This the final part of the Lessons Learned series.
For a quick recap…
Do not accept anything at face value. Ask questions to find out the ‘how and why’ behind what you’re being told.
Remain humble. The market Gods are far more powerful than you or any central banker.
Treat them with respect.
There are no new ways to go broke…it is always too much debt. Beware of over-committing yourself. Things can change unexpectedly…have contingency plans (cash buffer and insurances) in place for it.
Bad luck is good luck. Treat early setbacks as learning experiences. You learn far more from failures than you do from success.
Be patient. Rome wasn’t built in a day. Creating wealth takes time and discipline.
Don’t chase returns. Past performance is just that…in the past. Chasing returns invariably ends badly.
Never be afraid to take profits and leave some on the table for the next person. You cannot go broke taking profits.
Boom and bust are two sides of the one coin…just like night and day; wet and dry; fast and slow. Booms always end with a bust. It is never ‘different this time’. Hubris, complacency, excess and an upbeat social mood are all indicators of a boom that’s ready to bust. Take note and then take action before it busts.
Keep it simple. Transparent investments — the ones where you can make an accurate gauge of the risk — are the best for long term wealth creation. Opaque investments may offer more, but if you cannot identify where the risk in the investment is, avoid the temptation.
Risk does not always mean return. Taking a higher risk doesn’t always translate into a higher return…sometimes it can mean greater losses. The best risk versus reward equation is one of — low risk/high reward. This scenario only presents itself after a market bust…when most people are too afraid to recognise the tremendous value on offer.
These are the final lessons in the series…
Do not invest for tax reasons
No one likes to pay more tax than they have to, but never invest solely for tax reasons. The taxman tells you upfront the percentage of your income and capital gain he intends to extract from you. The market does not give you any indication of the percentages it can take from you.
If you are a successful investor, you must pay tax. There are certain structures you can use to minimise tax, but ultimately the investment must be sound.
Over the years there have been numerous agricultural, film, wine, cattle and tree schemes that offer attractive upfront tax offsets. Very few schemes have been successful. The majority have failed and provided a great source of revenue for Receivers.
Negative gearing and depreciation allowances are enticers used by the property industry to make an investment appear more affordable. What happens if the government of the day (in search of tax revenue) abolishes negative gearing and reduces the depreciation allowances?
Personally, I would rather have a positively geared investment property (rental income exceeding interest and other holding costs) — and am more than happy to pay tax on the additional income.
If your primary motivation to invest is for tax reasons, then this is a grave error in sound investment judgement.
Think of it this way — a massive capital gains tax bill means you have been a successful investor. This outcome is far better than having a capital loss to carry forward.
If it sounds too good to be true
Listen to your inner voice — if it’s saying ‘this is too good to be true’ — take the advice.
You may genuinely miss out on the ‘once in a lifetime opportunity’, but from my experience you have more than likely dodged a bullet.
Offers of a ‘guaranteed rental return’ is one ‘too good to be true’ promotion that comes to mind. Rental assurances are nothing more than the property developer (while they remain solvent) ‘guaranteeing’ to give you back your own capital as taxable income. The rental guarantee is built into the purchase price. There is nothing for nothing in this world.
Another favourite of mine is, ‘proven system for growth’. The Chinese government is the only group I know of that has a proven formula for growth — they pump vast sums of money into infrastructure spending and then pluck a growth figure out of thin air. Hey presto guaranteed growth. Unless the corporation offering you the ‘proven system’ is backed by the Chinese government forget about it.
A few years ago, I remember reading about a group marketing a trading programme.
The marketing boldly claimed a ‘proven track record of 800% per annum growth’ over X number of years. Sounds impressive, until you do some quick math.
If your initial investment was mere $1, within five years of 800%pa growth your portfolio would be greater than US GDP.
Nigerian scams, lotto wins in foreign countries and cold calls offering unique investment opportunities, all pray on people’s gullibility. Genuine opportunities rarely, if ever, land in your lap. The old adage of ‘the harder I worked, the luckier I got’ is applicable to successful investing.
The prospect of a quick road to riches or instant wealth is tempting. The harsh reality is ‘the too good to be true’ opportunity is a salivating wolf dressed in sheep’s clothing.
The magic of math
There is an old saying ‘the market goes down by the elevator and up by the stairs’. If a market loses 50%, it has to recover 100% for you to break even.
The 50% loss can happen in a blink of an eye.
Whereas, the recovery process can take years.
After the 1929 crash, the Dow Jones took around 25 years to permanently recover its losses.
Which is why calculating your downside is far more critical than focusing on your potential gains.
If you can properly assess the risk, then the gains will take care of themselves.
Those who are seduced by the prospect of future gains are likely to have their heart broken.
For those not familiar with my market thesis, I’m firmly of the opinion the US share market has the potential to fall 80% or more in value over the coming years.
I appreciate this sounds hyperbolic and is so far away from consensus opinion.
However, it’s mathematically possible. I’ve done the numbers based on historical precedents.
If the S&P 500 P/E ratio re-visits its Great Depression low and US corporate earnings revert to mean, then the market loss exceeds 80%.
Time will tell whether this transpires or not. However, for the point of this exercise let’s assume the market does fall 80% in value…turning $1 into 20 cents.
What rate of return do you need to make your dollar whole again?
Five hundred percent.
In practice, markets never fall in a straight line and stop where you have neatly identified the bottom should be.
Markets zig and zag their way to a bottom. Offering false hope along the way. Is this the bottom? Should we buy the dip?
The following chart shows the path the Dow took from October 1929 to August 1932 (it’s final low point)
Source: Intellectual TakeOut
Over the nearly three-year period, the Dow staged a number of mini-recoveries only for the selling pressure to resume and take it to a lower low.
Exhausting the fear in the market can take time. The first downturn is never the last one.
This jagged journey to the bottom is why my strategy is to deploy our capital on ‘dollar cost average’ basis. Gradually buying into a falling market. This is a proven risk management tactic in markets driven by fear and panic.
Understanding the maths of a market is absolutely critical to your ability to take calculated risks.
In a boom, investors (inexperienced and experienced alike) ‘hang on tight and enjoy the ride’. Everyone’s happy. Rarely is the sustainability of the boom questioned. Don’t jinx the market. Enjoy it. But we know from history, the party always ends.
In my experience, investors are not mentally prepared for the bust…especially one that wipes 50% or more off market values. There is rarely a Plan B. No-one told you this could happen. Which explains why the default position is panic followed by fear…and plenty of it.
My Plan A is also my Plan B. My strategy is firmly focused on understanding the downside…what can go wrong and if it does, what is the likely cost? Is this an acceptable or unacceptable cost? If these factors have been accurately assessed then you can make a reasoned decision on where to allocate your capital and the upside can take care of itself.
Knowing your tolerance for loss is far more important than dreaming about the riches that await you.
Personally, my tolerance for loss is around the 10 percent to 20 percent level, any more than this would make me uneasy.
The following chart of the S&P 500 index clearly shows the prospect of a significant fall from current levels is not without precedent.
Source: Macro Trends
What is your Plan B for a fall from this height? If you don’t have one, seriously consider reducing your market exposure to a level that can handle the next (and possibly most severe) downward leg we’ll see since The Great Depression.
My investment strategy — developed from 32 years of experience in the investment industry — is best summed as ‘Winning by not Losing’.
Editor, The Gowdie Letter