Wealth Management: a risky business
Share and property investments are risky …
Most people understand that the returns of growth investments (i.e. shares and property) fluctuate considerably. If they didn’t prior to the Global Financial Crisis, they most certainly have a better grasp of that now.
But most don’t really have a good understanding of the potential range of variation of returns, without anything particularly unusual happening. And nor do they appreciate how dramatically the pattern of returns can affect long term wealth outcomes.
We use the Australian share market experience of the 25 years to December 2009 to shed some light.
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Forecasting the Market – Skill or Luck?
How good is your crystal ball?
We’ve just been through (arguably) the worst share market downturn since 1929. We’ve also experienced a recovery that few predicted was possible at the start of 2009. Why were we not able to predict these events earlier and with more precision?
You may think it’s because you don’t have access to the information that the experts have. Yet most of the experts find successful predicting just as tough. While it was hard to ignore some of the apocalyptic predictions that were being thrown around during the depths of the downturn, acting on them would have proved very costly.
So, which predictions do you follow and which do you ignore? Or is there another way to manage your financial affairs.
Investment Return Volatility – A Potential Wealth Hazard
Investment return volatility is poorly understood
Most investors understand that in order to increase their expected future return, they have to accept a higher level of volatility (or variability) in the value of their investment portfolios. But beyond that, they do not understand just how damaging volatility can be to their wealth aspirations.
The amount of volatility you expose yourself to affects your probability of achieving a desired wealth outcome. In this sense, it is a forward looking concept. And, as such, it is an extremely important factor to take into account when designing and managing any investment strategy.
But this article reveals some poorly understood aspects of volatility, by looking backwards. That even when you know actual returns and actual volatility, wealth outcomes may vary dramatically.
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The Golden Rules of Investing
When it comes to investing, there is an inordinate amount of information and opinion that is freely available. Most people have an opinion about the direction of the economy, markets, which asset classes or sectors will do best, and which specific securities will out perform. And most of these opinions are supported by valid reasoning and sometimes by informational “evidence”.
But how helpful is this when investing?
To be a good investor over the long term you need to abide by some intelligent investment rules. Unfortunately, devising the rules is a much tougher act than coming up with forecasts and opinions. Following the rules is even tougher, especially when they may conflict with your forecasts and opinions.
The three golden rules:
- Never invest until you have an articulated, long term strategy with a clear set of rules for investing;
- Never disobey the rules;
- Never ignore the rules. To do so makes them obsolete. Replace them with revised and improved rules, but never ignore them.
Market Timing? … that’s easy!
Years ago at a foreign exchange course we were asked to participate in a practical simulation game. Prior to commencing the game one of the participants had a moment of clarity.
Participant: “So, what you’re saying is that we should buy low and sell high?”
Organiser: “Well … Yes.”
Participant: “Oh, that’s easy!”
What seems so easy in theory is anything but in practice. It’s a valuable lesson which few learn until late into their investing lives. Timing your entry and exit from a market is an appealing concept that seems a simple and smart way to add value.
What is it that makes it so difficult to turn this theory into reality?
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This Time it’s Different
These words are often referred to as the four most dangerous words in investing. They are often uttered at the peak of bull markets but what about their application with respect to bear markets?
While every market cycle differs in terms of the specifics of the situation, the underlying influences can have similarities. A well-cited study performed by two finance professors from the University of Chicago found that financial markets are always vulnerable to what they called a liquidity shock — a sudden tightening of credit. These liquidity shocks have happened before and are likely to happen again. The 1991 recession is a recent example of a liquidity shock, where lenders shifted suddenly from easy credit standards to extremely tight credit standards.
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Fortune favours the brave!
If you’re feeling pretty uncomfortable about the current state of financial markets you can be reassured that you’re not alone. Almost all investors are experiencing some discomfort from the recent falls in asset values, yet some handle it better than others.
How you manage your emotions in relation to the market’s volatility can have a big influence on your investment outcome over the long term.
In this article we explore the influence of our emotions on financial decisions and look at what we can do in times like these.
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Is there value in trying to time your entry & exit from the market?
This article aims to address the pros and cons of the investment strategy known as ‘market timing’.
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions and the strategy is based on the outlook for the market as a whole, rather than for a particular financial asset.
The aim of the market timing strategy is essentially to switch between growth assets and defensive assets in order to generate a better risk adjusted return than that from holding a strategic combination of both asset types. When the future looks bleak, the market timer reduces their exposure to growth assets and increases their exposure to defensive assets. When the future begins to look rosier, they will begin to increase their exposure to growth assets at the expense of defensive assets.
