Editor’s Note: The following is part two of Vern’s take on the Murray report. Part one appeared in yesterday’s DR. In case you missed it, you can read it here.
Given the financial planning industry is not about to undergo wholesale change anytime soon, I thought I’d share with you what my experiences have taught me and what I think I know about the investment business.
Twenty-seven years in the investment industry has taught me a lot. None of it came from textbooks. No amount of theory can replace experience.
Just when you think you know about markets, along comes a surprise.
‘The more I see, the less I know for sure.’ – John Lennon
When you are younger, your limited life experiences tend to cloud your judgement. At eighteen you know everything (at least if you are a male). The more you experience life, the more you realize how little you actually know. And that which you think you know, may not even be correct. Which is a perfect lead into my first lesson.
Markets can make you truly humble. Those who treat the market with disrespect eventually pay a very heavy price. Markets are like the ocean — one day gently rolling waves, the next, wild seas with strong undertows. Anyone who does not respect the power of the ocean is a fool and the same respect should be reserved for the markets.
Markets do have very long term trends. However, over shorter time frames — five to ten years — they can be completely unpredictable. The All Ords for example is back to levels it first reached in late 2006. Nearly eight years of zero growth — bet that wasn’t factored into the computer modeling used for a 2006/07 financial plan.
There are no new ways to go broke
Debt is the common denominator in all financial disasters. Those who live by the creed ‘you have to bet big to get big’ can be lucky, but they are in the minority. The majority ends up wrecked on the rocks of financial reality. Be prudent. I prefer the creed ‘slow and steady wins the race’.
The best luck is bad luck
Success without bad luck is a disaster waiting to happen. Bad luck and misfortune teach you to appreciate the good times. Success without setbacks conditions you to expect the good times to continue without disruption. More often than not, this manifests itself in over-confidence and greater risk taking which eventually ends in tears.
Patience truly is a virtue. In this fast paced world, instant gratification has become embedded in our society. The thought of taking twenty years to pay off a home or forty years to build retirement capital is completely at odds with the ‘want it now’ attitude.
Markets (interest rates, shares and property) do not always deliver the returns we would like or expect. Sometimes they defy the averages and perform abysmally for very long periods. You cannot make markets generate a level of return you need. Therefore, patience is the key to holding your nerve while markets do their own sweet thing, in their own sweet time.
Do not chase returns
If interest rates are low, the temptation is to leave the safety of the bank and chase an extra few percent. Invariably, the cost for chasing the higher return comes with loss of capital — this loss is usually far greater than the few percent you earned.
The importance of this lesson cannot be understated. It’s the temptation or promotion of a higher return that invariably leads most investors into areas they should not go.
Chasing yield is evident in the US at present. With zero bound interest rates, investors are being forced to seek out returns in any dark corner they can find. The following chart shows the yield differential between high yield (junk bond) investment and government bonds at historically low levels.
This pursuit of return at any cost is destined to end in tears.
click to enlarge
Even the Bank of International Settlements (BIS) Quarterly Review December 2013, titled International Banking and Financial Market Developments identified the increased appetite for chasing yield from poor quality investments with the following commentary that accompanied the graph below.
‘The search for yield was equally evident in quantity-based indicators. In the syndicated loan market, “leveraged” loans – granted to low-rated, highly leveraged borrowers – accounted for roughly 40% of new signings from July to November  (Graph 3, centre panel). Remarkably, throughout most of 2013, this share was higher than during the pre-crisis period from 2005 to mid-2007. This was the result of both higher volumes of riskier loans (blue bars) and lower volumes in the safer part of the spectrum (red bars). In parallel, investors’ drive towards high-yield credit resulted in a gradually falling share of those syndicated loans that feature creditor protection in the form of covenants.’
The last sentence is of particular importance, ‘In parallel, investors’ drive towards high-yield credit resulted in a gradually falling share of those syndicated loans that feature creditor protection in the form of covenants.’
The rise of covenant-lite (lack of security) loans is on the rise as investors ‘drive towards high yield’.
click to enlarge
Always take profits
You never go broke taking a profit. So many people want to squeeze the last drop out of a winning investment. Leave some for the next person.
Besides greed, the other reason people don’t take profits is tax. This is really dumb. Paying tax is a cost of successful investing. Live with it. Under capital gains tax (provided you’ve held the investment for 12 months), the taxman will extract a maximum of 22.5% of your gain. You keep 77.5%. This is far better than seeing the market wipe out your paper gains.
Busts always follow booms
We’ve known since Tulip Mania that booms always bust. Yet when the animal spirits capture society’s emotions, this logic is abandoned in the chase for the almighty dollar. Night follows day and booms always bust. When the heat is on in the market, get out and stay out. The market may get even hotter and you may experience seller’s remorse — get over it. The hotter the market becomes, the more violent the snap back to reality will be.
Transparency of investments
Only invest in something you understand. There are so many ‘iceberg’ investments out there. You think you see the risk, but most investors have no idea what lurks beneath the surface.
The rule of thumb is if you don’t understand it, don’t do it.
Higher risk can mean greater loss
Have you heard the saying high risk/high return? It’s not entirely true. In some cases, high risk pays off handsomely. However, high risk can mean greater losses. Personally, I prefer low risk/high return.
How is this possible? Buy low and sell high.
Far too many people buy high and sell low.
Do not invest for tax reasons
No one likes to pay more tax than they have to, but never invest solely for tax reasons. The taxman tells you upfront the percentage of your income and capital gains he will extract from your earnings. The market does not give you any indication of the percentages it can take from you.
If you are a successful investor, you must pay tax. There are certain structures you can use to minimise tax, but ultimately the investment must be sound.
If it sounds too good to be true…
Listen to your inner voice — if it’s saying ‘this is too good to be true’, take the advice. You may genuinely missed a once in a lifetime opportunity, but in my experience, you have more than likely dodged a bullet.
The magic of math
There is an old saying that the market goes down by the elevator and up by the stairs. If a market loses 50%, it has to recover 100% for you to break even.
The 50% loss can happen in a blink of an eye whereas the recovery process can take years. Look at the All Ords; it is still way below its 2007 peak.
Calculating your downside is far more critical than focusing on your potential gains. As an example, one of my recent investments was in US Dollars. Buying in at $1.05, my guess was the downside was probably 5% (if the AUD rose to its previous high of $1.10). However, the upside could be over 100% if the AUD falls heavily into the $0.50 range (perhaps GFC Mk2 could trigger this).
For a 50% loss on this investment, the AUD would have to appreciate to over $2 against the USD — highly unlikely.
Understanding the math assists in taking calculated risks.
Individually, we cannot change the financial planning industry unless the ‘virtual planner’ concept is created. What we do have control over is our mental approach to investing.
The other two pieces of advice are:
Caveat Emptor (buyer beware): Take your time to consider your options and do not be afraid to ask questions.
What the BIG print giveth, the small print taketh away. Read disclosure documents very carefully, especially towards the back.
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