What’s the key to a good night’s sleep in times of economic uncertainty and unpredictable market fluctations? Paul Stefansson shares his views on how to minimize losses in a volatile market by avoiding the classic mistakes.
------------------------------------------------------------------------------------------------------There is no secret formula to successful investing. For every Warren Buffet, there are thousands of hapless investors who have seen their portfolios wiped out by unforgiving markets. Yet, there are a handful of timeless rules that most professional investors adhere to avoid mistakes. While they may not guarantee success, they can help boost your chances of making money in the long-term, or minimize losses in a volatile market. These golden rules may seem obvious on paper, but sticking to them on a consistent basis can be a tall order, mainly because irrational human behavior and emotions tends to get in the way of sound investment decisions.
Build a portfolio using all the asset classes – cash, bonds, public and private equities, and hedge funds
Of all the rules of investing, this is probably the one that matters most. You don’t need to be a professional money manager to realise that spreading your funds among a basket of different assets – whether it’s cash, bonds, hedge funds, or public and private equities - that are not correlated to each other is an effective way to minimize risk, especially when markets are volatile. Practising what the professionals call asset allocation has been shown by research to account for just over half an investor’s return.1
Beat inflation and keep your purchasing power
A risk-averse investor may think he’s being prudent by putting the bulk of his savings in cash. But taking into account Singapore’s five-year historical inflation rate of 4.5%, a fixed deposit investor earning 0.5% will actually yield -4.0% (a return of 0.5% - inflation of 4.5%). Investors who do not want to lose purchasing power need to add higheryielding assets such as corporate bonds or equities to their portfolios.2
“You should buy your stocks the way you buy your groceries, check the price.” ~ Benjamin Graham
Avoid concentration in high yield bonds and equities
Having too much of your money concentrated in a few securities (i.e. less than 20 to 30) in risky asset classes like high-yield bonds and equities is not advisable. The default rate on highyield bonds is 51-times higher than those of investment grade bonds. There is a 1-in-20-chance that a high yield bond will default (i.e. 4.57% annual default rate).
Getting exposure to high-yield bonds through a bond fund or ETF is one way to actively manage your risk and generate higher returns, as a bond fund will usually hold more than 100 different bonds. For equities, research indicates that you need to hold at least 30 stocks in different industries to be fully diversified.3
Buy good stocks not good companies
What is the difference between a good stock and a good company? A good company has great products, excellent management, and a strong balance sheet. Most investors can identify good companies and think a great company is the same as a great stock. Great companies come with exciting emotional stories. For example, in 1999, the Internet and ‘dot-com’ stocks were going to change the world. While the Internet has changed the world, if you bought ‘dot-com’ stocks at a 100x price to earnings ratio, then you would have lost a lot of money (i.e. “Easy dot-com, easy dot go”). A high price is the enemy of great investors. A great company does not automatically become a great stock. The difference between a great company and a great stock is price. To quote, Benjamin Graham, the father of value investing, “you should buy your stocks the way you buy your groceries, check the price”.
Avoid mistakes and sleep soundly
Investors can use simple rules to avoid emotional investment mistakes including: (1) using all the asset classes (i.e. cash, bonds, public and private equities, and hedge funds); (2) avoiding investments that cannot protect purchasing power (i.e. cash returns are lower than inflation); (3) avoiding concentrated portfolios in high-yield bonds and stocks; and finally, (4) buying good companies at fair prices (i.e. buy good stocks). Investors following these simple rules should sleep soundly.
- The Equal Importance of Asset Allocation and Active Management James X. Xiong, CFA, Roger G. Ibbotson, Thomas M. Idzorek, CFA, and Peng Chen, CFA, 2000, March/April 2010
- How Many Stocks Make a Diversified Portfolio?, Journal of Financial and Quantitative Analysis, Vol. 22, No.3, September 1987, Meir Statman