We have always said that it is important to take time and revisit the basics every now and then. Living and breathing the markets day in, day out can let us lose sight of these basics, not seeing the forest for the trees if you will. It is often the simplest things that remain consistent for a longer time horizon. To crystallise things a little, we would like to go back and explain some things to our 21 year old selves with particular reference to some rules of thumb about how to think about finances and financial independence.
These principles are linked, interwoven and affect one another. The markets are complex organisms and we can't expect to apply sweeping statements that are independent and stand alone. The basics are exactly that, the basics. They can be built upon and complicated immeasurably.
Principle 1 - High Return = High Risk
The markets are a function of risk, though we often forget this in the world we live in given the unconventional policy shenanigans that have somewhat flipped this on its head . The key is to understand the amount of risk taken and the expected return. The strongest investments (and investors) are those that maximise expected return and systematically reduce risk. For example, if two investments, A and B, have the same expected return, the key will be determining which has a lower risk profile. Investment is an art as much as it is a science, hence this might be a question of belief as much as it is about quantitative analysis.
Risk can also be understood as volatility and that is something that we have to learn to live with. There are certainly times at which the markets can be brutal and, as Charlie Munger says, a 50% drawdown is simply the price of admission. However, keep perspective and remember that, with a few notable exceptions like the Great Depression, the markets have been excessively kind over the past century and a bit. The way to think about volatility is time frame more than anything else. If you are looking at a time horizon of decades (be it talking about intergenerational wealth or those still in the workforce) as opposed to years then volatility and forgoing returns now for the future is not necessarily all that bad. Time in the market, not timing the market. Which brings us to our next point….
Principle 2 - Rule of 72
The Power of Compounding
Einstein called compounding the eighth wonder of the world and nowhere is this more evident than in the “Rule of 72”, used to determine how long it will take for money to double. It is a simple principle, annualised return of 7.2% means that it will take ten years for money to double. Seems rather obvious but looking at your universe in this manner allows you to be more disciplined and the perspective lets us know that there is no need to be in too much of a hurry. Using the same 7.2% return over forty years, 100,000 grows to 1,600,000 assuming that there are no additional investments.
This just gets better with regular contributions, potentially the best way to build wealth over the long haul. It also goes a long way to minimizing what we call sequencing risk, going all in at once and, in the event of sell-off, spending valuable time recovering is a rather unexceptional outcome. Automatic investments allow you to do dollar cost averaging, a fantastic way to maintain a disciplined approach to investing and controlling the emotional aspects associated with volatility.
For those of you that are a little more aggressive and want to go beyond the basics, have a rules based system whereby every percentage drawdown in the market gets you to buy cumulatively more and vice versa. Basically making sure that the amount of “aggression” is a direct and inverse correlation with market sentiment.
Principle 3 - Buy Insurance
Hope for the best, plan for the worst
Whether you’re investing or you’re planning for your broader personal finances, it is crucial to understand that the only certainty in life is uncertainty. Unfortunately, the only certainty in the markets is that the markets hate uncertainty. We were reminded of this the hard way recently given the marked sell-off. We won't be doing that again. Buying contents insurance doesn’t mean that you want to have a burglary or a fire accident but it makes sense to spread risk anyway. Taking out protection on your portfolio may cost you 1% in returns in an "average" year but could save you many times that in the one-off major drawdowns.
Principle 4 - Don’t Borrow (If you can’t repay)
Leverage can be the ninth wonder since it can amplify returns. But debt should only be productive, using it for tactical purposes when it comes to investments or for making property investments is quite different from borrowing for the sake of borrowing. Always assume the worst. For example, if making a property investment what might happen if all of a sudden your tenancies are cut in half or interest rates double? Again, always prepare for the worst and put capital to work like it is a rarity, as though you’re constantly in distress, even when it is freely available.
