Blog #25 An Idiot’s Guide to Investing

Most people are not investors even if they say they are. I make this claim from many years of interacting with people I know and also from volumes of academic research into investor behavior in a field that is now called behavioral finance.

To invest is to put money in something where the odds are in your favor. This is opposite of gambling where you know the odds are highly against you, but you choose to gamble anyway for the hope of quick riches.

Gambling-like behavior is pervasive in the stock market, my focus in this blog. When an “investor” bets on a few stocks instead of diversifying across many to reduce stock-specific risks, when he turns over over his portfolio at the drop of a hat instead of patiently holding for long-term returns, when he focuses his trades on the most volatile stocks (usually those that appear regularly in the most-active list), this “investor” is behaving as a speculator or gambler. As mentioned, when you gamble, the odds are against you. Evidence from surveys and academic research backs this up. For example, a 2015 survey by Schroders Global Asset Management finds that 45% of Singapore investors prefer investments that yield outcomes within 1 or 2 years with an astounding 93% expecting greater than 10% return over the next 12 months. Patience and realistic expectations are apparently not strong virtues among Singapore investors.

So, what should what you do to be a good investor?  If that is your wish, I suggest that you follow four basic rules of investing:

Rule #1 Do not lose money

Rule #2 Invest with a concrete goal in mind

Rule #3 Develop a long-term asset allocation plan 

Rule #4 Review and adjust your plan 

What these four rules do is define an investment process.  Having a right investment process is important because contrary to popular belief, investment success is not defined by good outcomes. Outcomes (good or bad) can be due to luck and relying on luck for success is gambling, not investing.

Now I will elaborate on each rule in turn.

Rule #1. Do not lose money 

I do not mean that you should only hold cash, but that you should make a distinction between investing and gambling and largely avoid the latter. How? First, by tempering your instinct to want be rich in the shortest possible time and second, by understanding that investment success requires “time in the market” (to use a sports analogy, investing is a marathon, not a 100 meter dash).

Consider stocks or equities. History shows that stocks have higher average returns than bonds (the so-called equity premium) because stocks are riskier and may have worst returns than bonds in the short run. True investors understand that the equity premium is a long-term reward for bearing risk.

Rule #2. Invest with a concrete goal in mind 

My observations of friends, colleagues, and ex-students tell me that most people have no concrete idea what they are investing for. If you ask why people are investing, they will say things like:  to beat inflation”, to “achieve financial freedom”, and “to be rich” (the most common refrain).

Don’t get me wrong. Each of the above reasons for investing are not intrinsically bad. But they are too fuzzy to provide clear guidance to how to reach a desired goal. Rule #2 urges you to work out a clear and concrete goal with a reasonable time frame. For example, instead of saying “I want to be rich”, it is more useful to say, “I want to achieve a net worth of $1 million dollars in 20 years”. Or, “I want $2 million dollars in 30 years to finance 25 years of retirement spending”. Or, “I want $3 million in 30 years to finance 25 years of retirement spending and to leave behind a $1 million bequest to my children”.

Notice that each of these examples includes a time line and a numerical goal. This is what makes an investment goal concrete. So, you need put in time and effort to formula an clear investment goal. There is no short cut. For a detailed worked example of goal formulation, see the previous blog.

Rule #3 Develop an asset allocation plan

The only time one encounters the phrase “asset allocation” is when you are in a finance class or when institutional investors talk about it on the internet or in print. Let me cut to the chase: every one of us should have an asset allocation plan.

Asset allocation is simply the way you divide your investment portfolio into different asset classes such as cash, bonds, stocks, property etc.

There are two forms of asset allocation: strategic and tactical. The main difference between them is time. Strategic asset allocation has a long-term focus, based on the idea that different asset classes yield different expected returns because they have different levels of risk or volatility. The pecking order (in terms of average return and risk) is cash, high-quality government bonds, corporate bonds, developed country stock markets and emerging country stock markets. Property has roughly the same real returns as stocks but lower volatility.

Tactical asset allocation has a short-term focus. The idea is to switch around asset classes  based on your predictions of which asset classes are likely to do well or do badly over the short run (weeks, months, quarters to less than 3 years typically)

I would advise ordinary investors to avoid tactical asset allocation unless you are an accomplished market timer (very few investors are). I would rather see you put in place a sensible strategic asset allocation plan aimed at a long-term investment goal. Such a plan should have the following elements:

  • A long time frame (preferably 20 years or more)
  • A portfolio comprising of different asset classes
  • Low operating cost
  • An asset mix that is appropriate to your life stage

