I’ve had a few questions from people lately that all come back to one thing: the basics of investing. And you know what, they never change.
The markets rise and fall, the economy goes up and down, but two things are immutable: Alan Kohler presents the finance news on ABC, and investments need to balance risk and reward.
So, let’s take a look at these rules and how they apply right now.
There is no ‘perfect’ investment – It all comes down to choosing the right asset classes for your own goals.
Asset classes are just the different types of investment you can choose from.
There are broad buckets, then smaller, more specialist niches within them. If you think about music, we have pop, dance, rock and classical for example. In the same way, we have cash, equities, property and fixed income.
But you know how dance music gets broken down into niches like progressive house, trance and dubstep?
Well you can take property and break it down into commercial, residential, industrial etc. Then within that, there options for how you own it – for example you can buy direct property, or invest in a real estate investment trust (REIT).
The same goes for every asset class. In equities (i.e. shares), you might want to choose between micro-caps, small-caps, mid-caps and large-caps.
‘Cap’ is short for capitalisation, and relates to the size and value of the companies you are investing in. It also implies the risk level – broadly speaking, the bigger the company, the safer the investment.
Now obviously that is just a rule of thumb, but a small, up-and-company company is a bigger risk than a big bank. But the small company can make you more money if it takes off. It all depends on your risk appetite.
The large range of options in the investment industry is one reason why financial advisers exist. A good adviser knows the pros and cons of different asset classes and offers a balanced selection of them. A robo-adviser can do this too, but with a more automated process.
The aim of investing in different asset classes is that you spread your risk around – which leads me to the next point.
Diversification is key – Diversification simply means not putting all your eggs in one basket. You only had to watch the share market take a dive this year to see why.
If an investor had all their money in equities (i.e. shares), it would have been a stressful couple of months, to say the least. The Australian stock market plunged by 25% in a day at one point, although it has come back up since then.
Equities are a bit like a bad boyfriend in this sense. When they’re good, they’re rallying in a bull market and making you a crap-load of money. They’re like a lover showering you with gifts and attention.
But when they fall, equities can fall fast. It’s like doors slamming and that guy shouting at you, before giving you the silent treatment.
Now, if I was going to run this analogy to its logical conclusion, I’d say that’s why monogamy is a scam and you should always have a few lovers on the go. Maybe an unpopular opinion, but go with me.
Having multiple lovers is definitely a good idea for investing. Bonds are the solid, reliable but unexciting lover you can go and see when Equities Guy is being bad. Property can also be a bit of a douchebag, but in a totally different way to equities, so it’s good to have him on the hook. Cash is the guy who’s pretty simple but you can booty call him at 2am and he’s always available.
The advantage of this is that when one is acting like a dickhead, the others won’t be doing the same thing at the same time (hopefully). Which brings me to correlation.
Correlation is how different asset classes perform at the same time. The less correlation between your asset classes, the less risk in your portfolio.
When Shares Guy is acting like a knob, you would hope Bonds Guy isn’t. This has pretty much been the case in recent weeks, and is why you’ll see headlines like ‘Boring bonds turn into best investment of the year‘.
It’s not always easy to pick, because it depends what else is going on in the world.
Property’s correlation with equities can be hard to predict. Sometimes it’s a flight to safety: people buy a nice sturdy house when their shares are languishing. But the massive drop in employment we’re seeing now is probably not good news for residential property, as tenants struggle to pay rent. Certain types of commercial property are also under pressure, especially retail assets like malls.
So, correlation is tricky, but you can look backwards and see how things have performed in the past.
I love the ASX / Russell Long Term Investing Report because it captures the concepts of diversification and correlation in one mammoth chart. It’s also a good read if you’re interested.
When is the best time to buy and sell?
There’s a saying in investment circles: “It’s about time in the market, not timing the market”.
Trying to pick the perfect time to buy or sell is tricky. Even looking at the ASX chart above, you can see that each day in the last three months, we saw the market go up, down, up, down. How are you meant to choose?
Conventional wisdom says you don’t. You invest when you have the funds available to do it.
Like, if you have an event coming up and want to buy a beautiful new dress from Rodeo Show, what is the best day to buy it? Do you wait for the sales? Sure, if you can.
But if it’s not on sale before the event, then you have to buy at full price, or you don’t get to enjoy the dress at the event.
Waiting for the market to fall means you potentially miss out on the gains as the market rises. One option is to spread out your purchases over time, buying investments in parcels. This ‘dollar cost averaging’ means that you buy on some good days and some less good days – but it all comes out in the wash.
That can add to brokerage and other costs, but as long as the parcels are a reasonable size, I quite like it as an approach myself.
When to sell?
I’ve been amazed at how many people talk about selling out at the bottom, in the current crisis.
In the above example of having a panel of boyfriends, you only crystallise the loss if you break up with those guys. Having a fight and sending snarky texts doesn’t mean you won’t see each other again. You’re just having a bad day on the markets.
A paper loss only becomes a real loss when you sell. If I have an index fund that was worth $1000 on Friday, and then on Monday the market drops 25%, my investment is now worth $750.
But that’s just on paper. If I sell that day, I am definitely losing $250. If I hold on it might come back up.
The problem is, that’s exactly when some people freak out and sell. They panic and think ‘well this sucks, I’d better get the hell out of shares right now’. They crystallise their loss.
Whereas the Fierce Girl says, ‘well, markets always go up and down, and I’m in it for the long haul, so I’m just gonna have a martini and chill the hell out’. So she has only suffered a paper loss. If she holds tight, the market will in all likelihood come back up. It always has in the past.
The other reason you might sell is because you need the money, of course. It sucks to need your cash at the time when the market is down.
That’s why investments like equities and property are pitched as long-term. They should be your ‘nice to have’ money. Your emergency funds – used for things like being made redundant in the midst of a pandemic – should be in the bank.
And so, here endeth the lesson, with three rules:
- Aim to have a diverse range of assets
- Avoid selling at the bottom and crystallising a loss
- Never rely on one man for everything