‘The more I see, the less I know for sure.’ – John Lennon
When you’re younger, your limited life experiences tend to cloud your judgement. At eighteen you know everything (at least if you’re male).
The more you experience life, the more you realize how little you actually know. And that which you think you know, may not even be correct.
Twenty-six years in financial planning has taught me a lot. None of it came from textbooks. No amount of theory can replace experience.
Just when you think you know about markets, along comes a surprise.
Allow me to share with you what my experiences have taught me and what I think I know about the investment business…
Markets can make you truly humble. Those who treat the market with disrespect eventually pay a very heavy price. Markets are like the ocean – one day gently rolling waves, the next, wild seas with strong undertows. Anyone who does not respect the power of the ocean is a fool and the same goes for the markets.
Markets do have very long term trends. However over shorter time frames – five to ten years – they can be completely unpredictable. The All Ords for example is back to levels it first reached in late 2005. Eight years of zero growth – I bet few people factored that into the computer modeling used for a 2005 financial plan.
There are no new ways to go broke
Debt is the common denominator in all financial disasters. Those who live by the creed ‘you have to bet big to get big’ can be lucky, but they are in the minority. The majority ends up wrecked on the rocks of financial reality. Be prudent. I prefer the creed ‘slow and steady wins the race’.
The best luck is bad luck
Success without bad luck is a disaster waiting to happen. Bad luck and misfortune teach you to appreciate the good times. Success without setbacks is conditioning you to have unrealistic expectations.
Patience truly is a virtue. In this fast paced world, instant gratification is embedded in our society. The thought of taking twenty years to pay off a home or forty years to build retirement capital is completely at odds with the ‘want it now’ attitude.
Markets (interest rates, shares and property) do not always deliver the returns we would like or expect. Sometimes they defy the averages and perform abysmally for very long periods. You cannot make markets go any faster, therefore patience is the key to holding your nerve.
Do not chase returns
This is a follow on from patience. If interest rates are low, the temptation is to leave the safety of the bank and chase an extra few percent. Invariably the cost for chasing the higher return comes with loss of capital – this loss is usually far greater than the few percent you earned.
Always take profits
You’ll never go broke taking profits. So many people want to squeeze the last drop out of a winning investment. Leave some for the next person.
Besides greed, the other reason people don’t take profits is, ‘I’ll pay too much tax!’ This is dumb. Paying tax is a cost of successful investing. Live with it. Under Capital Gains Tax (provided you’ve held the investment for 12 months) the taxman will extract a maximum of 22.5% of your gain. You keep 77.5%. This is far better than seeing the market wipe out your paper gains.
Busts always follow booms
Since Tulip Mania became folklore we know booms always bust. Yet when the animal spirits capture society’s emotions this logic is abandoned in the chase for the almighty dollar. Night follows day and 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 – get over it. The hotter the market becomes the more violent the snap back to reality will be.
Transparency of investments
Only invest in something you 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’.
Higher risk can mean greater loss
Have you heard the saying ‘High Risk /High Return’? It’s not entirely true. In some cases high risk pays off handsomely. However high risk can mean greater losses. Personally I prefer low risk/high return.
How is this possible? Buy low and sell high.
Far too many people buy high and sell low.
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 will 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.
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.
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 – look at the All Ords, still way below its 2007 peak.
Calculating your downside is far more critical than focusing on your potential gains. As an example one of my recent investments was in US dollars.
Buying in at $1.05 my guess was the downside was probably 5% (if the AUD rose to its previous high of $1.10). However the upside could be over 100% if the AUD falls heavily into the $0.50 range (perhaps GFC Mk2 could trigger this).
To lose 50% on this investment the AUD would have to appreciate to over $2 against the USD – highly unlikely.
Understanding the math assists in taking calculated risks.
Contributing Editor, Pursuit of Happiness