The first step is to analyze your feelings and reactions to investment risks. Risk varies widely from one type of asset to another and our tolerance varies accordingly. Some are very tolerant to price volatility while they value liquidity highly (more suited to investments in equity), and some are more tolerant to credit risk and are prepared to spare the money over long periods (for whom investments in bonds, unlisted companies, or real estate are more suitable).
No matter what assets (or asset mix) you prefer you will need to establish your investment strategy, and make sure you’ll be able to stick to it when things don’t go exactly as expected. Strange as it may seem, investing is a long-distance race.
However, investing is not all that complicated: there are only 3 ways to invest, no more. All combinations of investments boil down to one (or a mix) of the following three options:
- Lending your money at an interest (time deposits, bills, Government bonds, corporate bonds, etc.),
- Investing your money in a company to share in the profits (listed or unlisted stock, etc.),
- Buying commodities or durable products, resilient to the effects of inflation (urban real estate, precious metals, –other commodities may be quite risky– energy, consumable goods, etc.).
And now, all you have to do is monitor the behavior of the assets in which you are invested and, most important of all, judge if you will be able to bear price variations, to avoid making the wrong decision in circumstances when your heart takes over reason.
Making the right investments won’t make you successful: no asset whatsoever will behave in a linear way, and setting yourself such a complicated target would be naïve. Success will depend on making sure you chose the right investments and avoiding making wrong decisions moved by emotions. Fear and greed, will both make you lose money sooner or later.
The first step to not let your emotions betray you, is to not persuade yourself that your tolerance to risk is higher than what it truly is. If you lend your money at an interest, even as a time-deposit, it may so happen that you never get it back. The higher the interest, the greater the probability that you won’t get your money back. If you invest in a company, it may not work out and your investment will lose value, at least in the short-term, no matter how good the company is. If you chose investing in commodities, prices can swing so sharply that at times you may feel you’ll never get your initial investment back.
Once you are fully aware of all this, you’ll be able to stick to buying assets with returns and diversification characteristics which are suitable to the risk you are willing to assume in each investment. Taking a risk isn’t wrong; what is wrong is assuming risks that aren’t adequately repaid. If ever one of those risks does in fact occur, you’ll have to bear a loss, and you’ll need to be sure that the rest of your portfolio has returned sufficient gains to offset that loss. If ever you feel that the potential loss of an asset you are considering as an investment can be close to the maximum loss you will be able to bear, don’t buy it.
The 3 investment options:
1-Fixed income: The first option is lending your money at an interest. The first mistake you can make in this case is letting yourself be seduced by the highest interest rate available, and end up justifying yourself by believing that “they” won’t ever stop paying because “they” – those who you presume have more information than you do and are smarter too – would lose much more than you (e.g. Bankia’s preference shares or the re-known Rumasa bills in Spain).
Don’t start by searching for whom will pay you the most, instead start by finding the issuer with which you feel comfortable enough to lend it your money: Governments? If so, which ones? Companies? If so, do you prefer top tier companies or worse rated companies offering a higher interest rate? Once you have selected your issuers, pick a sufficient number of them to keep your investment diversified and avoid unpleasant surprises. I bet the Greeks never even dreamed that their country would default, the same as the Spanish never did either. While the Greek did bear losses and the Spanish did not, the situation is Spain was nonetheless critical, and only a few investors took this matter seriously.
The next step is to value the return you get on your loan: it may so happen that you end up having to pay for lending your money, as is the case nowadays with short and mid-term maturity bonds in Germany or Japan. Are buyers of negative interest rate debt crazy? Probably not; it is probably the highest yield they have found for that type of asset, that otherwise does meet their investment objectives (protecting capital against a stock market debacle). The question you have to ask yourself is, what are you looking for of an investment in this kind of asset? Above inflation returns or protection against market corrections? You need to look for longer maturities if you want to avoid negative rates while not increasing issuer risk; however, returns can be, even so, negative if compared to the inflation accumulated over the period. Accepting returns that are below inflation only makes sense if the investment is part of a broader portfolio that has posted above inflation positive returns (corporate bonds, higher risk countries, etc.) If, on the other hand, your investment objective for fixed income assets is to obtain returns that are above inflation, knowing that risk increases with higher interests, you must also be sure to increase your portfolio diversification.
