Many studies over the years have indicated that shares provide higher returns than low risk cash and fixed interest in the long term. One recent study from Russell Investments and ASX compared returns over ten years to December 2017 and found shares and residential property were ahead of Australian and global fixed interest and cash despite the impact of the global financial crisis (GFC) on returns1. Another, from Vanguard, assesses returns up to March 2019 and does not include data from the GFC. It finds even stronger outperformance by shares2.
The challenge for many investors is how to realise their goals without making rushed decisions due to the panic that market fluctuations can cause.
Successful investing is about managing risk. Have a plan, stick to it, think long term, and know what sort of investor you are.
Have a plan
Know how much capital you have to start your share portfolio, and how you will split it between investments, so you are not putting all your eggs in one basket.
CommSec Development and Strategy Manager Chris Masina says diversification and position sizing are commonly used techniques to defend a portfolio against significant loss.
Diversification is the process of spreading your investments across and within asset classes. The objective is to reduce the risk that one bad investment won’t wipe you out3.
Position sizing limits the proportion of your capital in any one stock.
Building a portfolio according to these principles takes time and experience.
Masina suggests starting a regular investing program, beginning with one or two holdings and adding to them incrementally over time. “It’s better to start with a small allocation to one company and getting to know it really well rather than starting with six companies and doing no work,” he says.
Be aware of the broader economic and business cycles, says Masina, and pay attention to the forward guidance companies give about their future earnings and the state of the market they are operating in.
As you build your knowledge and experience, you will build confidence in your ability to spot buying opportunities and sell signals.
Stick to the plan
Building confidence is great, but overconfidence in your ability to beat the market does raise the risk of losing money. If the losses are large you may become demoralised, and that could reduce your motivation to pursue a sensible investment strategy.
In his 1949 book The Intelligent Investor Warren Buffett mentor Benjamin Graham said: “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”
The advice still has relevance today. A plan is only good if you stick to it. One of the benefits of staying the course is that you are less prone to knee-jerk reactions to market events. That doesn’t mean you should sit on your hands, but your investment plan, not emotion, should guide your decisions about when to buy and sell.
Think long term
Warren Buffett, meanwhile, is famous for characterising the equities market as a “voting machine” in the short term, adding: “But in the long run, it is a weighing machine.” That is, popular stocks come and go but quality businesses will grow in value.
“Time gives you an edge”, says CommSec Senior Business Development Manager, Doug Grant.
No matter how much research you do, it’s impossible to pick the bottom and top of the market. There will also be times when good stocks underperform.
“Maintain the majority of your equity allocation towards quality companies that will stand the test of time,” says Grant. “This will keep you from worrying about day-to-day market fluctuations.”
Grant says the characteristics of quality include good management, a strong balance sheet that has enough cash to handle upcoming commitments, regular development of new products and a competitive advantage (commonly known as an economic moat).
Understand what sort of investor you are
Your asset allocation will depend on your tolerance for risk.
When you are young you may be able to afford to invest more heavily in higher risk growth assets to weather market ups and downs. As you get closer to retirement the focus is more on capital preservation and income, including dividends from shares.
“If you want to take more risk and invest in the speculative end of the market, limit your exposure to a small percentage of your overall portfolio,” says Grant.
All investment involves risk, but the rules for managing risk and building wealth are timeless.
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Important: This article has been prepared without taking account of the objectives, financial or taxation situation or needs of any particular individual. Before acting on the information, you should consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice. Any information used in this article is for illustrative purposes only.