Extraordinary situations often call for extraordinary action.
One such situation may be your own retirement, advancing towards you at high speeds, along with the realization that you might be unprepared, and underfunded.
Many business owners and high income professionals may find themselves in this exact situation. And with a scorching hot equity market driving returns upwards on every front, you may consider taking a swing at an opportunity that might otherwise be more speculative than what you would normally feel comfortable with – for fear of missing out.
But swinging for the fences – is not an investment strategy. So when it comes to laying the groundwork for a solid, enduring portfolio, what should you be paying attention to?
The Five Components of a Well Thought Out Investment Strategy
1. Understand the Difference Between Investment and Speculation
An “investment” connotes that you believe there to be identifiable value in the asset, that will grow or produce a return over time. The opportunity may not yet be fully developed; or perhaps it is mispriced due to market activities.
By contrast, a “speculation” is, by definition based on theory or conjecture, in the absence of solid evidence, where there’s likely no intrinsic value currently. You may hit a jackpot or you may lose everything you’ve contributed – both opportunities exist.
When in a highly emotionally charged situation – like an impending retirement with limited resources – we can convince ourselves that a speculation is in fact an investment. We can get excited, and overconfident, believing that the outcome is very likely to be positive.
In the gold and oil rush days, a speculator was someone who purchased a particular piece of land, theorizing that these particular commodities would be found there, under the soil. If they struck gold, oil, or even copper, depending on what was hot at the time, they could become unfathomably wealthy. If they didn’t, they would lose their money, their time, and their livelihood.
More recently, toward the end of 1999 and 2000, there were numerous speculators in technology. There were many who did tremendously well in the short term on some of these investments. People were paying enormous amounts to buy into IPOs in a plethora of dotcom corporations, many of which had no revenue whatsoever. As things unraveled, heavy losses ensued and took decades to recover.
Recently, we’ve seen wild movements in some speculative investments that are completely disconnected from any kind of value. Whether that’s a cryptocurrency or the spectacular rise and fall of Gamestop, the “strategy” behind placing your capital in these types of ventures has likely been little more than simply closing your eyes and wishing.
The luckiest speculators make significant short term gains, getting in and out before the money starts to evaporate, but this experience is far more similar to gambling at a Las Vegas casino than it is to implementing an actual plan.
Understanding the difference between investment and speculation, and choosing the far less exciting world of analysis, research, and thoughtful investment is the first step towards creating a strategy that works.
2. Invest in Things That You Understand
How does this particular investment vehicle make money? What drives the price upwards or downwards? Does it have intrinsic value right now, and what are its opportunities for increases in the future?
If you don’t understand why your investment is trending downwards, you are far more likely to make an emotional decision to sell it, and that might not be the correct action to take. Perhaps a given company has been impacted by an external factor, such a short-term interest rate change or an upswing in a competitor. That doesn’t mean that the company has lost its value. It may very well have a strong balance sheet, positive cash flow, and a clear trajectory towards increasing growth.
Knowing how this company makes money, whether the business plan is one that will potentially increase profits in the future, and what external factors could impact its growth are keys to making a great decision. If you understand the source of your investment’s value, it’s much simpler to make an intelligent decision about whether to keep it, invest further, or sell.
As an example, think back about 15 years ago, when it seemed like every other person you met was a real estate speculator, flipping houses and making enormous amounts of money. Eventually the frenzy ended, and when it did, at the bottom of the bust, close to 40% of the residential real estate in the city of Stockton, California sat in foreclosure.
My point is that if you had owned a home in Stockton at the time, you might have been watching the incredible rise and devastating fall with some concern. But you likely weren’t falling for the idea at the peak, that your home was actually worth triple what you paid for it, nor did you choose to sell it when it dropped 10%, then 20%, and then further. You understood the neighborhood, the local economy, the job opportunities in the city, and you understood that these peaks and valleys were the result of mispricing – not a rapid increase or decrease in actual value. Since you understood all this, the volatility of real estate did not impact you to the same degree as it would have if you had not.
When you are looking at investment in stocks, such as Apple and Amazon, and other large companies we are familiar with, what do you know about them? Do you understand that Apple makes not only iPhones, laptops, but much more? Do you have some clarity about their market share versus competitors like Samsung? Do you understand how Amazon makes money – not only from online shopping but also from cloud services? Are you aware how both shopping and cloud computing have radically changed in this last year – perhaps irreparably so? Knowing what you do know, do you think you could handle some volatility in their prices over a significant period of time?
