5 axioms every investor should remember

24 Oct 2018

investorThe following are a set of principles every investor should remember before starting long-term investing:

Number 1: You can never start too early
Albert Einstein may not have said that compound interest is the 8th wonder of the world, but it is a good motto to remember. If someone started a pension for their 3-year-old, and assuming a return of 4% a year, this means that the sum doubles in 18 years, quadruples in 36 years and rises eightfold in 54 years. You can look at it another way: say you have a set sum in mind for retirement, if you start saving at 20, you need to contribute only half as much money a month as you would have if you started at age 30.

Number 2: Risk and reward are related, but do not think the latter is a guarantee
In financial theory, academics like Harry Markowitz developed sophisticated explanations for the link between risk and return. This is where we get concepts such as the capital asset pricing model (CAPM) or beta, a security's riskiness relative to the market. Risk however, is measured in terms of short-term volatility. It is assumed that if you hold a risky asset long enough, you will eventually get rewarded. However, this this is not the case when you start from a high valuation—think of Japan in 1989 or the Nasdaq in 2000. Britain's FTSE 100 index is barely higher than it was at the end of 1999. A positive nominal return could have been earned from dividends, but the real return this century from UK equities has been only 1.9%; real return from bonds 3.2%. Risk is not about volatility, it is about loss of capital. That is why investors should always have some money in cash or government bonds.

Number 3: Long-term returns are likely to be lower from here
Even if equities do not perform as badly as in Japan since 1989, they are still likely to earn lower nominal returns from here - this is just maths. Short-term rates and long-term bond yields are low in both nominal and real terms. The return from equities is a "risk premium" on top of those rates. There is no plausible reason why the risk premium should be a lot higher today. The London Business School team of Dimson, Marsh and Staunton think it is currently 3.5%. Based on a return to mean valuations, GMO forecasts negative real returns for all equity markets, bar the emerging ones (the same goes for bonds). Realistically, U.S. pension funds that think they are going to earn 7-8% are deluding themselves.

Number 4: Diversify globally
A lot of statistics about long-term performance are derived from America, which was the great economic success story of the 20th century. This, however, is an example of survivorship bias. Back in 1900, people might have thought that Russia or Argentina would do just as well, or better. It is tempting for Americans to think that they do not need to invest abroad - most of the tech giants are based in the U.S. The Japanese, however, might have seen no need to invest outside their home market in the late 1980s, after its phenomenal post-war performance. The U.S. market is more than half the MSCI World Index - it will not last. Diversifying protects the investor against currency risk and political mistakes. Economic power is shifting towards Asia (where it resided before 1500), where more than half the global population lives.

Number 5: Do not specialise too much
The current fashion today is to create thousands of different funds, covering ever smaller slices of the market. There has even been  ETF investing in ETF providers. Unless you are an investment professional who has researched the area extensively, you do not need this nonsense. It is also wise to be wary of new investments that simply claim to be uncorrelated. This could just mean that they do not rise in value when everything else does. The return from investing in equities is a share of profits, whilst the return from bonds is the risk-free rate plus credit risk. It is not at all clear what the return from investing in volatility should be, (if investing in cryptocurrencies, make sure it is only a small portion of your investment), there may well be no expected return from them at all.