Rules for successful investing in 2010

The roller coaster ride in investment markets over the last two years highlights the need for investors to have a disciplined approach to investing.
Shane Oliver explains...

The last two years have been tough for investors. Since 2007, the markets have been on a roller coaster ride, first having their worst bear market in generations only to be followed by a rapid 50% or so rebound. And most other assets - bar government bonds and cash - have been on a similar ride. Timing any of that has been particularly challenging. Whats more, there is no end of experts with widely differing opinions of where things are going. Some think that the next great depression is still just around the corner and that the recovery we have seen over the last six months is nothing more than a bear market rally. Others, myself included, are of the view we have begun a new cyclical bull market with more upside to go. So what should investors do? There are several highlevel rules worth following. These are particularly pertinent in the current economic environment.

Forecasts must be treated with caution The first thing to note is there is no easy way to predict where markets will go. If there was a foolproof method then I wouldnt be writing this and you wouldnt be reading it!  The difficulty in forecasting is highlighted by the experience of economic forecasters. Surveys of economic forecasts are regularly compiled and published in the media. It is well known that when the consensus (or average) forecast is compared to the actual outcome, it is often wide of the mark, particularly when there has been a major change in direction for the variable being forecast, as has been all too obvious over the last two years. The difficulty with forecasting applies not only to economists forecasts of economic variables but also to equity strategists share market forecasts and share analysts forecasts for company profits.

Of course, this problematic track record has led to plenty of jokes about economists: economists were invented to make astrologers look good, an economist will know tomorrow why the things he or she predicted yesterday didnt happen, economists have predicted five of the last two recessions, and so on.

There are numerous examples of gurus using grand economic or financial theories - usually resulting in forecasts of new eras, great booms ahead or, as is more fashionable at the moment, great depressions ahead - who may get their time in the sun but who also usually spend years either before, or after, losing
money for those who follow their grand calls. Sure, some did get it right in terms
of the global financial crisis last year, but as former Reserve Bank of Australia
Governor Ian Macfarlane observed; Everyone who predicted what has
happened [in 2008] has been predicting it for 10 years. And thats not a great
track record. No guru or expert will get it right all of the time.

Prognosticators of doom can be particularly alluring. Firstly, because its
easier to sound logical and inquiring when painting a bearish picture regarding
the outlook than a bullish one. As JK Galbraith once observed, we can all
agree that pessimism is a mark of a superior intellect. Secondly, numerous
studies show most investors are far more worried about a loss than a gain. This
natural wariness and twitchiness on the part of investors probably explains
why, historically, share markets in stable countries have provided a higher return
premium over safe assets like bonds and cash than can theoretically be justified.

The trouble with forecasting

Forecasts for economic and investment indicators can play a useful role but need
to be treated with care:

- Forecasters are not immune from the psychological biases that beset everyone. These include the tendency to assume that the current state of the world will continue into the future, the tendency to look for evidence that confirms ones views as opposed to evidence that contradicts them, the tendency to only slowly adjust forecasts to new information, and overconfidence in their ability to foreseethe future.

- Precise point forecasts convey no information regarding the risks surrounding the forecast. They are also conditional upon the information available when the forecast was made. As new information appears, the forecast should change. Setting an investment strategy for the year ahead based on forecasts at the start of the year and making no adjustment as new information arrives is often a great way to lose money.

- Economic forecasts can be selfdefeating for example, economists forecasts for a recession in Australia this year were in a large part headed off by fiscal and monetary stimulus which themselves were a response to forecasts for a recession.
- When it comes to investment management, what counts is the relative direction of one investment alternative versus others; the precise point at which they end up is of secondary importance.

- The difficulty in forecasting financial market variables is made harder by the need to work out what is already factored in to markets. And rules of logic often dont apply in investment markets. While precise economic forecasts can be useful, particularly in communicating a view, investors need to recognise that they have limitations.

So if there is no easy way to predict the market, what should investors do? There are several rules worth following:

1.  Respect the market

It is well known that investment markets are not always rational. But, there are numerous examples of investors who came a cropper because they thought they were better than the market. JM Keynes observed that the market can stay irrational for longer than you can stay solvent. In other words, you may even have a view that ultimately turns out to be right, but could end up losing a lot of money if you get the timing wrong. Take the well known story of a wealthy Australian investor who, in the mid 1980s, (rightly) thought shares were heading for a fall, but lost a fortune because he shorted the market too early and by the time he had to buy the shares back they had actually gone up further in value. Of course a little while later we had the 1987 share market crash. There is often a big difference between being right (ie, getting some sort of forecast right) and making money, and many investors just dont realise this.

In the 1970s, a US investment professional named Charles Ellis likened share market investing to playing a losers game. A losers game is a game where bad play by the loser determines the victor. Amateur tennis or boxing after several rounds are examples of losers games, where the trick is not to try to win but to avoid making stupid mistakes and thereby win by not losing! Investment markets are fickle, sometimes rational, but sometimes far from it and highly seductive, and thus are a classic losers game in which the winners win by simply not making stupid mistakes. Thus for many, the best approach to investing is to adopt and religiously follow a long-term strategy consistent with ones objectives. However, for those who want to take a more active approach and who are prepared to put the effort in, the next few rules may be of interest.

2.  Have a disciplined process

This is absolutely essential for investors who want to move away from a long-term strategy and become more actively involved in timing investments into and out of markets or stocks.

This should ideally rely on a wide range of indicators - such as valuation measures (whether markets are expensive or cheap), indicators that relate to where we are in the economic cycle, measures of liquidity (or some guide to the funds available to come into markets), technical readings based on historic price patterns for the share market, exchange rate or whatever (the evidence suggests there is value in such analysis) and measures of market sentiment (the crowd is often wrong - so if everyone is bearish that is likely to be a good sign and if everyone is bullish that is likely to be a bad sign).

The key to having a disciplined process is to stick to it and let it filter all the information that swirls around financial markets so you are not distracted by the day-to-day soap opera that engulfs them. The huge flow of information often confuses rather than aids any investment decision making. And most of it is just noise anyway.

The problem is that having a disciplined process to actively manage investments can be costly and time consuming and well beyond what most investors are prepared to do.

3.  Remain open minded and flexible

Markets regularly prove even the best investors wrong. One should constantly consider contrary views and test them against your own. It is useful to have some form of stop loss. In the past, I have ridden losing positions too long based on arrogant confidence I will be right (because a forecast says so). A stop loss (either in the form of a formal sell order to reduce/cut a position if the market goes through a particular level contrary to your own position or just a trigger for a review) is useful in forcing investors to consider whether they are on the right track or not.

4.  Know your self and check your ego

Smart investors have an awareness of their psychological weaknesses and seek to manage them. Examples of these include over-confidence, the tendency to overreact to the current state of the world, the tendency to look for confirming evidence, and any innate bias towards optimism or pessimism. A key to successful investing is to leave your ego at the door. You cant expect to be always better than the millions of investors who make up the market.

Conclusion

It is tempting to think that it is easy to outperform the market or perfectly
time moves into or out of it over time. But it is never that easy. For most investors, the best approach is to respect the market and have a long-term strategy and stick to it. For those who want to delve more into active management of their investments, it is essential to have a disciplined process, to remain flexible and to know and control your psychological weaknesses.

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