Beginners guide to investing part 5:Managing risk in the sharemarket

“In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well

— J Kenfield Morley

INTRODUCTION

Among my friends and family, the top reasons for not investing in the sharemarket are lack of knowledge and fear. The intention of the investing series of articles is to increase knowledge and reduce fear. If you are new to the blog, the investing series begins here.

The sharemarket has the potential to deliver great returns - if done right.

There are some things we can’t control when investing in the sharemarket. We can’t control interest rates, inflation, exchange rates, company bankruptcies, and so on. This is why many stay away from shares. The unknown. This is a shame, because returns from shares over the long term are arguably better than other accessible investments.

How can we reduce the risk of the unknown?

 

1/. DIVERSIFICATION

Don’t pick individual stocks. Invest in a wide range of stocks. We can have stocks from a wide range of industries or countries. We can have stocks from both new and established companies, high and low paying dividend companies, big and small companies. Diversification can also apply to the percentage of your portfolio that stock investing makes up. For example, 60% stocks, 20% property, 10% bonds and 10% cash may be considered a diversified portfolio. The percentages all depend on the level of risk we are prepared to take and how long we intend to invest for.

Effective diversification can greatly reduce the risk we are exposed to. The theory is that when one asset class, one industry or one region is performing poorly, another asset, industry or region within our portfolio is going well. The plan is to minimise the downside of our investments. The great thing about a well-diversified portfolio is that it can also maximise the upsides.

There is such a thing as too much diversification though where some investments overlap each other. In other words, they are too common. The more investments we own, the more likely we are to have duplication. With the proliferation of index funds, we really only need a few funds to be adequately diversified.

Using Smartshares as an example we can be well diversified with just 4 funds. The NZ share fund, the total world fund, the bond fund and a real estate or value fund.  A more ambitious investor may also wish to add a commodity fund. This is a good example of diversification because they invest in different asset classes, regions, industries and company structures. A poor example would be investing only in the NZ share market, or both the NZ and Australian sharemarket only. NZ and Australia are too similar in many respects to consider that a diversified portfolio.

 

2/. BUY AND HOLD INVESTING

Despite what anyone says, it is impossible to make predictions about the price movements of stocks. Fight the prediction addiction. It is all very exciting making predictions when they come off, but it is also dangerous. Trying to time the market by guessing when a good time to buy or sell is, often results in poorer returns than if we just rode the market.

We may think it is the top of the market and sell, only to find out that the bull market still has another 3 years of rising stocks. That would be a long time to be sitting on the sidelines during the best possible time and not even be invested. Conversely, buying all in when we think the market has bottomed out, only to find it is only half way to the bottom. It is a fool’s game.

There’s no reason we can’t do as well as the pros. What we cannot do is to beat the pros at their own game. The pros can’t even win their own game! Why should we want to play it at all? If we follow their rules, we will lose – since we will end as much a slave to Mr market as the professionals are.

 

3/. DOLLAR COST AVERAGING (DCA)

One of those investing terms that sounds complicated but is actually very simple. Basically, instead of investing a lump sum of money into the market at one time, spreading out your investing into regular, smaller payments over time. For example, instead of investing $1000 today, we can invest $100 a month for the next 10 months. This helps to reduce the risk of entering the market at a bad time (when shares are expensive).

With DCA, the emotional dangers of overconfidence or panic during times of market volatility are removed from the equation. Investments are made regardless of how we are feeling. A strong stomach is needed for when the market is falling. Not only are we not selling using the DCA strategy, but we are also buying.

Pro-tip: When stocks are decreasing in price, think of it as buying shares on sale. The good returns will come at a later date.

Pro-tip 2: When the sharemarket is falling, avoid checking your balance every day. This is a sure-fire way to get emotional, panic and sell up your shares. If you are investing long term your shares will go back up to a level higher than this point. If your strategy is to buy and hold, then only check your balance every 6 months when stocks are falling. Ideally, don’t check them at all.

Bonus pro-tip. Set up automatic payments from a separate bank account or on pay day so you don’t miss the money, much like Kiwisaver.

3 pro-tips. It's your lucky day.

 

4/. INVEST FOR THE LONG TERM

Investing in the sharemarket is for the long term. I wouldn’t recommend any less than 10 years if you have more than 30% of your investments in the stock market. Long term the market always goes up. Short term it can lose substantial money.

A few NZ specific stats to show how volatile the market can be:

  • The average return since 1975 has been 15.4%
  • The average return since 2000 has been 8.1%
  • In 41 years of data there have been 13 down years and 28 up years. A ratio of 2 years out 3 in positive.
  • 7 of the 13 down years have been down by over 10%.
  • Maximum down year was 48.2% in 1987
  • Maximum up year was 117% in 1983
  • Highest up year in the last 20 years has been 26% in 2003.
  • If you had money invested before and during the 1987 sharemarket crash (48%), it would have taken 19 years to get back to break even (with no buying or selling). This wasn't helped by another large crash of 40% just 3 years later. 
  • If you had money invested before the 2008 recession (33%), it would have taken 4 years to break even (with no buying or selling). 9 years later and you would have almost doubled your money.

The 1987 crash was preceded by a 260% increase in the previous 4 years so was an anomaly. 3 years later the 87 crash was also followed by a 40% crash in 1990. Yes, it wouldn’t have been great, but it is of some comfort to know that if still invested today you would have almost double your money. If you were investing cheap shares during the crashes you would be even better off today.

