Playing Investment Defence

In any sporting contest there is usually a time to go on the attack and a time for a more defensive strategy.

It’s the same with investing. You analyse the conditions and make a strategic decision about how to put your money to work.

It’s not so much about trying to time the market but more to ensure you have the correct exposure to achieve your investment goals.

The suggested investment mix of a young person will be very different to that of a middle aged worker which will be different again to that of a retiree.

The young can survive and thrive on large investment drawdowns (the decline in portfolio value) because they have time and new money to invest. That same large drawdown can be financially catastrophic for the self-funded retiree.

Hence no single portfolio is right for every person and that’s how financial planners justify their fees - giving advice and helping with investment decisions.

Getting the advice of a professional is always a wise thing to do but it is also important that you have enough personal understanding of investing to help you distill the wisdom from the wackiness.

In the ’olden days’ it was quite common for advisers to recommend investments to their clients that generated the largest commissions. This led to massive losses in seemingly secure options (think Trio, Storm Financial, Great Southern Plantations and the like).

Many of these losses could have been avoided if clients were familiar with the basic financial concepts of risk, return, leverage and diversification.

That knowledge would also be enough to assist them in making a better choice of adviser and an investment strategy that suits them.

In short, every man, woman and child will benefit from a basic financial education. It’s part of defending your wealth in a very uncertain environment.

Today, we are going to cover the very basics mentioned earlier - risk, return, leverage and diversification.

Risk

I think about risk in a slightly different manner to many.

It stems from my belief that money is just a means to an end rather than an end in itself. Hence investment risk isn’t just about the variations in your portfolio value but how you intend to use that money and when.

Think about it like this.

You have an important goal in mind. Let’s say it is to retire to the beach in twenty years with a place big enough for your family to come and stay. You calculate the average investment returns and identify how much you need to save to reach that goal.

What happens if those investment returns aren’t achieved? What happens if beachside property prices rise disproportionately? What happens if the market suddenly collapses just before your are ready to purchase?

You may miss out on achieving your lifetime dream and may not get another shot at achieving it. That’s financial risk with a real world overlay.

Risk is really about achieving or not-achieving time-sensitive life goals.

Many may say that the long term returns of any given investment market are relatively predictable. They’d be right.

However, long term returns are also characterised by prolonged periods of under and over performance. Who knows what conditions you’ll encounter in pursuing your time-specific goal.

That’s where defensive investing can come to the fore. It may produce lower returns but they can be more predictable and thus offer a higher chance of achieving your goals.

Return

Investment advertising often centres around headline returns. After all, who doesn’t want their money to grow by a constant rate every year. Unfortunately investing doesn’t work like that.

Real world returns are seldom guaranteed (even governments default on debts) and rarely operate in a straight line.

Even if we accept the wisdom of average returns in the stock market (for instance), most research suggests that the average investor never gets those returns.

That’s because they become emotional about the investment and end up selling and buying at the worst possible times. That’s when they usually promise to never go near the market again....until the next boom comes and they buy near the top (again) because they fear missing out.

Many investors also forget about the damage inflation does to nominal returns. Inflation erodes the purchasing power of your money. That’s why you need to concentrate on real returns - the return on your investment after accounting for inflation. It’s a more accurate measure of how your wealth has grown over time.

Leverage

Borrowing money to invest can be a good thing or it can be a disaster.

It can assist in generating better results or can send your broke much more quickly. The difference isn’t always about the investment return either. Other factors like cashflow, taxation, loan ratios and interest rates all come into play.

Many would be familiar with the concept of getting a mortgage to purchase an investment property. It’s not uncommon to borrow around 80 percent of the purchase price from a bank. Repayments are dependent on cashflow from rents which depend on good tenants. If you maintain your mortgage in good order, the bank will rarely want to revalue your property or call in your loan.

It doesn’t work like that with borrowing for other investments.

The prices of investments in the public markets are updated all the time. That means your financier knows exactly what your collateral is worth and how much of your debt it covers.

It also means they can demand more money from you at any time to make sure their loan is safe. It won’t matter if you have been an exemplary borrower, if you don’t meet the extra demand for capital they will sell your investments.

If you are using any borrowed money to invest then you need a strong and prudent defensive plan in place.

Diversification

If you are a young investor it may be tempting to simply allocate all your money to the asset offering the highest long term return. That’s what I did with my children when they were born because they had two advantages over adults.

The first was time and the second was having no emotional attachment to the money invested.

As babies they don’t know what money is or what market fluctuations mean. They can live through financial crisis after crisis blissfully unaware of what it does to their stock portfolio.

However, there comes a time when they do understand the concepts of money and portfolio value. That’s when coping with the short-term and long term negative performance becomes almost impossible for most people.

A diversification strategy can then help make the investment journey an altogether more pleasant one. It won’t stop you rueing the underperforming assets in your mix but it will help smooth out the emotional roller coaster of investing.

Diversification is really just putting lumps of money into different investments to smooth out returns. The major asset classes include stocks, bonds, real estate, commodities, cash and precious metals.

Then there are subsets within these broad groups. Value stocks and growth stocks will often perform differently. So too will smaller companies differ from larger ones. There are corporate, 'junk' and government bonds to choose from, residential and commercial real estate, gold, silver, platinum and more.

Where you invest will also impact your returns depending on market performance, currency changes and money flow. Domestic investment may seem safer but that may not always be the case.

Diversification prevents you from having all your eggs in the one basket and is intended to help generate more consistent investment returns rather than just the highest theoretical ones.

That's important because human emotions aren’t theoretical and they have more impact on your ultimate investment performance than anything else.

People hate losing money more than they like making it and that changes the way people react to wins and losses. How you will react is unknown until it actually happens.

Most people sell their winners far to soon and keep their losers for far to long to ever get rich investing.

Diversification will help you manage how you deal with the relative performance of the assets within your portfolio. It will force you to have the most basic plan which informs you of how to react to almost every circumstance.