Sometimes it just seems as though there’s too much to keep an eye on as an investor.
In the US, tech stocks are tumbling and threatening the wider market. In Europe, the European Central Bank threatened to print money again at the weekend – is it bluffing, or is eurozone quantitative easing on the way? Meanwhile, tensions in Ukraine just keep mounting.
And this is just the last week’s news. We’re not even thinking about wider issues of huge government debts, tapering in the US, and epic technological change.
What on earth can you do in the face of all this uncertainty?
Simple. Ignore it….
You cannot control the future
If you’re investing for the long run – and most of us are – then it’s a mistake to spend too much time fretting about the news. Second-guessing the actions of the European Central Bank, or Putin’s next move in Ukraine, might be some peoples’ idea of fun. But for the average investor, there’s no profit in it.
If the success of your investment strategy is dependent on the next move of Mario Draghi or any other central banker for that matter, then you’re either running a hedge fund, or you’re doing it wrong.
Trouble is, it’s easy to get distracted by all this stuff. Humans are badly suited to dealing with market ups and downs. If the market is rising, we worry that we don’t have enough money riding on it. If the market is falling, we worry that we have too much. This in turn leads to a tendency to buy when markets are high, and sell when they tumble – pretty much the opposite of what we should do.
If you want to save enough for a comfortable retirement (or whatever other long-term goal you have), you need to short-circuit this self-destructive behaviour. The best way to do that is to have a plan, and to automate as much of it as possible.
The first step is to understand what you can and cannot control as an investor. You can’t control the future. The past 15 years has seen two dramatic stock market crashes. While both were obvious with hindsight, they caught most investors unawares.
You don’t know for sure what’s going to happen next. So the logical next step from that is to make sure you don’t stake your entire investment future on any one outcome. You don’t want to spread yourself too thin, but nor do you want to have all of your eggs in one basket.
So you should diversify. Have a set amount of your money in stocks, preferably in a range of global markets. Have some in bonds – they mostly look expensive, but if Japan-style deflation did end up going global, they’d still do well. Have some in property, some in gold as insurance, and some in cash. (This process is known as ‘asset allocation’.)
History shows that diversification makes your portfolio less risky, but without reducing your potential returns by as much as you’d expect. In other words, diversifying enables you to get the same potential reward, while taking less risk. That’s a very desirable outcome in an unpredictable world.
How to automatically buy low and sell high
We know that we can’t control the future. But there are two very important things that we can control. The first is the price we pay for an investment. The second is our cost of investing.
When it comes to price, we’re always told to ‘buy low, sell high’. The ‘father’ of value investing, Ben Graham, characterised the stock market as a slightly manic individual who would cheerfully offer to buy your stocks at a high price one day, then be back hammering at your door the next, begging to sell at any price.
Your job as an investor is to sell when he’s cheery and offering good prices, and buy when he’s desperate to offload his stocks.
But as I said above, our instincts are usually to do the opposite. When shares are falling, we don’t think: “Oh good, they’re getting cheaper.” Instead, we just worry that they’ll fall further.
The good news is that the asset allocation process gives us a very easy way to avoid this self-destructive behaviour. Say you’ve decided to put 50% of your money into stocks, and 50% into bonds (to keep this simple). After a year, stocks have had a good run. They now account for 60% of your portfolio. Bonds have had a mediocre performance. They account for 40%.
Your overall portfolio is larger, but it’s no longer allocated in the way you want it to be. So at this point, you ‘rebalance’. You reduce your holding of stocks back to 50% of your portfolio, and top up your bonds to 50%. You can do this in a range of ways (you could invest more in bonds to bring it up to the same level as stocks, or you could sell some stocks and invest the proceeds in bonds).
But the point is, this encourages you to take profits on the bits of your portfolio that have done well, and to buy assets that haven’t done as well.
In short, rebalancing automatically makes you ‘buy low, sell high’. And it takes the emotion out of the process, so you’re never going to have one of those horrendous moments where you sell a tumbling investment at exactly the wrong time.
You can’t control the future – but you can control your costs
The other thing you can control is how much your investing costs you. Changes in regulations have made investing costs much clearer in the past year or so. Instead of paying commission to a financial advisor or platform, you’ll be charged directly for the services you use.
This is great news. But it’s also made one thing a lot clearer to lots of people – financial advice can be expensive. And paying a fund manager to try to beat the market (‘active’ management) is also expensive – yet the majority of them don’t deliver on that promise.
All these costs add up. Paying an extra 1% a year of your portfolio to the financial industry for the privilege of managing your money, can leave your savings pot depleted by tens of thousands of pounds over the long run.
The good news is that you can invest in a wide range of markets very simply using exchange-traded funds, or index tracker funds. These ‘passive’ funds simply deliver the return on the market – often beating active managers – while being a lot cheaper than those same active managers.
That’s what you need to know, as far as I’m concerned. Don’t put all your eggs in one basket. Buy low, sell high. And be utterly ruthless about keeping your costs low – it’s the one aspect of investing you have the most control over.
• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.
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