Today I want to focus on some investing home truths in a bid to address some questions I’ve had from a number of readers..
First - I wanted to look at something that I know seems illogical to many people - what is sometimes called “the break-even fallacy”.
If you ask someone: “...if you lose 50% on an investment, how much would it then have to rise by to get back to where it started?”.
A majority of people will say the answer is 50%. This seems logical. If something falls by 50% then surely it must rise by 50% to get back to "break-even” (the level where it started).
The real answer, however, is 100%.
If this seems wrong to you then let’s quickly look at the numbers: Say you owned a share that was worth £100. If there is then a big stock market crash and it falls 50% it will then be worth £50. If your share now rises 50% from £50 - the share will only get back to £75! 50% of £50 is only £25 of course. To get back to to £100 the share will have to rise 100% (100% of £50 is clearly £50).
This is why it is so important to minimise your losses in investment and why famous US investor Warren Buffet says:
Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1.
He also says “You don’t need to be an expert to achieve satisfactory investment returns.”
A long-proven way of lowering the risk that you make a big loss is to own a wide variety of assets from around the world - to Own the World. The reason this works should be quite intuitive: Over time, different types of asset (shares, bonds, commodities) and different regions of the world (Europe, US, Asia, emerging markets) come in and out of fashion.
It is also true that some investments tend to be “negatively correlated” with others: That is to say that when one goes up the other tends to go down. If you ensure that you own a wide range of assets from a wide range of geographical regions you have a good chance of consistent performance. There is plenty of evidence to support this and the strategy has worked for many of the smartest investors in the world for many decades.
The tortoise beats the hare...
Importantly, it should be noted that this approach is unlikely to give you 30% or 50% years. The aim is to grind out 10% or so performance on average over a lifetime of investing and, crucially, minimise your risk of losing a big chunk of your money in a “crash” year like 2008.
Some years you might only make 2% - when lots of other people are crowing about how they’ve made “a killing” in the stock market and you might feel a little stupid as a result. This is precisely when you should stick to your guns. The people who are making a killing in the stock market this year are the ones who will lose 40%-50% of their money in a year like 2008.
Over a lifetime of investing the tortoise will beat the hare and you will be the one with a seven figure sum so please resist the siren call of the “I’ve made a killing crowd” (a call that has been particularly loud in the last couple of years for obvious reasons).
I would hope this will reassure any of you worrying that you have “under performed’ the stock market by following an “Own the World” strategy of late. Over time the fact that you were a tortoise in a year when the hare was running particularly fast will likely be a blessing in disguise.
The other great thing about this approach is that you don’t really have to think about where to invest. You don’t have to worry about whether you should be investing in Asia, the US or Europe or mainly in bonds, commodities, real-estate or shares because you will simply own a good mix of all of them. Crucially, it is only in the relatively recent past that investing like this has become possible thanks to innovation from the financial services industry. It is just a shame that relatively few people (or financial advisers) understand why this is a great approach or how to implement it.
£5,000 becomes nearly £1 million
As a reminder of how powerful making around 10% a year can be: If a wealthy relative was to invest £5,000 for you the day your child was born and you were to achieve 10% per annum, with no further investment, your child would have £945,000 on their 55th birthday (compound annually) or just short of £1.2 million (compounded monthly).
That’s where being a tortoise can get you. That same investment in something that went up 50% then down 40% then up 18% and so on would result in nothing like the same sum at retirement. “Slow and steady wins the race…”
If you would like to learn in more detail about why this approach works then please do consider reading some of the best books on the subject.