Investing is the process of delaying consumption from today to sometime in the future. In the meantime, that money is deployed in the markets to grow at a rate at least in line with inflation, but preferably more.
Sound straightforward, doesn't it - so why do so many people have a less-than-perfect experience of the stock market?
It all comes down to having a logical and robust framework on which to build a lifelong investment programme. As the saying goes, "Failing to plan is planning to fail."
Ten fundamental steps provide the solid base on which to build a successful investment experience.
Step 1: Accept capitalism and have confidence in the markets
Capitalism has proved itself to be a robust and resilient economic system, and the markets are an efficient mechanism for rewarding those who provide capital to those engaged in the pursuit of wealth creation.
Step 2: Accept that risk and return go hand in hand
It's an unavoidable truth that to achieve higher returns, you have to take on more risk. That seems logical enough, but you would be surprised just how many investors seem to think that it is possible to get high returns with low risk. But the one thing we know for sure about risk is that if an investment looks too good to be true, it probably is.
Step 3: Let the markets do the heavy lifting
Investing offers two main sources of potential returns: one, the return that comes from the market and two, the return generated through an investor’s skill. And there are two main ways in which an investor's 'skill' can try to deliver a better return than the market return: one is to time when to be in or out of the markets (market timing); the other is to pick great individual stocks (stock picking).
In this game, there are very few long-term winners. We cannot control the return of the market, and better-than-average returns from skill are rare. So the structure of your portfolio becomes key.
Step 4: Be patient - think long-term
There are rarely any quick wins. In the short-term, market returns can be disappointing. The longer you can hold for, the more likely the returns you will receive will be at worst survivable, and hopefully far more palatable.
It is time that allows small returns to compound into big outcomes for the patient investor. If you want to be a good investor, you have to be patient. Impatient investors tend to lose faith in their investments too quickly, with often painful consequences.
Step 5: Be disciplined
Patience and discipline go hand-in-hand. Once you realise that generating long-term returns takes time, patience and belief in the markets, you have to put in place the discipline to stop yourself succumbing to impatience and ill-discipline.
Discipline comes in many forms: sticking to the core principles; building well-researched and tested portfolios designed to weather all investment seasons relatively well; avoiding chasing investments that have gone up dramatically, but sticking with the logical reasons for not owning them in the first place; and having the discipline to avoid becoming despondent about short-term, unimportant market noise, instead focusing on your long-term strategy.
Step 6: Build a well-structured portfolio
Once you accept that returns come from markets, rarely from the judgemental approaches of professional managers of market timing and stock picking, it makes sense that a well-thought-out mix of different investments (referred to as asset classes) should sit at the heart of your investment programme. Your long-term portfolio structure will dominate the investment returns obtained during your investment lifetime.
Step 7: Diversify to manage an uncertain future
Not putting all of your eggs in one basket is an intuitive and valuable concept. No-one knows what the future holds and owning a highly diversified portfolio is the key tool that we have to prepare for whatever the markets throw at us over time. It brings its own challenges. Inevitably there will always be one or two parts of the portfolio that are doing well, but one or two that are not. The patient and disciplined investor knows that there is little point in knee-jerk responses, and that this is simply the way that markets are. The impatient and ill-disciplined will seek to change their strategy. More fool them!
Step 8: Avoid cost leakage from your portfolio
Costs eat away at the market returns that you should be gathering for yourself. Small differences in costs will compound into large differences over extended periods of time. Investment industry costs are high, particularly those related to judgemental (active) managers. The difference can be staggering: take two portfolios with the same gross (pre-cost) returns - one with a low cost of 0.25% a year and the other with a high cost of 1.5% a year. The low cost strategy will, on average, end up with a staggering 65% more money in the pot over 40 years.
Step 9: Control your emotions by adopting a systematic approach
Evolution has ensured the human brain is particularly poor at making investment decisions. Evidence of wealth destroying, emotion-driven decision making is everywhere. Impatient and ill-disciplined investors chase fund managers and markets that have previously performed well, and sell poorly performing investments.
Buy-high, sell-low is not a good investment strategy. Research reveals that this bad behaviour may cost investors around 2.5% per annum, on average. Given that equities have only returned around 5% above inflation, on average, that is a significant hit with long-term consequences.
Step 10: Manage risks carefully across time
Start thinking of your financial adviser as a 'risk manager', rather than a 'performance manager'. His or her job is to keep the risk in your portfolio at an appropriate level. This is achieved through ‘rebalancing’ periodically back to your long-term portfolio strategy, by selling, rather than buying, ‘hot’ performing asset classes. Fund selection, due diligence and the ongoing governance of the investment process are all important risk management functions.
For more on this subject, read Acuity Volume 33: The Foundation Stones of Good Investing.