Capital Growth Theory: how to maximise your long-term wealth

Position sizing

If you’ve ever played blackjack at the casino you’d be familiar with the concept of bet sizing.

You don’t bet the same amount regardless of your hand; instead you aim to place larger bets on high probability events.

Here’s a very simple formula where ‘p’ is the probability of winning, expressed as a percentage, and ‘x’ is the position size:

2p – 1 = x

It’s very logical: if you’re less than 50% certain of an outcome then that’s no better than a coin flip and you shouldn’t bet, whereas if you’re 100% certain of success then you go all in!

Of course, in the real world few things are 100% certain, and when it comes to investing you’ll need to adopt a different and more conservative stance.

Capital Growth Theory

If you want to maximise your long-term wealth from investing then you can think of your strategy as a series of repeated similar bets.

The Kelly Optimization model can help you to determine what fraction of your available capital should be allocated to a new investment.

The advantage of the Kelly model is that it maximises your long-term gains, and can help you to minimise losses.

As a general rule, where there’s a reasonable margin of safety, you can maximise returns by increasing your exposure, but this only works up to a certain point.

For one thing, no outcome is certain, and you also shouldn’t over-bet as there will always be other great investment opportunities in the future.

For this reason, many investors choose to use a fractional Kelly strategy to manage risk.

The traditional view

Capital Growth Theory differs from the traditional Modern Portfolio Theory (MPT) taught in business schools.

In the real world we don’t have to invest all of our money today, or indeed in any given market.

Unlike a fund manager, an individual is not bound by a mandated asset allocation, the demands of nervous investors, or the need to benchmark against an arbitrary index or other measure of returns each year.

And since some markets are much cheaper than others, we can use this information to our advantage.

Most investors aren’t very good at stock picking – it’s surprisingly challenging to get right over time – but these days you can buy country or sector ETFs, so you don’t necessarily need to be.

What we’re really interested in is maximising our wealth for the long term, and there will be numerous wonderful investment opportunities in the future to help us achieve that goal.

The Kelly capital growth strategy is the approach that’s mathematically proven through simulations to maximise long-term expected wealth.

Variations of Kelly strategies are used by some of the wealthiest and most successful investors of all time, including Jim Simons, Bill Gross and others.

Thinking in bets

When you contribute to your superannuation fund a portion is invested in the markets regardless of the environment, according to the fund’s allocation.

It’s often noted that super funds don’t beat the market, but when you think about it that’s not really what they’re setting themselves to do.

Super funds generally track the fortunes of the market, and the name of the game is maximising assets under management (and their fees), not your long-term wealth.

To a certain extent institutional investors are the market these days, so in aggregate fund manager returns lag the market due to the fees and transaction costs.

But those of us managing our own money strategically as a series of bets know that the odds of success are considerably higher when markets are attractively priced.

Impressive and substantial gains are achievable, provided you practise careful risk management, although there may be more volatility in your portfolio from month to month.

Indeed, using a Kelly capital growth strategy can see your wealth exceed that of any other strategy, and by more and more as the horizon becomes more distant.

Next we’ll take a look at the Kelly Optimization model in action.

To find out more about our coaching programs see here.

The benefits of effective asset allocation

Asset allocation

If you see your financial advisor they’ll likely recommend that you allocate your assets between property, stocks, and cash (partly due to the tax incentives for real estate and equities in Australia).

That’s because all asset classes have summer and winter seasons.

Source: Novel Investor

Sensible asset allocation can help you to adopt a disciplined, long-term approach to building wealth, while helping you to see the big picture.

And while one asset class isn’t delivering another might be, so this can bring smoother risk-adjusted returns to your portfolio.

However, because of increasing globalisation over the past 30 years or so, certain asset classes may have increased in their correlation, so it may not be quite as simple as it used to be.

Source: Novel Investor

Still, asset allocation remains an important investment principle that we use to minimise risk and maximise our investment returns.

Asset allocation and timing

The legendary football player and then coach Knute Rockne once said:

‘As a coach, I play not my 11 best, but my best 11.’

This is also how you should think about your portfolio.

Even if equities are the best performing asset class over the long term, your timing is still important.

Closer to home, astute asset allocation is aptly demonstrated by Australian residential property in Sydney and Melbourne booming while the ASX meandered back and forth. 