For equities investors, leverage can be a double-edged sword and the long-term benefits and drawbacks have more to do with emotional stability than about the actual numbers. For most of us (and this author in particular), if the first use of margin calls and leverage was a positive experience then the likelihood of staying in the game and developing bad habits is much easier. On the flipside if it is bad, then you might be irrationally risk averse and gun-shy.
Human beings are fundamentally motivated by two things, fear and greed. At their most base level these are literally just survival instincts, avoid things that will hurt us and acquire as much as we can of the things that make life/survival easier (i.e. food/shelter or the means to acquire them, also known as wealth?). Even the most stringent and genuinely altruistic ESG investor is simply motivated by the fear of what kind of world they think they will have to live in down the line given the current course, that long-term (unselfish) fear is simply outweighing short-term greed. The key is exactly that, finding a balance between the two. It was also very early on that this author learnt the downside of leverage too. If, instead of the -25% decline, you can stomach a -50% drop in a perfectly reasonable portfolio due to unforeseen events, such as those that have recently taken place (assuming a 2x leveraged portfolio), then you will be fine and recover over the long-term. If not, then steady as she goes and don’t bother.
The key here being don’t take risks on what you can’t afford to lose and always plan on the premise that what you borrow has the potential to go to zero and work around that. Plainly, only use leverage for a small proportion of your portfolio.
Principle 5 - Quit Procrastinating!
This one is probably the hardest. We constantly get overloaded with information, cognitive biases and different views on any number of markets and stocks. On a subconscious level, this overload might be an excuse for us to procrastinate and not make decisions. If you decided that you wanted to avail yourself of every possible bit of information and opinion on Apple stock before making any decision to buy then you would probably die never having logged on to your trading platform, let alone held it. There is simply too much information to do so. That is an extreme and hypothetical example (and that is why entire companies exist to distill some of that information) but it illustrates the point. Don’t get paralyzed by information overload.
Budget right, figure out your goals, the parameters within which you wish to achieve them and, as Nike says, just do it. The markets never have certainty, you can’t expect it from them, they are a function of probabilities. Develop a view, use your judgement and rationale and follow through with it. Be nimble if things have changed and willing to accept when (notice we didn’t say if) you get it wrong. In the immortal words of television survivalist Bear Grylls, “Improvise, adapt, overcome.” (We’re more paying attention to the “adapt, overcome” part here, feel free to improvise within your set parameters though.)
Yes, we might lose, but that's life. Diversification and action is better than procrastination. Don’t get us wrong, we’re not saying be aggressive all the time but understand that even inaction is conversely an action in and of itself. If you have actively made the decision based on LOGIC that it isn’t a particularly good time, ask yourself the question why? And do so with the idea that you’re giving a presentation to a room full of so called financial experts who will question every assumption and everything you say. If you can’t do it then go back to the drawing board.
Time is money! The saying exists for a reason.
Principle 6 - Diversification is Vital
Remember Principle 1 about risk? Diversification is central to managing risk over a long-term time horizon. The key to diversification is managing, over the short-run, volatility risk and, over the long-run, market risk. Volatility risk is self-explanatory but market risk is the potential for a permanent loss in investment and this is exceptionally important on a long-term horizon. Though a full-time investor can afford to be a lot more concentrated given that they are constantly tracking underlying investments but for most of you that actually have a life to be lived, this is crucial. Remember that some of the top companies even a few decades ago, like Kodak, are no longer market darlings. So, no matter how good you think companies are at the moment, there is a potential over the long-term for risk to accrue as markets change and new technologies eat away at incumbents, the point being though the market might be a “voting machine in the short-run over the long-run it is a weighing machine” stay diversified and take move the weights. The obvious lesson here is stay attentive and make adjustments as markets and trends change but we are talking about diversification. There are those in the TAMIM office that believe you should only invest in companies that you are comfortable holding for ten, twenty or even thirty-plus years and this is where diversification becomes important. If Company X goes to zero and is one of ten (evenly weighted) stocks you own then the pain is significantly worse than if it were one of thirty.
