With advanced economies still struggling to perform, and investment markets showing uncertainty, investors would do well to stick to five tenets that will guide them through any investment setting and yield respectable outcomes.
1. Anchor asset allocation with desired returns.
Substantial research shows that asset allocation decisions materially impact on the behaviour of investment returns.
Indeed, the single most important decision for investors relates to their strategic long-term asset allocation. However, to be effective, a strategic asset allocation needs to appropriately reflect an investor’s risk profile, required investment return, life stage and ability to tolerate variability in returns, especially draw downs in portfolios.
The second most important decision that any investor will take is the decision to adhere to this asset allocation.
Moving a portfolio, say, from a "risky" asset class, such as equities, to a more "stable" asset class, such as cash, will dampen a portfolio’s volatility during turbulent market conditions. This gives investors the illusion of safety as the portfolio’s behaviour becomes less volatile, but risk to investors has actually increased as they have moved their portfolio away from the asset class that produces the best long-term returns.
Investors who do this often enough, and for long enough, raise the risk of not achieving their long-term investment objective, and this is exacerbated by the fact that buying at the bottom of the market is difficult from an emotional perspective and almost impossible from a technical perspective. Investors will do best by using their strategic asset allocation as a guiding light in managing investments.
Of course, circumstances change, and it would be naïve to suggest that investment strategy is fixed for all time: investors should revisit the asset allocation strategy at certain intervals and adjust it as necessary but this should never be a knee-jerk reaction to market "froth" or "noise".
2. Forget forecasts — they are mostly based on noise disguised as news.
Accurate and reliable forecasting is notoriously difficult and bad forecasting leads to bad investment decisions.
James Montier showed that analysts struggle to get the absolute return figures reasonably correct: the forecast and actual columns seldom share similar magnitudes. Perhaps more notable is that there is no year in which analysts forecast a negative return for the market, whereas the actual market return was negative in four of the ten occasions.
In short, forecasts are biased and wrong.
Russell Lamberti at ETM Analytics depicted a similar poverty of forecasting in the South African case. What is evident from Lamberti’s work is that almost all of the time analysts do not even get the direction of rand/dollar movements correct and, similar to the previous example, there is clear evidence of bias on their part: they consistently expect the rand to weaken.
Given the poverty of the predictions, investors are well advised to look past forecasts.
Article continues on pages two and three: three more steps to getting rich through your investments...