Asset allocation – in two parts

(i) Macro allocation

This simply means dividing your funds between your chosen asset classes, and partly because of tax incentives in Australia this allocation is normally dominated by stocks and property.

We can also include cash and bonds as they can be useful asset classes for protecting capital.

Since we understand market cycles, we believe there is ample evidence to show that moving between asset classes at the macro level can increase your returns.

For example, investors in Sydney in 2011/12 made excellent investment returns simply by choosing property when it was on the cusp of a large increase.

The same can be done for stocks using market cycles and the CAPE ratio.

With the advent of ETFs, which allow us to buy country indexes, US sectors, and styles, we can use the cycles to increase our returns.

When stocks are cheap, you should consider allocating more of your funds to stocks in order to gain from the increased returns on offer.

When stocks are expensive and offering minimal or below-average returns, then you should pivot to alternative asset classes such as property or cash.

Remember, cash has an important role to play because it’s uncorrelated with stocks, it gives you a safety buffer, and it gives you the optionality to buy stocks when they do become cheap.

(ii) Micro allocation

Micro allocation is how we divide our funds once we have determined our macro allocation.

An example will suffice.

Let’s use US sector ETFs, where we might be looking to invest in the most out of favour sectors.

Then we would go on to look at the CAPE ratio for each sector.

You may choose three methods to invest:

  1. Invest in all the out of favour sectors equally because while some investments will seem more appealing and appear to have more potential, you can’t always be sure; or
  2. Invest in all sectors but adjust the initial amounts according to some indicator (you may choose a greater weighting based on market cycles and where the sector performs best in through the business cycle); or
  3. A judgemental selection of sectors – we believe this is a sound approach as it allows you to adjust your allocation according to our 8 timeless principles (for example, mean reversion and CAPE ratios)

Under this method, you would select those sectors that have the best expected returns.

We often favour buying the bottom three performers (‘the losers’), and then allowing mean reversion to play its role in delivering solid investment returns.

Notice how over an extended period that no one sector dominates, and so they swap positions.

Leaders become laggards, and vice versa.

Many investors over-allocate or allocate the full 100% of funds rather than keeping some cash allocated against the stock.

This is often done because you think the opportunity is so good.

So many folks leave themselves no wriggle room or opportunity to buy after their initial allocation.

However, it’s more prudent if you choose $10,000 as your potential allocation, to initially spend $5,000 and hold $5,000 against it in cash.

After all, none of us is clairvoyant – we can’t pick the bottom of the market precisely – and so it pays to keep some of your powder dry in case the price sinks lower.

This can often be the case because you are buying when the sector or country is out of favour – but remember that is when the best returns are on offer.

Cash is (sometimes) king!

Cash is uncorrelated to equities, and is important for several reasons.

Firstly, cash gives you options.

As Warren Buffett said, holding cash is painful but a lot less painful than making a dumb investment decision and losing money.

Although we can’t predict what future opportunities may arise, cash allows you to take advantage of them when they do.

Secondly, having cash against each stock allows you to add additional funds if the stock falls.

We’ve found this to be very reassuring psychologically.

We have the knowledge and emotional comfort of having cash available should the stock price fall, and so we can put our cash to work and realise that we are reducing our average entry price as the stock falls.

And over time you will find that holding cash (which does at least earn a small amount of interest) helps you to outperform the market.


Remember: Markets can be volatile!

And this volatility can be your friend because it throws up opportunities.

Holding spare cash gives you a greater range of options to add more stocks during those intra-year declines.

Stock markets can fall 20% to 40% in a very short space of time, and if you have cash, you can take full advantage of these falls.

Even better, when the CAPE ratio is low – and by now we hope you are realising what type of market and where in the cycle you are presently – it is important for asset allocation.

You can adjust your asset allocation according to the expected return.

Expected returns are not an exact science, but in general, we know that when the expected return is high, you should consider increasing your initial allocation.

So if the expected return is high (as happens when asset classes are cheap and out of favour), then you may, for example, start with a 70% allocation and hold 30% in cash.

To find out more about our coaching programs see here.

Why you should adopt systematic investing

Why you need a system

Having a system is important because it guides you to follow successful habits, until eventually, you make successful decisions intuitively.

Too often people start out in business or investing without systems, and this leaves them exposed to mistakes and errors.

