If you want to be a great investor, you must resist impulsive actions and understand that the road won’t be straight.
Accepting some volatility is a pre-requisite for good returns in any market, but today’s market arguably requires greater care than usual. You need to earn, save, invest and protect. This latter two can be achieved with careful portfolio allocations and smart diversification.
The Morningstar Investment Management team shares some brilliant insights from which the below have been extracted.
DON'T forget why you are investing.
The future holds a wide range of possible outcomes and is characterised by unyielding complexity that continually defeats those who seek to make confident forecasts.
Your role as an investor is not to forecast the future, but to construct a portfolio that enables you to reach your goals, whatever be the economic and market conditions.
The entire purpose of investing is to let your money work for you. It is an active decision to put money aside (delayed gratification) to fund a desired future lifestyle.
Ultimately, it is to help you achieve your goals. Therefore, always start with your objectives, before you move on to solutions that are most pertinent to you.
DON'T get carried away by extreme market situations.
Returns are determined by the cashflows generated by the assets we invest in, and the price paid to acquire those assets.
A fundamentally attractive asset can become an unattractive investment when purchased at a high price and, equally, a fundamentally weak asset can provide the most attractive returns when bought at a sufficiently low price. The importance of this dual focus when undertaking investment analysis tends to be lost in markets characterised by excessive optimism or pessimism.
As investors become increasingly focused on the future path of prices, confident of either a continuation of the past or a sharp reversal, many forget that most paths lie between these two outcomes.
It is for this reason that it makes sense to adopt a fundamental and valuation-driven approach to investing, acknowledging that expensive markets can provide opportunities, and cheap markets may be a source of threats. In every situation, the right approach is to view the future probabilistically and think long term.
DON'T lose sight of your primary goal.
Your primary goal is NOT to maximize returns. Your goal must predominantly be to avoid permanent loss of capital. As Warren Buffett said: “The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule.”
Drawdowns happen. And they are frightening, especially for investors with shorter time horizons.
The common message is that compounding is a beautiful thing, however it is more powerful on the downside than the upside. Consider various scenarios. If the market were to sell off by 20% tomorrow, you need to make 25% to get back to square. If it falls by 50%, you need to earn 100%. Avoiding losses matters because losing less means you require less to bounce back.
Hence, risk aversion is a rational and essential response as people often fail to appreciate the danger of negative compounding. Which brings us to our next point.
DON'T avoid risk.
Investing is all about taking risk. Not taking a calculated risk is a risk itself.
To achieve your investment objectives and meet your goals, you need to assess the investment environment and take appropriate risks.
In this context, it is prudent to recall Warren Buffet’s guidance: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” During the height of the pandemic-induced sell-off last March, we were in an environment where opportunities were plentiful, and a very targeted approach wasn’t required. Today, the situation is different. Investors ought to take a more measured approach to constructing their portfolios: i.e., put out the thimble, and save the proverbial bucket for a period with heavier rain.
Sometimes the opportunity set will be rich. Other times, that’s not the case. Right now, the path ahead could be a little rocky, but we must accept some risk to achieve goals.
DON'T put all drawdowns into one basket.
All drawdowns are not the same.
There are broadly two types of drawdowns: 1) valuation-induced drawdowns, and 2) volatility-induced drawdowns. While investors need to embrace volatility, try to avoid valuation-induced sell-offs.
Volatility provides investment opportunities—the ability to get set in assets with significant upside. As investing great Bill Miller says, “volatility is the price you pay for returns” and accepting volatility will be necessary for most investors.
Periods of volatility will come and go, which are scary at the time, but they rarely impact goal attainment. Valuation-based drawdowns (paying too much for an asset) can be more enduring and may not be fully recouped—even over the long term. Equities that go bankrupt or bonds that default are extreme examples. These are the drawdowns our process seeks to avoid where capital can be permanently impaired.
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