Riding the Rollercoaster
I recently heard a great analogy. Investing is like riding a roller coaster. There is the feeling of euphoria when hitting the heights, the fear of the falling, the nausea of reaching the bottom and the relief when your carriage starts to climb again, only to do it all over again. Investing is similar with the markets taking investors on similar journeys. Would you ever think to jump out of the roller coaster ride? No, because you would risk your life.
Staying in to the end is a rewarding experience that you often want to do again.
Nothing ever happens without taking on risk. To live a long life, you would be safest to stay indoors.
What are we talking about when we use the word risk in relation to investing?
Well, there are different kinds of risk. Let’s look at what these are:
- There’s the risk of never getting your money back - Permanent loss.
- There’s the risk of your money dropping in value. – Temporary loss.
- There’s the leverage risk (lots of jargon here that we’ll explain later)
- There’s the risk of not doing anything.
We’ve probably all heard someone say, investing is too risky. “I bought a few shares, and they dropped significantly so I sold them.” Or, “I bought a property, the tenants were a nightmare, they didn’t pay rent, they owe me $7000 and I never got it back. In the meantime, I had to pay the mortgage and I just about went broke”. Because of these experiences these people have savings, but they could be much better off if they had invested, just with better strategies.
How do you avoid these risks and enjoy a better investing experience?
Diversification, insurance, emergency fund, horizon, manage emotions, don’t chase performance.
Diversification. You would have heard the cliché, “don’t put all your eggs in one basket”. If you’re buying shares, buy the market. Have some of your portfolio in index funds. This will mean you own shares in every company listed on an exchange eg you can own the entire NZ50, every listed company in New Zealand. These are usually cheap, and you will achieve the same return as the market (less the fees). If one company falls over, it will have an insignificant impact on your portfolio value. Then add to your portfolio to achieve better than market returns with factors that add premium. This should avoid permanent loss unless there is a failure in capitalism. The key to the strategy, don’t get emotionally attached to a company, sector, or trend. That attachment could lose you some money.
Knowing and understanding your time horizon is also key to managing risk (managing temporary loss). For example, if you require your money in the next couple of years, then cash investments will provide you with the lowest return, but the value of your investment should still be intact. When investments drop in value, it is typically temporary. You just need to be in a position to hold until the market improves. If you have a short horizon, then you have no time to allow for a recovery. Your focus should be on capital preservation rather than growth. Sometimes people think that retirement is their horizon. However once retired you may live for another 30 years. Furthermore, you may leave money in inheritance, this gives you long horizons and the flexibility to take on more risk. In other words, time to recover from temporary ups and downs.
Leverage. The concept of borrowing money to buy assets that typically appreciate (grow) in value. Sadly, expensive cars don’t count! Property investors use leverage to buy rental properties. Leverage magnifies your gains and losses. You can refresh how this works in this article Discussing what to invest in | Isbister Partners
Leverage is great when your interest costs are lower than your income and your asset is growing in value. When your revenue is less than your interest costs then you need to subsidise the deficit with other income. That could be rental income, salary and wages etc or cash reserves. So its important to understand how you will pay for the deficit. Ideally you don’t want the deficit to eat up income that provides for your lifestyle. We’re seeing plenty of property investors caught out by this situation at the moment.
Managing your emotions. This is probably the most important. Your emotions cause you to make irrational decisions. Examples include:
- Recency bias – Things have been going up, so I better get in now. Things have been dropping so I better get out. Decide what you want to achieve and follow a plan.
- Performance – This asset, manager, sector, country has been going crazy, is delivering great returns. I better get in or I will miss out. Otherwise known as FOMO. (Fear of missing out) There are plenty of asset managers that take significant risks which achieve grand returns.
- Attachment to a company or asset class. People hear about a company that is doing really great stuff. That’s great, does it fit into a good investment strategy? Possibly, but highly likely it should only make up a small portion of your investment.
Finally, there is the risk of doing nothing other than leaving your funds in cash (savings accounts, term deposits). The average cash rate for the last 10 years has been 1.97% an Aggressive share fund has averaged 10.3% (Official cash rate and Booster Geared growth fund, supplied by Booster).
If you save $500 a month for 40 years, investing in cash at the return listed above, you will achieve $216,798. Investing in an aggressive fund, with a return listed above will achieve $1,451,439. This is before tax and takes into account inflation (Deducts 2% of the return for the impact of inflation).
What difference would that make to your retirement?
Back to the roller coaster analogy. The massive difference in your retirement fund is your reward for staying in your seat through the different feelings of euphoria, fear, contentless. Pulling out of an investment for just a few days can have a massive impact.
By Tony Alexander
On September 12 Treasury released updated forecasts for the economy and the government’s accounts as they are required to do ahead of a general election. Media reporting focussed on the better than expected outlook for the economy and the risk of higher interest rates. But they missed something important.
The cut-off date for Treasury’s forecasts was August 2. Since then we have seen a substantial cut to Fonterra’s prediction of their dairy payout this year to a mid-point of $6.75 from $8.0. Following that I have received a high number of comments from businesses exposed to the farming sector that farmers are closing their wallets.
This means weak growth if any lies ahead for many regions in New Zealand through into late-2024 and the situation could be worsened by a second new negative. There appears to be an El Nino weather pattern development and if this happens then we can expect drought in many parts of New Zealand including the east coast of both islands.
The crunch to farm income will eventually weaken the overall pace of growth in the economy and this will have two main impacts. First, it reinforces the view I have stated many times that this housing cycle will be led by the cities and Auckland in particular while the regions lag. This lag will be accentuated by the migration boom which will greatly accelerate Auckland’s population growth rate more than any other region around the country.
The second major effect from reduced farm incomes will be weaker than anticipated inflation and that in turn increases the scope for interest rates to be cut through 2024 – the exact opposite of what was implied by Treasury’s already out of date predictions.
For borrowers the upshot is that continuing a focus on terms less than two years is likely to remain optimal.
For additional information on the economy, housing market, and interest rates, you can subscribe to Tony’s free weekly Tony’s View publication at www.tonyalexander.nz
Disclaimer: This newsletter is meant to be informative and engaging, hopefully not a cure for insomnia. Please don't take this as personalised financial advice. Discuss your situation with an Advisor. This is where I need to say past returns are no guarantee of future returns.