There’s an old rule of engineering that says if something can go wrong it eventually will.

The same line of thought can be applied to your investment strategy.

As such, you need a system to protect yourself in all markets.

A consistent routine of good habits will set you up in the best possible stead for a successful life, and investing is no different.

Avoid gut feel and hunches

Think about this statement:

‘I always decide to buy and sell my stocks by gut feeling because I think my emotional state is critical to my success as an investor.’

If you don’t agree with this statement, then you must have a system of some sort.

If you don’t have a system, on the other hand, then we’re afraid to tell you, this is effectively the way you invest!

Buffett’s sidekick Charlie Munger says that although investing is simple it is not easy, and if you think it is, then you are stupid (no offence intended, we’re sure!).

Having a system can help to make you less stupid in the markets.

Which system of thinking do you think works best in the markets?

Source: Daniel Kahnemann

What is systematic investing?

Systematic investing is where you have developed a rational process that contains ground rules and signals for buying and selling stocks.

Systematic investing is important because its primary aim is to assist you in your decision-making process.

That is, avoid using your gut instincts.

We can pick an inexperienced investor from an experienced one simply by determining whether they have a system.

Most inexperienced investors buy and sell based upon hunches.

Yes, they’ll make money sometimes, but usually, they lose or underperform overall because they let emotions such as greed and fear dominate their decision-making.

Experienced investors may appear to make snap decisions intuitively, but that’s most likely because they’ve followed their system for so long they instinctively know what to do.

Success in investing over time is more about process than outcome.

A good process will not mean all your investments are winners.

After all, every investment involves a mixture of skill and luck.

You can’t control luck, but you can control your skill and your process.

Sticking to the system

Now simply announcing to the world that you have developed a set of buy and sell rules does not make you a systematic investor.

But sticking to it does!

When you find yourself itching to buy or sell an investment, go back to your system.

Does it comply?

Or are you making your decision based on a fear or greed type basis?

Are other investors influencing you?

Developing a repeatable system takes time.

You will likely go through phases where you favour one approach over another, especially when your ‘system’ appears to be not working.

Nothing makes you question your system like having a bad run!

It’s amazing how suddenly you might think technical analysis or fundamental investing could be the answer.

If you think deeply about your approach and develop your own system, then investing will become easier because you will not be ruled by emotions.

Actioning a systematic approach

It’s really all about the process.

If you have a flawed process, then you are simply bound to repeat your mistakes.

You would be surprised though to understand that it is usually the last thing we choose to inspect when a decision ‘goes against us’.

It’s natural to look externally for blame rather than internally.

And in some cases, it will be an external issue, that results are a failure, not your internal process.

But if the process is right, then you will win more than you lose.

To find out more about our coaching programs see here.

Applying our 8 timeless principles

Nothing new under the sun

Fads will always come and go in markets, especially during bull markets.

The problem with many such strategies is that they only work when the market is going up, but then all hell breaks loose when the market crashes.

‘Only when the tide is going out do we found out who is swimming naked’ as one famous investor sagely put it.

In other cycles markets drift lower for years or even decades, leading many to similarly underwhelming results.

When markets are rising almost anything seems to work, and therefore comparatively little rigour is applied by most investors to their process.

Timeless investment principles, on the other hand, can be applied to any asset asset class at any time, whether you’re investing today, or ten years from now, or even a thousand years from now.

We’ve brought together a timeless investment strategy which you can use at any time, to continue to compounding your net worth at wealth-producing rates of return.

The 8 timeless principles

It’s important to adopt a systematic approach to investing, otherwise everything is prone to collapsing in a heap at the first sign of distress.

We use the principles to develop a systematic approach, which ensures that you stay on the right track and avoid becoming tempted to drift.

The simple big idea is to use our 4 thought principles (systematic investing, market cycles, personality, and the risk hierarchy) to think about investments before you invest.

Here, then, are our 8 timeless investment principles that you can apply at any time, in any markets, to any asset class (there are already posts on each of these principles – follow the links below for a little more colour):

4 thought principles

(i) Systematic investing – if you don’t have a systematic approach to investing, then on a long enough timeline eventually something will not go as planned and you will fail. Plan accordingly;

(ii) Personality – there are 9 different personality types, and we all have our own motivations, strengths and weaknesses. Understanding your personality type and dominant beliefs will help you to invest with less emotion and more rationally;

(iii) Market cycles/mean reversion – market sentiment swings higher and lower over time, but over time valuations have tended to revert to an average or mean level; and

(iv) Risk hierarchy – some investments (e.g. individual companies) may entail a greater risk of permanent loss of capital than others (e.g. an all-World ETF that holds more than 1,500 stocks).