2-Equity: The second option is investing in corporate equity (listed or not). Ironically, this is the most popular asset type and that in which there are most accidents. The main mistake that can be made when assessing an investment in equity is to value a share based only on how its price behaves and the media coverage of the company’s brand. We tend to associate a good company to a socially accepted brand, and consider prices as good (cheap) as long as they are lower to a previous maximum price. This is the worst possible way to assess an investment in equity. A good business that affords security is a business generating enough cash profits for its shareholders in a way that is sustainable over time. The only way to do so is by reinvesting the company’s capital at an adequate return. Furthermore, its income statement and balance sheet must grow in an steady and ordered manner, without excessive debt. Cash generation must not be confused with cash dividend distributions to shareholders. If a company is able to reinvest its cash in assets offering sufficient returns, reinvesting that cash is much more beneficial to the company’s economic strength than distributing it to shareholders. If you invest in companies that don’t meet these requirement, risk increases considerably, and you enter the speculation terrain, the best breeding ground for fear or greed to take possession of you and compromise your decision making capabilities.
All things taken, good companies sometimes also go wrong, and success is many times unexpected. If you diversify among good companies you will be rewarded in the long run. Be quick exiting bad companies, and you’ll have all the more money to reinvest in the good ones. Recovery periods for bad companies can, occasionally, be so long that it is not worth waiting when there are so many good ones out there offering attractive returns. A few words on the famous phrase “Invest only in what you know”: don’t take for granted that just because you’ve invested in it, you know enough about the company or its future –not even the executives managing it know that. If the company’s financial data isn’t looking good (not only the share price) be quick in accepting your mistake and sell your shares. If, on the other hand, financial data continues to improve year after year, don’t let price hikes make you dizzy, keep your investment even if you do suffer temporary corrections. In normal market conditions the value of good companies should increase in 4 to 5 times over a period of 10 to 15 years. This discipline is the best strategy to make your equity assets grow.
3-Commodities: The third option is also normally the most cyclical and volatile of all three. Commodities are the resources necessary to produce finished products. As long as the commodity is a raw material indispensable for consumption or industrial production, with a limited supply due, for example, to the fact that it is a finite resource, its extraction cost is high (diamonds, precious metals), it has a fossil origin (oil/gas), or its exploitation has been limited by a regulatory decision (urban real estate), it will be worth your while to consider it. Although the commodities’ price may be volatile in the short term, its long term value will normally be stable. This investment option is only good for you if your creed is long term investing and if the fact that its value can take a 50-70% plunge one year, only to recover the lost ground over the next 3 to 7 years, will not keep you awake at night. Raw materials such as gold are usually a good refuge in times of system confidence crisis, but there is really no guarantee that its value will continue to increase sustainably over long periods of time.
Hybrid investments: Finally, a clarification about assets that seem different to the 3 options described above, but which really are pretty similar. Real Estate is not a category of its own: it combines commodities (urban real estate) and company (accommodation service) elements. “Own-use properties” is providing oneself a service and as such don’t tend to be profitable. Your living standard improves, but you have a client (yourself) to whom you won’t increase the rent as you would do to others. Currencies shouldn’t be considered a category apart either. They are the means that allow you to purchase the other 3 basic assets (fixed income, equity and commodities) in the countries in which those assets are in supply. In the long term, the value of currencies of countries with a higher demand for their products and services, and a more controlled inflation, increase more so it is a good idea to use them as a reference when building our portfolio. Short term evolution of currencies is harder to manage, and currency hedging techniques usually resource to products that are not available to non professional investors. Leaving currencies unhedged is usually not a bad idea in the long term, but then you need to focus on countries with stable currencies and economies (such as G10 countries).
Now that you know what your options are, it’s your turn to set yourself a return objective and decide if you are prepared to accept the price variations that you will encounter in the asset type of your choice. In normal market conditions, you should ideally keep a balance between fixed income and equity that is suitable to your risk profile, but unfortunately these are bad times for conservative investors. Fixed income prices are sky-high and commodities are in general too volatile. Therefore, the only reasonable option available in the long term is equity, but this implies accepting sharp price falls in certain periods.
For these investors, the best is to delegate assets management in professionals who can control the risk of investing in equity with hedging instruments based on stock indices and currencies, or to bear the loss in value of their assets caused by inflation, until fixed income prices return to more acceptable levels.