However, that said, the marginal benefits of adding additional investments decreases as the numbers get larger and the costs become greater, taking us back to the risk/reward trade-off. If you want to shore up your risk profile then you are going to have to sacrifice some reward. The optimal is probably between 15-30 different strategies or allocations with the older you are, the more likely you are to go towards the higher number.
Principle 7 - Ask Questions
This is true life in general, not only for investing. It is what makes us human and what distinguishes our species. Asking why?
Everytime you make a new investment or think through an opportunity, keep asking why until it drives you quite literally mad. Just as a child who constantly questions, ask your investment managers why they do certain things and why they make their decisions, ask your local candidate on what your tax money is being spent. Questioning every assumption you’ve made and your entire belief system will make you not only a better investor but a better citizen (within reason, we don’t want hundreds of people spiraling into an existential crisis having read this).
For the more enterprising amongst you, please feel free to raise a ruckus if you go to AGMs, it might be worthwhile every now and then to have management realize that they are merely custodians. We are the owners, thank you sir!
Principle 8 - Emergency Cash Fund
We live in a lucky country, but also a country with some of the highest levels of household debt in the developed world (120% of GDP and likely to go higher). The low interest rate environment can make this seem painful but it is also true that we haven’t had excess amounts of inflation, it might therefore make sense to keep a certain portion of overall wealth in cash (no, not because you’re procrastinating!) for living expenses. The rule of thumb would be at least three months income for below 35s and for every five years after that add on another three months.
Principle 9 - Keep Track of Mega-trends & Mega-themes When Investing for the Long Term
This calls back to the point made in Principle 6 about staying attentive and adjusting. The best way to illustrate this principle might be to give examples. Some thematics that we currently recognise are the following:
One does want to be careful with these mega-trends though. There will always be massive winners from these mega-trends but they are not easy to pick, let alone pick early on. Just look at one of the dominant mega trends of this millennium, social media. Back in 2006, who would have picked Facebook to so comprehensively and completely eviscerate MySpace? MySpace overtook Google as the most visited website in the US in June 2006, Facebook took over worldwide in April 2008 (May 2009 for the US). And yes, MySpace does still exist. The trend is more mature now but players are still coming, going and being acquired by the incumbents. Think Vine, Snapchat and now TikTok (a lot of those words will mean nothing to those that aren’t at the younger end of their adult lives or are without children). The point here being that picking the ultimate winner in these mega-trends is difficult, it is more interesting to think about how these mega-trends will support or detract from companies that are also not directly involved. Oversimplifying it a bit and looking at something that is playing out in the world today, don’t try to pick the electric car manufacturer that will ultimately be the big winner, pick the company that will be providing the components to half the players for the batteries, the semiconductor metrology manufacturer for the tech companies etc.
Simply put, simplify some of the mega-trends you might see, overlay it with your portfolio and try to get creative around how your portfolio behaves as those mega-trends play out. Make sure you are comfortable within this context.
Principle 10 : Minimise Taxes
First of all, duh. The less you give up in taxes, the more you end up with in your pocket. Following on from compounding, minimising the amount of taxes can make a marked difference in the long-term wealth of individuals and their families. In Australia, it is as simple as things like putting capital growth assets within the superannuation environment and utilising franking credits appropriately. Using credits to defer, reduce or “avoid” income taxes are things that have to be done in a disciplined manner.
With that being said, remember to not use tax incentives to make investment decisions, only the vehicles within which those investments sit. "I'm not selling because I don't want to pay capital gains tax" is one of the most frustrating pieces of logic we hear all too often. First of all, you're paying those taxes because you have done well, that is a good thing. More importantly, refusing to sell for this reason when you KNOW there are better companies/opportunities out there to allocate to doesn't make sense. Taking the short term hit to set yourself up for better long-term growth just seems like the prudent course of action for a genuine long-term investor. Unless you trust your policy makers so much that you believe the status quo will be kept indefinitely. As last year has shown, remember the debate around franking? Keep the purity of investment and make them on their own merits, after which you can undertake the exercise of tax minimisation.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.