The early 90’s experienced some very good returns and I imagine a lot of people sold during the 87 and 90 crash, and would have been scared to re-enter the market. Fair enough too. But all emotion taken out, they missed out on some good returns.

The point is short term is dangerous, long term not so much.

 

5/. KNOW WHAT YOU ARE INVESTING IN

Even if we have a fund manager looking after our investments, it’s still important that we know what we are invested in. The test to use: if someone asks you what type of investments you have, you should be able to answer.  If you don’t know, then how do you know if the investment is right for you?

 

6/. KNOW YOUR INVESTMENT GOALS

If we have clear investment goals that we want to achieve we can find out how long it will take us to reach them and how much risk we are willing to take. Risk to one person is not risk to another. Risk depends on how likely something is to stop us from achieving our goals. If we want to eat well then we should be prepared to take on more risk, if we would rather sleep well then less risk is preferred. Do not let greed get the better of you and take on more risk than necessary. 

 

7/. KEEP AN EYE ON INVESTMENT COSTS

Funds can vary greatly in terms of brokerage and administration costs. Shop around and look for the best rate for your situation. A 0.5% difference in costs may not sound like much, but since investing in shares is long term, it really can add up. Let me use an illustration:

Let’s assume we are invested in a NZ share fund for 30 years. The return has been 7% before fees. Fees have been 2%. We will ignore inflation as we have assumed that our increase in annual contributions balances that out. We started out with $0 and invested $1000 per year.

After 30 years with 2% fees - $101,500

After 30 years with 1% fees - $133,300.

$32,000 is a lot of money, but If we instead started with $20,000 or invested $5,000 per year, then the difference could be well over $100,000 over 30 years. This is not chump change from just a 1% difference in costs.

The point is higher fee funds, need higher returns to compensate us for the risk. If we can’t get the higher returns then we are much better off in a low fee fund. More money in our pocket means we are taking on less risk.

 

8/. ELIMINATE THE NOISE AND STAY THE PATH

There will always be media, bank managers, so called professionals, government, friends, family and our next door neighbour Bob making predictions about what they think will happen. As long as we are confident in our strategy, stick with it and don’t deviate. Ignore all the noise if it is not part of your plan. If we deviate from our plan, we run the risk of not meeting our goals. It is our money, not theirs. This is easier said than done. Think about the panic after the Brexit vote or around the NZ elections or Donald Trump getting elected. Many people predicted chaos and would have panic sold, but since those events the markets actually improved.

 

9/. DON’T OVER INVEST IN THE SHARE MARKET IF YOU DON’T HAVE EMERGENCY SAVINGS OR HAVE HIGH INTEREST DEBT.

Before we invest in shares, if we want to reduce our exposure to risk, it is a good idea to have a good financial base to work from. This means all high interest debt such as credit cards, car loans and loan company debt should be cleared. Student loans and home loans are OK. We can definitely invest in shares whilst having these loans as they are low interest. By paying off both home loan and investing in shares, that helps with our diversification by spreading our risk. Paying off just the home loan, can create extra risk by being invested in just one asset class. 

Once you have no high interest debt, I recommend putting some money away for an emergency. How much you have here is a very personal decision and you can read more about how much to put away here.

Then, you can invest in shares from a more powerful, and less risky, position. If brown stuff hits the fan and we need some money urgently, we can dip into our emergency savings. This is much better than having to sell our shares or bonds at a time in the market that may be bad for selling (low prices).

 

10/. REBALANCING

No, this isn’t a gymnastics manoeuvre. When we start investing we should have a plan as to how much we want invested in each asset class. For example, 60% stocks and 40% bonds. Over time, as one asset class performs much better than the other, the ratio in each changes. If stocks have a really good year, we could potentially end up with 75% of our money in stocks and 25% in bonds. This is more risk than our initial plan calculated for.

To reduce our exposure to too much risk, we would need to rebalance our portfolio back to 60% stocks and 40% bonds. This would involve selling off some stocks and/or purchasing some bonds to bring the percentage of overall holdings back to 60/40.

This works quite well because we are selling when prices are high or going up, and buying when prices are low or going down. The danger is that we end up missing out on even further gains. The flipside is we aren’t selling when prices are low or buying when prices are high. Remember, timing the market is dangerous and rebalancing is a great way to maintain your strategic direction. It may or may not give the best result, but it absolutely won’t give the worst result. Once per year is a reasonable timeframe to rebalance.

Another strategy to time our rebalancing is to set a percentage that we don’t want to go above or below. For example, if we have a portfolio of 80% stocks and 20% bonds, we may set a limit to have a maximum of 85% in stocks and a minimum of 75%. If our portfolio allocation reaches the upper or lower limit, then that is the trigger for us to rebalance.

 

FINAL THOUGHTS

All these tips are geared towards minimising the worst possible results from investing in the sharemarket, whilst maximising our returns. The safest way to invest is for the long term, with a buy and hold strategy, regular investments, in a wide range of low cost funds, whilst sticking to our plan and not letting our emotions get in the way.

The whole point of investing should not be beating the average, but to earn enough to meet our needs. Problems arise when we start looking for the "best” investment or the next “hot” thing. In other words, don’t take on more risk that you want or need.

Risk is natural. As long as we can identify risk ahead of time we can employ methods to minimise it. The key is to understand what we are investing in so that we are not blind-sided by events we are not prepared for.

The next article in the investing series will focus on how our behaviours can have a negative impact on our investment returns.

I hope you have found these articles useful, and realised the sharemarket is not that scary a place.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

 

Are there any other tips that you use that help you invest in a volatile market?