4 action principles

(v) Asset allocation – consider investments in uncorrelated assets. For example, cash and stocks are uncorrelated, so you might split your capital between these assets;

(vi) Buy low/sell high – exactly what it says on the tin! Buying low and selling high is a timeless strategy for all markets and all asset classes;

(vii) Diversification – there are several ways to diversify, including across multiple investments, by investing in products that are themselves diversified, and across time by carefully staging your entry to investments; and

(viii) Rebalancing – a critical part of any investor’s armoury, to ensure that you are never over-exposed to any single investment position. Rebalancing helps to manage your risk and can improve your returns over time.

Applying the principles

Individually, each of the 8 timeless principles is coherent and very logical.

But their true power becomes apparent when they’re all applied together to give you a robust framework for making money consistently in all markets (and especially when markets are going awry).

Applied properly these 8 principles may lead you to the holy grail of investing: higher returns with lower risk.

To find out more about our coaching programs see here.

Personality goes a long way

It takes all sorts

When it comes to investing the dominant line of thinking seems to be that we’re all sensible and coolly rational people.

And yet, we should know that when it comes to financial decisions this is not the case, and it could be one of the most damaging beliefs in investing.

We all experience a range of emotions every day – love, sadness, happiness, anger – and there’s no reason it should be any different when it comes to money.

Markets continue to cycle, driven by groupthink and the human emotions of fear and greed, and those without a systematic approach are routinely punished with cruel results.

The 9 types

The Enneagram is a model of human psyche which is understood to identify 9 interconnected personality types.

During our coaching programs we find that we come across the same three personality types very often, because these are the personality types which place a value on money.

The three types we most commonly see are type 3 (achiever/performer, driven by the need for significance), type 5 (thinker/observer, driven by a desire for financial security), and type 7 (enthusiast/epicure, motivated by adventure and freedom).

Sometimes we have one dominant personality type, with a second personality type ‘wing’.

We’ve developed our own personality assessment you can take for free, which leads to your own investment map (see at the end of this post for details of how to get your free investment map).

The risk/reward trade-off

Stock markets are all about the risk/reward trade-off.

Some of us are brave and carefree and happy to take risks if we believe the rewards are there.

These folks tend to be classified as risk-tolerant.

Others who are more cautious and focus on the risk side of the equation would be deemed more risk-averse or conservative.

The truth is it’s a continuum, rather than specific points.

For example, when you go to a financial advisor, they will ask you about your risk level as it’s an important aspect of developing your investment strategy.

However, most of us know little about our innate risk level and usually only understand more when we have some context.

We answer the question on risk along the lines of ‘about the same as most people’.

The problem here is twofold.

First, your risk level may be high or low because of your personality, but we aim to show you that should not play a large role in developing an investment strategy.

The simple reason for this is that when the stock market is cheap, you should – if the cycles are understood properly – increase your investments rather than reduce them.

You should like low prices because this means there’s a high likelihood that future returns will be good.

The other problem relates to timing.

In the midst of a stock market crash, most people believe themselves to be risk-averse rather than risk tolerant.

In other words, emotions can run high, clouding calm and rational judgement.

Elements of decision-making

There are two major elements to your decision-making.

One is your personality, and the second is the influence that your family, friends and the wider society play in your decision-making.

Although we tend to have much in common, whether we like it or not we all have our own strengths and weaknesses, quirks and foibles.

For this reason, it’s important to understand your personality type and have an investment map which allows and compensates for your potential risk areas.

Free assessment & investment map

You need to take a calm and rational approach to investing.

Although relying on gut feel may pay off once or twice, eventually you will get found out if you don’t have a systematic approach.

As the old saying goes, the stock market is an expensive place to find out about yourself!

To get your free personality assessment and investment map send us an email at one of our addresses below:

To find out more about our coaching programs see here.

The benefits of diversification

Broken glass

When I was growing up we were obsessed with backyard cricket, which was a bit hairy because the back of our house had a door with a very large glass window pane.

