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.

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To find out more about our coaching programs see here.

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.

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To find out more about our coaching programs see here.

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:

pete@gonextlevelwealth.com.au

steve@gonextlevelwealth.com.au

To find out more about our coaching programs see here.

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.

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To find out more about our coaching programs see here.

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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.

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.

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.

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.

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

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.

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.

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To learn more about our coaching programs see here.

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.

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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To find out more about our coaching programs see here.

The magical benefits of rebalancing

Suppose one of your investments shoots 40% higher.

What are the chances of it doing so again soon?

Not impossible, of course! But also unlikely.

Too often investors experience exciting results, only to undo all the good work by giving back most or all of their paper profits.

As Benoit Mandelbrot said in The (Mis)Behaviour of Markets:

‘Take a profit’.

Rebalancing: a stylised example

For the sake of simplicity, let’s say you have $100,000 and decide to begin with a 50/50 allocation to stocks ($50,000) and cash ($50,000).

We wouldn’t recommend it, but suppose you make a dreadful mistake and decide to invest immediately before stocks crash 50%, dropping your portfolio down to $75,000.

To rebalance back to a 50/50 allocation you take $12,500 from your cash to buy more stocks, so that you have $37,500 in each pile.

And then the stock market bounces, rising by 100% back to where it started.

Although the stock market has taken a round trip to nowhere, you have a portfolio of $112,500 and a profit of $12,500, while the buy & hold investor still has $100,000 before accounting for dividends and inflation.

Of course, this is an unrealistic and stylised example – and when stock markets are cheap you may well want to be more than 50% invested – but this oversimplified example shows how rebalancing can help you both to manage exposure/risk and capitalise on great buying opportunities.

What a Turkey!

Let’s take a look at Turkey, a volatile emerging market that’s delivered handsome pickings for us in the past.

ETF returns range from a tremendous 126% in 2003 (dinner party bragging rights!) to a gut-wrenching 62% loss in 2008 (the sort of year where greedy investors undo all of their previous good work).

Rebalancing helps you to limit the destruction that years such as 2008 can do to your portfolio (in fact one of our timeless investment principles concerns macro valuations/mean reversion, ensuring that we’re not exposed to such expensive markets, though that’s not the point we’re making in this post).

Importantly, practising rebalancing also means you pocketed some of the handsome returns from the preceding years of 126%, 42%, 57%, and 75%.

It also means that you have cash available to invest after the crash, so you almost doubled your money again on the rebound in 2009, when the market surged 99% higher.

Source: Novel Investor

This example is not just hindsight bias and cherry-picking figures; it’s making an important point.

Because of the interplay between momentum and mean reversion, you must take profits off the table at the highs and put them back in at the lows, both to manage risk and to maximise returns through the cycle.

It’s always tempting to hold onto winning investments for longer, but this risks giving back all those hard-earned gains.

And always remember the detrimental impact of negative numbers on compound returns: a 25% gain is completely erased by a 20% loss.

So, take a profit!

Managing exposure

Professionals rebalance their portfolios to manage risk, and you can too, either on a percentage basis or on a time basis.

Rebalancing systematically on a calendar basis may be easier, as it’s often psychologically hard to sell winners due to the inevitable bragging rights attached.

You can rebalance your portfolio weekly, monthly, quarterly, or annually if you wish, and this simple practice can force you to buy low and sell high.

Remember the famous quote from Bernard Baruch:

‘I made my money by selling too soon’.

You can find out more about our coaching programs here.