Foundations of Financial Economics

Smart investment decisions

What should a smart investor do?

In summary, the key messages for investment practice that emerge from modern portfolio theory are:

• Do not attempt to pick "winners" i.e. shares, properties, fund managers, brokers, tipsters, etc;
• Do not attempt to time markets i.e. move from industry sector to sector, asset class to asset class based on forecasts or "gut feel";
• Focus on those aspects of investment that you can directly control or influence (i.e. costs, risks and taxes), rather than those you can't (i.e. the returns that investment markets deliver);
• The purpose of defensive assets is to reduce portfolio volatility, not increase expected returns - ensure these assets are of high credit quality and of short maturity;
• Increase exposure to the three risk factors to increase expected returns i.e. sharemarket, size and price;
• Diversify broadly to reduce volatility i.e. have many holdings across all selected asset classes, rather than concentrations within any asset class; and
• Choose an appropriate asset allocation and stick with it i.e. choose a portfolio consistent with your risk tolerance and objectives to hold for the long term, rebalancing as required.

The messages are clear, straightforward, even boring. We believe that your long term investment experience will both be enhanced by disciplined adherence to them and give you a high chance of achieving your lifestyle objectives.

But we also know effective implementation is more difficult than it sounds. Not because implementation is complex, but because there is too much "noise" trying to take you in a different direction. This "noise" plays on psychological biases that we all reveal (see "Foundations of Behavioural Science") and results in us making decisions that are irrational and not in our long term best interests.

This is where Wealth Foundations has a critical role to play. Not only to help you understand and accept the key messages to draw from modern portfolio theory. But to keep you on track when markets are gripped by fear or greed and the "noise" becomes a crescendo.

• Go to the Foundations of behavioural science

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