Understanding what you’re investing in helps you remain invested for a longer period of time, something that is also vital to a great investment strategy. With that understanding, you can invest based on value, rather than gyrations in the market.
3. Be Wary of Manias
It could be tulip bulbs, gold rushes, dotcom companies without business plans, housing, cryptocurrency, marijuana, and whatever else is exciting people for the moment. Be very, very wary.
Take the dot-com bubble as an example, when the Nasdaq composite index rose a shocking 400% between 1995 and 2000, falling an even more shocking 78% by October 2002. Despite still holding on to great companies like Cisco, Amazon, and Google, it took something close to 17 years for the index to break even. If you just bought the index it would have taken you that long to earn your money back. If you’d invested in some of the many companies that went entirely bust, you would still be counting your loss.
It is not just tulip bulbs and gold prospecting that have eaten fortunes. There have been companies even in the last year that rose to crazy highs and are now experiencing rapid descents because the valuation that they’d achieved was simply not sustainable.
At some point you have to recognize that you cannot simply rely on the “greater fool” theory, the one that says that someone is going to pay a more ridiculous price than what you paid.
Although manias can be a lot of fun, at least on the way up, they’re not part of a sound investment strategy.
4. Understand Your Downside Risk Tolerance
Investment industry folks love to talk about risk tolerance – it’s part of the responsibility of providing the services we do. You might hear this question: How tolerant are you to risk?
We will let you in on a little secret few people are talking about: no one is intolerant to upside risk.
Everyone adores upside risk. Nobody says, “You know, I don’t really like the fact that my investment went up by 20% or more.” No one is missing a night’s sleep over that. If anything, they want to buy more of that particular investment.
What you really, genuinely need to understand is your downside risk tolerance. How?
As with anything really useful and important, it’s complicated. Your risk tolerance should be different depending on the phase of life you are in. If you’re someone who is living off of your assets, you can’t really afford to be too aggressive – the downside risk is too high. A massive blow to your portfolio is much, much harder to recover from, because you’re drawing from that portfolio while its value is down. Studies show that portfolios trying to manage with this scenario often struggle to recover.
Risk tolerance is also related to the size of your portfolio, and the percentage of that portfolio that you really need to draw from now and in the future. For some people, a 10% reduction in value is devastatingly hard to recover from. For others, where the portfolio is valued at more than what you might spend in your lifetime, a drop like that could be immaterial.
Part of having a great investment strategy is not only understanding what we would historically call “risk tolerance” but also exactly how that relates to you, where you are in your life, and the cash needs you have from your portfolio.
5. Diversification, diversification, and diversification
Mitigating downside risk and managing through manias means building a portfolio full of diversifiers. This is not as simple as choosing to invest one portion of your portfolio in some bonds, and the rest in some stocks. We have learned, especially recently, that we can’t count on these wide categories to not correlate – specific types of diversification don’t always hold. Sometimes the most unexpected investments become dance partners.
These things change over time; if you’re not paying attention you may end up exposing yourself to more downside risk than you have tolerance for.
Part of diversification is ensuring that you hold different asset types, and part of that is being active, watching for assets that start to dance too closely together and taking action before you suddenly have a portfolio full of assets all moving in the same direction.
We build portfolios with a combination of divergent strategies for just this reason. It can be natural for an investor to look at strategy one, which is trending upwards, and strategy two, which is trending downwards, and ask to invest entirely in strategy one. Of course that seems like it makes sense, but it’s a short term approach when you really need a long term one. Strategy one is up today, but in another cycle, it’ll be down – just when strategy two is on its way up. With both strategies in place, your opportunities for consistent return are increased.
Knowing that today’s diversifier may not be tomorrow’s – and that diversification is vital to long term success – is a key component of your successful investment strategy.
They say that death and taxes are inevitable. A third inevitability is change, something that continues to rip through the world of investment at a steady pace. There was once a time when technology was slower and it was easier to track market activities. However, today, you might blink and a position you hold could be down 40% in 25 minutes – which is exactly what happened to Gamestop on a particularly bad day. Managing through that change is about having a thoughtful strategy, an understanding of your investments, choosing investment over speculation, working with your own downside risk tolerance, and staying as far away from manias as you possibly can.
Be deliberate, and be patient. It’s not anywhere near as exciting to be the tortoise who wins the race, but when your goal is to win, it’s a great deal more satisfying.
By: Greg Stewart, CIO