Well, you can guess what happened.

I’d have liked to explain to my old man that if there’d been lots of smaller window panes instead of one large one the repair bill would’ve been cheaper, but funnily enough he wasn’t in the mood for that conversation…

Eggs in multiple baskets

Diversification is one of the most resounding mantras of investing, and most of us like to hold a balance of uncorrelated assets, including property, Aussie stocks, international stocks, and cash.

Diversification can help to minimise the risk of loss, and preserve capital, and it can help to generate returns by giving you exposure to multiple investments.

There are a number of ways to diversify within stocks, including holding a range of separate investments, investing in products which are themselves diversified (such as country or sector ETFs), and diversifying over time by staging your entry to an investment (because even a cheap investment can always get cheaper).

The home bias

Most people like to invest in assets that are close to home, both for property and stocks.

There’s some psychological comfort in being able to drive past a tangible real estate investment.

But given Aussie stocks might make up just 2-3% of global indices, it’s not so rational that we invest so heavily in our home index.

To be fair, over the past 120 years the Aussie stock market has been one of the strongest performers, but in reality that kind of timeframe is irrelevant to any individual investor, and it’s future returns that we’re interested in.

Thus when local stock market returns look set to be low, it makes sense to consider international markets.

Closer correlations

The old assumption was that the stock markets of countries around the world were not closely correlated at all.

But the world has become more interconnected since the 1980s, and the global financial crisis showed that international markets may be more closely correlated than was previously thought.

When the poop hits the fan everything correlates to one, as the saying goes!

There’s a growing need, then, to pay attention to how well diversified you are in your stock portfolio.

If you look at a ‘quilt’ of returns from developed markets, you’ll notice that they do tend to move together to a certain extent, even if the annual returns differ.

Given that the US might account for around half of the value of global stock indices by market capitalisation, it’s unrealistic to expect that a crash in the US wouldn’t impact all other markets (and Australia isn’t immune, as we saw when our market crashed in 2008).

Diversification in practice

Yes, there’s still a correlation between markets, but generally, the CAPE ratio shows that countries (and indeed individual stocks) that are already cheap do not fall as much as their higher priced compatriots.

In a globalised world it’s critical to watch what is happening in – and the valuation of – the US market.

It’s folly to believe that a whale of a market will not impact the large number of minnows.

When the US is expensive (as it is of the time of writing), it’s prudent to reduce your exposure to markets that may be more expensive than their average CAPE ratio.

You should not, however, avoid all investing because the US is expensive.

If you invest in overseas markets by taking a long-term approach, you can, for example, purchase large-cap systemic type stocks that pay a reasonable dividend, or you can focus on ETFs and diversify across countries, sectors, and styles that are cheap.

Combined with the principles of asset allocation and rebalancing, we can succeed in generating solid returns in a low interest rate environment, even while the US market is expensive.

When the next US correction comes around, it will bring other developed markets down with it, and you will have some dry powder (cash!) to capitalise on the wonderful opportunities that such corrections always bring.

To find out more about our coaching programs see here.

Reversion to the mean

Market cycles

Stocks don’t always go up, they continue to move in cycles, in turn becoming expensive and then cheap.

New ideas gain currency driving markets higher on the promise of future riches, until eventually the products and companies in question fail to deliver, whereupon valuations fall back to earth (often faster than they went up!).

Bear markets follow bull markets, and vice-versa, so with the benefit of hindsight it’s clear to see that when the market has been smashed that’s your cue to buy.

Source: Advisor Perspectives

Fortunately, in the real world nobody invests all of their money at the market peak, and this doesn’t mean there’s no place for passive investing.

However, it is possible to generate better than average returns through the cycle, by recognising…

Macro valuations

There are many ways to determine whether a market is historically cheap or expensive, none of which can be totally reliable in isolation.

One of the more robust measures has been the Shiller PE or CAPE ratio, since it uses a smoothed average figure for earnings to iron out volatility and fluctuations in profit margins.

Although lower interest rates than in cycles past may somewhat justify a higher market valuation, the CAPE ratio has only once been higher than it is today, in the lead up to the tech wreck.

One of the challenges with using such ratios to predict cycles, is that – as you can see – crashes have happened from much lower valuations, while bull markets can also run for longer than you think.