Simplicity is a virtue in strategic asset allocation. You can keep things simple by focusing on at most three broad asset classes (cash, bonds, and stocks). The easiest way to purchase diversified bond and stock portfolios is through exchange traded funds (ETFs). An ETF is an open-ended investment fund that is traded like a stock on a stock exchange. An ETF’s main goal is to produce a return that tracks a specific bond, stock or commodity index. Since the underlying index that an ETF tracks is usually well-diversified, buying an ETF is an affordable way for individual investors to acquire broad asset classes such as bonds, stocks and gold. Examples of such ETFs listed on the Singapore Exchange (SGX) are the ABF Singapore Bond Index Fund, the deustche bank (db) x-trackers MSCI World Index Fund, and the Standard and Poor’s Depositary Recept (SPDR) Gold Shares. Unlike unit trusts, ETFs are passively managed with no attempt to “beat the index”. Passive management translates to lower operating cost (expense ratios) for ETFs compared to unit trusts.

The last point (“an asset mix appropriate to your life stage) refers to an investment strategy called life-cycle asset allocation. The idea behind this strategy is that young investors should take more risk both because they can and are a better position to do so than older investors.  This is because compared to older investors, young investors (a) have longer time horizon and (b) have more years of earned income to buffer against inevitable short-term losses. A popular life-cycle rule of thumb is “100% minus your age”.  This means that a 30-year old investor should invest 70% of his portfolio in stocks and 30% in cash/bonds, a 40-year investor should invest 60% in stocks and 40% in cash/bonds and so on.

The following chart shows a more nuanced version of this idea in the shape of an investment “glide path”.

Image result for life cycle asset allocation

Let’s pause here for a moment and think what it means to invest according to a glide path. First, it implies that your asset allocation should be sensitive to the stage of your life-cycle. More precisely, it assumes that you have less tolerance for the risk of losing money as you get older. This is a sensible assumption for most people.

Second, it implies that you have no time to lose because what a glide path effectively says is: “take risks while you can, for there will come a time when you won’t”. Many investors make the common mistake of delaying investing “until I have more money”.  Believe me: when you have more money, you will more wants and you will “kick the can” again. My advice is: start now, start small but do it.

Rule# 4 Review and adjust your plan

While life-cycle investing is largely auto-pilot, it is not cast in stone because the actual returns of your portfolio may differ from what you expect. Indeed, this is what risk or uncertainty is about. Thus, it is important to review your asset allocation from time to time to see whether there is a need to adjust your wealth target, time horizon, savings, or asset mix. Consider the following scenario.

You started investing for retirement at 30 by following a life-cycle asset allocation. At 40, you upgraded your property from a HDB flat to a condo, which you will be your retirement home. Meanwhile, a recent stock market crash has erased a chunk of your investment wealth. For now, it seems that the sky has fallen, dashing your hope of retiring early at 57. You are now 45. What should you do?

Scenes are this are all too real. While it is hard to avoid market crashes, diversification helps to cushion risk, which is why life cycle asset allocation recommends that equity exposures decrease with age. Still, when investment outcomes disappoint, you may need to adjust your overall game plan by deferring your retirement, downsizing your retirement goal, up-sizing your savings, changing your asset mix or a combination of these.

The last action (changing asset mix) is a tough call. Does one increase the allocation to stocks to “average down” investment cost, or does not reduce equity exposure by switching to safer assets like bonds? My view is that you avoid taking too much risk if you don’t have the luxury of time (e.g., your time horizon is than 5 years). On the other hand, if you have a much longer time horizon (preferably at least 10 years), averaging down is attractive as history shows that beaten down stock markets eventually recover. To lower downside risks, you can switch to focus less volatile stocks such as stocks with low betas (a measure of exposure to market risks) and high dividend yield stocks (which have the added benefit of providing stable income).

To summarize, investment success is not only about outcomes but having the right investment process, and the rules that make that happen.

Rule #1 Do not lose money

Rule #2 Invest with a concrete goal in mind

Rule #3 Develop a long-term asset allocation plan

Rule #4 Review and adjust your plan

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2 thoughts on “Blog #25 An Idiot’s Guide to Investing

  1. Hi, we all know that if we purchase a company’s stock, if the company goes bankrupt, we will lose all our investment.

    What will happen if we were to purchase the SPDR Straits Times Index ETF or the Nikko AM Singapore STI ETF and the company behind these ETF were to go bankrupt? Will we be losing all our investment here or is there a mechanism that protects the investor?

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    1. I guess your questions is about whether investor’s assets invested in the SPDR STI or Nikko STI ETFs are safe in the event the sponsors go under. The answer is that these ETFs are backed by an independent trustee (e.g., DBS in the case of the SPDR STI) whose primarily role is to safeguard the assets that flow into the ETF. The presence of trustee provides an important element of safety to the ETFs.

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