In our new book “The Wealth Secret” we set out a series of principles to achieving long term wealth creation.
One of these principles is the basic idea of optimising your risk/reward position when you invest. If you ignore investors who take outrageous risks or are incredibly lucky, then you will find that all other (and therefore most) successful investors are exceptionally good risk managers. Or they use strategies, with their advisers, which manage risk in the most efficient way.
This is a complex subject, in the sense that there are a number of overlapping parts to this which can take some learning. We can explain how the Book deals with this.
The first point is an obvious one. If you invest and you lose money this is exceptionally detrimental in the quest to create wealth. If (or when?) your savings or investments fall in value you are getting poorer not wealthier. On the surface therefore losses need to be avoided.
However to get decent long term returns, according to historical data and trends, you need to invest into real assets. Real assets will involve price movements which are volatile, they will rise and fall from time to time. So some of the time the value of your investments will fall.
You have to do something to create wealth which entails incurring losses from time to time. To be acceptable they most certainly need to be temporary losses.
Yet you can never know when a loss is a temporary one or otherwise (except with the benefit of hindsight).
Our Book illustrates how difficult it can be to overcome losses. For example if you invest into an asset and its value falls by 33% it takes an approximate 50% subsequent rise to recover your position.
£10,000 invested which falls by 33% takes the value down to £6,700. To get back from that point back up to £10,000 requires a 49.2% increase (£6,700 x 1.492 = £10,000).
This basic point and principle is very important, because many people chase growth at the expense of a risk which could derail the long term position. Crucially, such investors can be very successful for long periods, but sooner or later then tend to come unstuck.
Tortoise and Hare?
Various and impressive bits of academic research are remarkably consistent around this. From Markowitz to Kaplan the basic conclusion is always that maximisation of investment returns comes from optimising the risk/reward position.
As an aside, if you ever have a few minutes to spare, please read up anything you can find on the ‘Kelly Criterion’ – although largely assumed to be a way of managing stakes in betting, its fundamentals lie in other areas (telephones of all things). What is important about Kelly’s work and his formula is that it is mathematically proven. It is about optimal returns over long periods.
To get these returns requires a formulaic approach to money management.
The takeaway from all of this is that wherever you look to try and fathom how ‘best to invest’ you will see the same thing time and time again; manage your downside and minimise the potential for losses.
Turning back to real assets, you cannot avoid losses with real assets because they are volatile, so you have to assume from time to time values will fall.
To deal with this challenge (“I need to use real asset to build wealth, but I have to avoid losses”) we have to return to the academic research, which tells us the way to do this – or manage this – is via diversification.
This really is the key. But diversification is not about holding different shares in different companies, it is about holding different asset classes in your portfolio.
Often investors confuse the different types of diversification.
You can achieve risk reduction in a share portfolio – but it is limited. If you invest all your wealth in one company you are taking more risk than if you invest in two companies. But if you invest into fifty companies the risk reduction against holding shares in twenty companies is negligible.
However if you hold your money in funds of shares, funds of bonds (e.g. gilts or corporate bonds), property and commodities etc. you are now diversifying aggressively and obtaining significant risk reduction. This is more pronounced if you diversify even further between different countries shares and bonds, big company shares, small company shares and so on.
This is what diversification really means and this is what is shown to eventually win the day.
You may have to ignore a lot of ‘chatter’ that tells you different and this could include many who claim to have found another way; but on closer inspection you will probably find they have taken or are taking unacceptable risks and have got away with it.
The difficulty here for many investors is that they sometimes believe that the focus on risk reduction comes at a price, one of lower future returns.
The evidence suggests otherwise – over time, optimal returns (i.e. the best returns you can get for the level of risk you can tolerate) come from this approach; you can’t better the return than the optimal return.
If you are not using this as your approach at the moment, you are unlikely to create the wealth you desire, you may do so another way (for example by developing your own business or becoming a Premier League footballer) but not through saving and investing.
There is one stone left unturned here: you still have to fathom – how do I diversify? What mix of assets should I use?
Good question. You may be surprised, even very surprised, by the answer.
In a way it doesn’t matter.
That’s because if you employ active asset allocation techniques and rebalancing disciplines you will pretty much succeed over time regardless.
This is possibly the most mind boggling part of this subject.
Where it starts from is the premise that no-one can reliably predict future returns.
No-one. Of course, many can predict future returns and many do, but evidence shows that these predictions turn out wrong as often as they are right. You may as well ask the cat.
The way forward therefore is to use past returns and long term trends, for example the fact that investing in shares over time has produced better results than investing in bonds (albeit this statement can be reversed during some shorter time periods, depends when you start and finish).
You therefore apply an element of what has gone on before into your selections. Let us say this leads to a situation where you allocate from day one (which is the first day you start using this approach):
30% into UK Equities, 30% into Overseas Equities, 20% into UK Bonds, 20% into Overseas Bonds.
(Clearly a simplistic example for illustrative purposes)
Now where diversification and active asset allocation come together to create the magical outcome is that you then, over time, apply a consistent rebalancing to this allocation.
Let us say that the equity proportion of your portfolio doubles in one year and the bond portion halves.
If you do nothing your revised position after this year is: 43% UK Equities; 43% Overseas Equities; 7% UK Bonds and 7% Overseas Bonds.
This now out of kilter applying too much risk into the position – so you rebalance and sell some of the equity holdings and repurchase some of the bond holdings; to get back to 30%, 30%, 20%, and 20%. If that remains the favoured allocation at that time.
Regular rebalancing, over time, will continually manage your diversification back towards an optimal position.
This is an over simplification for the purpose of easy explanation. Hopefully, though, it does stress the point that your overall asset allocation decision is not as important as it may first seem, because if you start in a relatively sensible position, the constant rebalancing takes care of the rest.
In conclusion, the most important aspect of successful investing is risk management; this is achieved through diversification and active asset allocation.
Click here to order a copy of our Book, The Wealth Secret.
If you’d like to read more on the subject, take a look at our Business Owners Guide to Achieving Your Goals – The Business Secret.