Market timing

The above conundrum could lead you to the conclusion that trying to time the market is impossible or pointless.

On the other hand, there’s well over a century of available data to suggest that money invested when markets are cheap delivers outsized returns, while money invested at expensive valuations typically delivers only modest or negative results.

Source: Paul Claireaux

It’s also important to consider risk, since market drawdowns have, on average, been greater when markets are at an expensive phase in the cycle.

Managing exposure

Famous investor John Templeton said that the only investor that shouldn’t diversify is the one that’s right 100% of the time, and his approach was to reduce his allocation to stocks when markets became expensive.

Source: Meb Faber

A workable alternative approach is to hold some cash and look elsewhere for markets, sectors, and companies showing more attractive valuations.

Each stock market has its own cycle, and although markets have moved in a more synchronised manner since the 1980s, there’s sound evidence to show that investing on a global basis can be very positive for your portfolio.

To find out more about or coaching programs, see here.

Understanding the risk hierarchy

The lifespan of companies

When you look back at lists of the top companies from 20, 30, or 40 years ago, it’s nearly always remarkable how few of them are still at the top of the tree (or even around at all!) today.

But where do they all go?

Well, some get taken over by Aussie companies, others are bought by foreign businesses, some are merged, and many become worthless and are de-listed.

Source: Cuffelinks

Like you and me, companies have a lifespan.

They are born, they grow, then they fade away, and one day they die.

Unlike well-located land in a capital city, which might be expected to have a near-infinite economic life, a company might not be around a decade or two from now.

This can present a quandary for investors.

What if you’ve missed the growth phase and have bought into a company that’s now slowly dying?

Lifetime returns

History suggests nearly 2 out of every 5 stocks might prove to be a loser, while 1 in every 5 stocks could see you lose dramatically.

Given we know that becoming wealthy over time is about not losing money – to compound your net worth – this presents investors with a real problem.

Partly due to the tail risks, it’s surprisingly tough to pick a portfolio of stocks which consistently outperforms the averages, year in and year out.

The rise of indexing

The good news is that it’s now easily possible to invest in low-cost index funds which will generate roughly the same return as the benchmark index.

Some companies in the index will inevitably fall upon hard times, but these will drop out of the benchmark index to be replaced by others, and your investment lives on unharmed.

The index returns may be lower than for any given individual company, but so too is the risk.

The risk hierarchy in practice

These days investment products come in all shapes and sizes, each with their own level of risk.

For example, a diversified global ETF probably sits towards the lowest end of the risk spectrum, followed by country ETFs, then sectors.

As we’ve already seen individual companies typically carry a greater risk of permanent loss.

Note that it’s still entirely possible to apply our 8 timeless principles to invest in individual companies.

But to do so safely, it’s typically less risky to look at large, well established, systemic companies, with modest gearing and a decent track record of profitability.

Of course, investors can and do still lose money investing in ETFs and index funds, which is why we suggest that you look for value, to buy low and sell high.

And although ETFs are usually considered to be diversified products, you should still spread your risk across a range of investments.

Since even a cheap index can get cheaper, staging your entry to an investment is a sensible third way to diversify and reduce risk (a fourth way is to hold some cash as a buffer and for its optionality).

Remember, becoming wealthy is about not losing money, so think of your strategy as a series of bets with that core principle in mind.

To learn more about our coaching programs see here.

Sequence of returns: risks and opportunities

Don’t be average…

If someone told you to cross a river because it’s 4-feet deep ‘on average’ you’d be justifiably upset if it turned out to be 8-feet deep in the middle with strong cross-currents.

It’s a bit the same when it comes to so-termed ‘average returns’ from investments.

It’s often said that you might expect 7-8% returns from markets on average, but that’s not much use to you if your parents got 16% and you get zero!

Plenty of investors fail to make any worthwhile returns at all from the markets, so we want to make sure we’re on the other side of that trade.

Sequence of returns

The sequence of returns risk is normally something of concern to retirees, and in particular as it relates to the risk of running out of money if markets run against them in the early years of retirement.

The graphic below shows two retirees with the same average returns (in fact their annual returns are identical, but in reverse order).

