealing with the laws of nature or the laws of life.’
The five critical steps in the process for success are:
- Have clear goals.
- Identify and don’t tolerate the problems that stand in the way of achieving your goals.
- Accurately diagnose these problems.
- Design plans that explicitly lay out tasks that will get you around your problems and on to your goals.
- Implement these plans — i.e., do these tasks.
Here’s a brief summary of how these five steps have aided the development of my strategy to successfully deal with the laws of the market.
- Have clear goals. Avoid capital destroying losses. Investments must satisfy the low risk/high reward test. Any investment must be transparent without any hidden surprises — know exactly what you are investing in. Do not chase a specific rate of return.
- Identify and don’t tolerate the problems that stand in the way of achieving your goals. The major impediment to long term investment success is self discipline — losing patience with your strategy; not sticking with what you said you were going to do; not doing sufficient research; ignoring the asset allocation suitable to your risk profile. The likes of Buffett and Dalio are successful because they adopt a highly disciplined approach to investing and stick to their ‘knitting’.
- Accurately diagnose these problems. Nearly 30 years in the investment business has provided me with plenty of time to analyse where people have gone right and gone wrong. Over-confidence, lack of self discipline, investing in opaque investments and following the herd are the major problems that lead to investment failure.
- Design plans that explicitly lay out tasks that will get you around your problems and on to your goals. Continually question your assumptions. Read a variety of opinions from independent sources with sufficient experience to make insightful and constructive commentary. Regularly review the premise of your strategy and the investment selections. Remain humble and realise your place in the world. Evaluate the market against time honoured valuation measures — Tobin Q, Shiller P/E 10, Market Cap/GDP ratio, etc. Remind yourself that markets are going to do what they are going to do, on their time.
- Implement these plans — i.e., do these tasks. Every day is committed to assessing the progress towards my investment goals.
Any investor who identifies with the philosophy of ‘winning by not losing’ needs to ask themselves what level of loss they can handle before their lifestyle and/or retirement dreams are affected.
Here’s a table to assist you in determining the range of exposure to shares depending upon how tolerant you are to losses. Naturally, if you cannot afford to lose anything — cash up now.
|LEVEL OF LOSS||
EXPOSURE TO SHARES
|10+%||15% to 20%|
|20+%||30% to 40%|
|30+%||40% to 60%|
|40+%||60% to 80%|
|50+%||70% to 100%|
If you suspect the next stock market downturn could be a real doozy, then go with the bottom end of the exposure range for the level of loss you are comfortable with, i.e. a 30% exposure for a 20+% loss.
If the market continues to rise, take profits (pay the taxes) and re-balance your portfolio back within the exposure level you are comfortable with.
This disciplined approach is how you sidestep the majority of the capital destroying losses and leaves you with sufficient capital to bring to the bargain basement asset sale.
Tomorrow we’ll look at the strategy to capture a good chunk of the recovery.
For Markets and Money