We’d all love to get rich quick. There’s nothing wrong with that. Who wouldn’t want to have all their money worries solved overnight by a lucky lottery win?
The trouble is, many investors carry this mentality with them into the market. And that’s a near-certain way to lose your hard-earned capital. Investing is about growing your wealth slowly, not quickly. So as we come to the end of 2012, here are three ways to make sure you take the right approach to investing in 2013.
Make financial goals
As Carl Richards notes in The New York Times, “beating an index isn’t a financial goal”. Nor is beating the return your neighbour claims to get on his investments. Proper financial goals should be long term, based on your own specific needs rather than anyone else’s, and achievable.
Maybe your aim is to pay for children’s university fees, or to retire at 60. The key is to set a realistic target, then work out how you will hit it (obviously, the bigger the goal, the more growth you require, and the more risk you may have to be willing to accept along the way).
The key is to know what you want – then you won’t be distracted by tales of multi-bagging stock tips or property-market bargains that others claim to have landed.
Just how fast can you expect your money to grow? It helps to realise that almost nobody consistently achieves annual returns in double figures. As Richards notes, “among large-cap-stock mutual funds (that use the S&P 500 as a benchmark), with a 25-year record (something not that many funds can boast), not one had an annualised return of greater than 12% over the past ten or 15 years”.
Sure, had you put your entire retirement fund into precious metals over that period you’d have done it, but you’d hardly have been sleeping soundly in the meantime. So what is a realistic long-term growth expectation for a fund? Take a hint from the regulator.
The Financial Services Authority has asked pension funds not to base their “central projection” (they normally give you three based on different growth rates) on an 8% growth rate, but to revise it to 5%. That’s a big difference.
Take a 30-year-old planning to retire at 60 and aiming for a fund of £500,000 based on annual growth of 5%. The contribution needed is about £7,500 a year, or £625 per month. Someone assuming growth of 8% a year would only save about £4,400 a year, or £366 per month. So of course it’s tempting to be optimistic. But you’ll pay a heavy price later for getting it wrong.
Don’t confuse skill and luck
For how many years does a fund have to beat an index before you can say the manager was skilful? One year? Five years? Try 64. Professor Kenneth French at Dartmouth College says that if a fund beats the market by 5% a year and has volatility (the variability of its returns) of 20%, that’s how much data you’d need before you could be confident that the fund manager wasn’t just getting lucky.
Clearly, no one has that kind of time – our investment horizons aren’t that long, and if they were, we still couldn’t spend 64 years just trying to work out who was lucky and who was skilful. The solution, apart from learning humility when investing, is threefold.
First, don’t chase the latest hot stock, sector and theme in the hope of skipping a few years of patient investing. You are merely leaving yourself open to the danger of a big loss. We all think we’ll get out of a bubble before everyone else does, but this is a mug’s game. And remember, a big loss can take years to recover from simply because of the way the maths works – a 50% loss on a share can only be subsequently recovered with a 100% gain.
Next, be honest about how you make your profits – write down the reasons you bought a stock in the first place and review these periodically to see whether your criteria were right or whether the facts have changed and you owe your gains to that. Don’t assume that just because a stock you bought goes up it’s down to your investing prowess.
Lastly, don’t overpay for ‘alpha’. Expensive, actively run funds usually come with a promise of outperformance, but as French’s study shows, in effect you can never be sure a manager is skilled rather than lucky. Morningstar data for the US show that among large equity funds only 47% have beaten the S&P 500 over 15 years, and only 32% over the last ten. Rather than trying to pick a winner, stick with cheap funds that track the market. At least you know what to expect.
Be wary of shares in firms acting like banks
According to some estimates, Apple holds enough cash on its balance sheet – around $122bn – to buy up all the gold stockpiled in the People’s Republic of China. To some analysts, all that cash gives the firm great ‘optionality’ (the ability to pounce on a bargain) and, of course, liquidity; this is not a firm that’s about to go bust. But actually, having that much cash on its balance sheet presents Apple, and firms like it, with a headache called ‘cash drag’.
As an investor you don’t pay a firm like Apple to sit on cash, earning you next to nothing. When you buy Apple shares you expect a much higher return, commensurate with the level of risk attached to buying shares.
Put simply, the money that Apple is holding could be earning you more just sitting in the bank, and you’d be taking less risk. So the firm’s management should really make a decision to either invest it to generate more revenue and therefore profit, or return it to shareholders, ideally in the form of a dividend.
That’s why one of Mark Carney’s first pronouncements on being appointed as the new governor of the Bank of England was that cash-rich firms should reduce their cash piles. It’s also why, despite the old cliché that cash is king, investors should be wary of buying shares in firms that have started to look too much like deposit-takers.