Surprisingly, over 25 years one retiree ends up broke, while the other generates outstanding results and is sitting on a handsome pile:

Fortunately there are a number of ways to mitigate the sequence of returns risk in retirement, but investors earlier in their journey should take note of this slide regardless.

And that’s because it illustrates how misleading the concept of average returns can be.

Average vs. geometric returns

The range of returns you get has an impact on your results.

For example, three periods of 5% returns delivers a better result than any other sequence of returns that averages 5%, and the greater the volatility the more detrimental this is to the final outcome.

More pertinently, negative returns can have a far greater impact on your end result than intuitively seems reasonable.

For example, if the market falls 20% in one year and then rises 20% the next, then you lose 4% of your capital, even though the average returns appears to be zero.

Remember, the geometric return is what you get, not the arithmetic average:

What the simple graphic above shows is that money invested when the market is too expensive can fail to deliver solid returns over a very long period…even when markets have been rising for most of the past 10 years.

Transfer of wealth to the patient

This is why Warren Buffett said that rule #1 is don’t lose money.

Because by being patient and investing for value in markets that are cheap, you can continue compounding your wealth at a considerably faster rate.

And, due to the nature of compounding, this can make a very substantial difference to your wealth over time.

The stock market is a no-called-strike-game, and you don’t have to swing at everything (or indeed, anything).

It’s also not a race to invest your money immediately in anything that moves (although investment advisors and groups will always produce evidence to ‘prove’ that you must invest everything right now…today).

Remember, the sequence of returns matters.

To find out more about our coaching programs see here.

Time in the market, or timing the market?

Nobody knows anything

Although we like to weave convenient narratives to explain history, the belief that life is linear and predictable can be a dangerous fallacy.

In real time, the world is random and unpredictable, and heavily impacted by rare and totally unpredictable outlier outcomes, known as ‘Black Swan’ events.

The dirty little secret of economics is that forecasters can’t predict the future reliably, and certainly not complex and volatile markets.

Economists confidently expected the Aussie stock market to finish 2008 at around 6,500, for example, but instead it ended the year closer 3,500.

When expert predictions can be as wildly inaccurate as this, it may be wise to treat forecasts are mere entertainment rather than something to build a strategy around!

Asymmetrical bets

An investment strategy is effectively a series of bets.

Given the world is unpredictable and prone to randomness, investors should consider seeking bets with more upside than downside.

It’s also wise to avoid investment strategies which are akin to picking up nickels in front of steamrollers.

In business, investment, and life, we should remain paranoid about negative Black Swans; but we should also actively seek exposure to positive Black Swans.

From an investment perspective, when there’s limited downside you can afford to be somewhat more aggressive.

Dollar cost averaging

A popular alternative approach to timing the market (buying low and selling high) is known as dollar cost averaging (‘DCA’), whereby a set dollar amount is invested in the market each month or quarter regardless of market conditions or price.

This buy and hold strategy is based on the assumption that markets will move higher over time, which history suggests is probably true (though sometimes there will inevitably be long periods with no real returns).

The most important thing to note about such a strategy is that you mustn’t abandon it when the outlook starts getting hairy!

Following the Wall Street Crash of 1929 the Dow Jones index fell by 89% from peak to trough, while a notional portfolio of $500,000 dropped to $75,000 in a single year (1930).

The market did recover its lost ground eventually, but it took until 1954 to do so.

Long periods of nil or negative real returns have also been a characteristic of Aussie stock markets, even inclusive of dividends:

Source: Philo Capital

This doesn’t mean that DCA can’t work, but it does show that when market valuations become expensive a long period of zero or negative real returns is quite possible (if not likely).

Volatility does not equal risk

Our ‘buy low sell high’ approach is relatively agnostic to forecasts, predictions, or the economy, and we don’t worry unduly about unforeseen events or market crashes.

In fact, we positively benefit from such volatility because market crashes throw up great buying opportunities.

Back to the question in the blog post title: time in the market, or timing the market?

The answer is that it depends on the phase of the market cycle that we’re in.

When your favourite markets are cheap (2009-), time in the market tends to work just great.

When valuations are high (2020-) then it makes sense to cast the net further afield to look for opportunities to buy low.

Of course, it’s true that it’s impossible to time markets perfectly, but that’s not the point, and, importantly, nor is it necessary.

The good news is that it’s a big world out there, and it’s more than possible to identify cheaper markets to invest in.

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