Always take profits
You never go broke taking a profit. The greed in our DNA often blinds our objectivity. The desire to squeeze the last drop out of a winning investment can be very overpowering.
Ignore the voice of greed in your head and be happy to leave some for the next person.
Another reason people don’t take profits is ‘I’ll pay too much tax!’
This is just plain dumb, dumb, dumb. Got the picture?
Paying tax is the cost of successful investing. Live with it.
The maximum Capital Gains Tax payable (provided you’ve personally held the investment for 12 months) is 22.5% of your gain. Which means you keep 77.5% of your gain.
On the other hand, the market does not give you a formula on what it will extract — it can not only take away all your profits, but also some or all of your capital.
The market can be far more brutal than the taxman.
Taking profits locks in your gains and adds to your capital base. Even if you take out your original capital and leave the profits to ‘ride’, at least this way you’ve protected your wealth.
Taking profits is even more critical if you are investing with borrowed money.
In late October 2007, my weekly newspaper column, ‘The Big Picture’, warned investors with margin loans to be prudent and sell enough shares to pay down their debt.
Sadly, this advice was ignored and, as mentioned in Part 2 of this series, capital destruction from the losses on margin loans in 2008/09 are well documented.
Busts always, always follow Booms
Since Tulip Mania became folklore, we know booms always bust.
Yet, when the animal spirits capture society’s imaginations and emotions, this logic is abandoned in the chase for the almighty dollar.
Night follows day, booms always bust. When the heat is on in the market — get out and stay out.
The market may get even hotter and you may experience sellers’ remorse. My advice is: get over it.
The hotter the market becomes, the more violent the snap back to reality will be.
Look at the All Ords index and you’ll see a near vertical move up from 2003 to 2007.
The GFC ‘snap back’ took the market down to levels first seen in 2001.
Had you sold in 2006 — and watched the market continue to soar — your prudence would have been rewarded in the fullness of the market cycle.
Source: Yahoo Finance
Never be afraid to take profits and pay tax in the boom time…because markets will inflict far greater financial pain in the inevitable bust.
Over the past nine years, the Dow has experienced a four-fold increase in value. This has been an extraordinary boom, ably assisted by the Fed.
The bust is coming.
Never — not one single time — in the course of history has there been a boom without a bust.
Human nature dictates that these two go hand in hand.
Transparency of investments
Only invest in something you truly understand. There are so many ‘iceberg’ investments out there. You think you see the risk, but most investors have no idea what lurks beneath the surface.
The rule of thumb is: ‘If you don’t understand it, don’t do it’.
Simple, easy to understand investments — cash, term deposits, an index fund tracking the ASX 200, gold bullion, etcetera — may be boring, but what you see is what you get.
There are no extortionate management fees, no fancy promises and more importantly, no nasty surprises.
Sure, an ASX 200 index fund can fall heavily in a bear market — but you know that’s a risk.
Whereas, an individual share like Blue Sky Alternative Investments could fall much further due to internal gearing levels, poor management or other corporate shenanigans.
Unless you are on the inside, you are not fully apprised of these matters.
Worst still are the option trading programs — the ones that paint the picture of you laying around the pool while you earn a living.
In my circle of contacts, I know a few serious traders and they do not lay around the pool.
They spend an inordinate amount of time tracking elaborate momentum models, undertaking research and executing trades. Every day is a day of learning for these guys.
Being seduced into a specialised area that you have no experience or knowledge in is sheer madness, and a guaranteed way to lose money.
KISS is the overarching philosophy of my model portfolio.
If ever you feel tempted to pursue a ‘once in a lifetime’ opportunity, please only invest what you can afford to lose.
Higher risk can mean greater loss
Have you heard the saying ‘high risk, high reward?’
I’ll let you in on a secret: it’s not entirely true.
In some cases, high risk pays off handsomely. However, high risk can also translate into greater losses — or no return whatsoever.
Financial planners must (as a matter of compliance) undertake a risk assessment on clients. This usually involves a series of questions designed to unearth the inner risk taker or risk avoider.
Some risk assessment questionnaires are more detailed than others.
But, in my opinion, there’s a serious flaw in this assessment process.
Social mood tends to ebb and flow with market movement. In 2007, after nearly four years of 20+% per annum returns, investors tended to gravitate towards the higher end of the risk curve. Subconsciously they were being influenced by an extended period of prosperity.
Ironically, the client risk profile indicated their willingness to accept greater risk at precisely the time when the market offered the least reward…
The common perception (consciously or not) is: ‘if I accept higher risk, I’ll participate in the higher returns’.
Unfortunately, accepting higher risk at a market top is a recipe for greater losses. Just ask anyone who invested in the markets with a margin loan in 2007.
Conversely, when a market has performed abysmally for an extended period, the risk appetite is almost negligible. Investors want to seek safety after a market has fallen.
When the consensus is to be safe, this is the time to deploy capital into an unloved and undervalued asset class.
Personally, I prefer the low risk/high return investment profile. How is this possible?
Buy lower and sell higher.
But as we know from countless studies, most people adopt a ‘buy high and sell low’ strategy — especially during a boom.
A disciplined approach to investing, using a number of proven long-term valuation metrics, can assist in determining when markets are in the ‘buy low’ or ‘sell high’ zones.
These metrics are not timing tools, but rather signposts that give an indication of what lies ahead.
More lessons to come this Friday.
Editor, Markets and Money