Investing is a full-time profession for many people. Countless books have been written on the hows and whys of making smart investment decisions. If you are an expatriate, you must also consider the role that different currencies and tax jurisdictions play in your portfolio. These issues are complex, and our goal today is to simply introduce you to some of the concepts behind successful investing, as well as to provide you with some additional resources and book recommendations to help you design an investment strategy that will work for you.
1. The Difference Between Speculating and Investing
In popular media, speculating is often confused with investing, but there is an important difference between the two. Speculating involves betting on the direction of short-term price movements, while investing is purchasing assets that generate an economic return over time. Betting on the short-run (also called market timing) is generally a losing proposition-you may occasionally get lucky, but luck is not an investment strategy, and you'll probably lose over the long-run. This is because short-term returns driven by market greed and fear are inherently unpredictable. On the other hand, long-term investment returns are ultimately driven by the cash flows generated by the underlying businesses. Having a calculated, well-thought-out, long-term investment strategy is much more likely to work for you than trying to time the market and hoping to get lucky.
2. Risk, Return, and the Relationship Between Them
Return is generally defined as how much you've made on an investment, and it is measured in percentage terms versus the original cost of the investment. At a basic level, we often think of risk as the possibility that a given investment will lose money. In the investment world, risk is often defined as deviation from the return that was expected. Risk is often measured in terms of annual volatility or standard deviation from the mean, but both risk and return can be measured in either the short- or long-term.
The important points to remember when it comes to investing are:
- It is really the long-term return and risk taken that should concern you.
- There is a link between the amount of risk taken and the expected return of an investment.
Generally, you have to take on more risk (in this case, greater annual volatility in the price of your investments) in order to get a chance (not a guarantee) of a higher long-term return.
3. Diversification-Not Putting All Your Eggs in One Basket
Diversifying means spreading investment risk among many investments. Holding a couple of concentrated positions in individual stocks, even market favorites like Google or Apple, rarely makes sense. The risk of something going wrong when you own just a couple of stocks is simply higher than can be justified by those stocks' potential return.
A better strategy is to purchase the entire asset class (in this case, U.S. large-cap growth stocks). While some of the companies in an asset class may experience real difficulty, overall a broadly defined asset class will not. Instead, the value of the asset class can be expected to appreciate over the long run, corresponding with the aggregate growth of the underlying companies in that particular asset class.
In today's world, buying an asset class is easy to do-you can purchase an index mutual fund or exchange traded fund (ETF) that tracks the entire asset class. That way, you get the overall growth of the asset class combined with diversification benefits, but at a far lower cost than you could do on your own.
4. Asset Allocation-The Driver of Long-Run Returns
Allocating your savings between a defined mix of different asset classes is called "asset allocation," and numerous studies have shown that it is asset allocation (as opposed to market timing) that is the major driver behind the long-run return of a portfolio. The greater proportion of volatile asset classes (equities and alternatives) that you include in your portfolio, the greater your chance at a higher returns over the long-run. But to have a shot at the greater long-run returns, you'll have to put up with volatility. Remember that while diversification will reduce your risk of loss, it doesn't guarantee that your portfolio won't experience a down year.
5. Investment Portfolio Returns-What to Expect
The following table is intended to give you some realistic expectations of what kind of long-term returns investment portfolios at different levels of risk (in this case, short-term volatility) might generate, as well as what types of short-term or single-year losses you might have to put up with on the way to achieving those returns. As this table shows, if you were to look back after 40 years of investing, the path to the end result would have been volatile. This is shown in the columns "Worst 1-Year Return" and "Range of Annual Returns Expected (2/3 of the Time)." However, if you look at the value of your investments at the end of the period and compare the average percent returns achieved, you would find that you'd done well as compared to keeping your savings on fixed deposit.
Investment Portfolio Returns (1972-2011, in U.S. Dollars)
Source: Ibbotson & Associates, MGP
Notes: Both equity and fixed income are globally diversified among several sub-asset classes. Returns are pretax, exclude fund fees and assume annual rebalancing. Real return excludes average inflation of 4.34% per year during the period. Expected Range of Returns corresponds to one standard deviation from the Total Return, or the range that occurred within two out of every three years.
6. Passive vs. Active Funds-Why Minimizing Fund Fees Matters
To get exposure to a certain asset class, you can either choose a passively managed fund, such as an index mutual fund or an exchange traded fund (ETF). Alternatively, you can choose a mutual fund with an active fund manager. In most cases, buying passively managed funds is preferable. This is because, in general, most active managers don't outperform their passively managed funds peers in a single year, let alone consistently over the many years you'll plan to invest. While there are exceptions, it generally just doesn't make sense to purchase an actively managed fund which may have a front or back load fee and running costs of 1.75-3% or higher each year. All this can equate to giving up a substantial portion (more than half) of the real rate of return that you might otherwise have expected to receive over time.
7. The Importance of Rebalancing
When the markets get rough, you may be tempted to bail on your investment portfolio and move to cash or fixed deposit. Conversely, when markets are booming, you may also feel enticed to put all of your holdings into the hot asset classes. In fact, that's exactly what market greed and fear will be telling you to do.
As tough as it may be, when your portfolio's asset allocation percentage holdings have moved substantially away from your targets (or perhaps once a year) you'll want to rebalance your portfolio back to the original weightings. This may require you to sell what has outperformed, and purchase what has underperformed, or it may be done by adding new cash savings. Rebalancing may sound easy, but it can be difficult in practice since it goes against what most market players will be doing. However, over the long-run, rebalancing ensures that you buy low and sell high, one of the basic principles to successful investing.
Hopefully, this post has taught you a few useful concepts that will help you succeed in investing. As we mentioned in the introduction, there's a lot more to this topic and we encourage anyone interested to consider reading the following excellent books:
- The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between by William J. Bernstein
- A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (10th edition) by Burton Malkiel
- Investing in an Uncertain Economy For Dummies® by Sheryl Garrett (with three chapters contributed by Creveling & Creveling)
The Top 5 Investment Mistakes Expats Make (and How to Avoid Them)
Investment Returns: What Can Expats Expect? (And Why Real Returns Matter)
Want to Help Make Your Money Last a Lifetime? Invest in Equity
Does Higher Risk Equal Greater Return? Not Always
About Creveling & Creveling Private Wealth Advisory
Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future. For more information visit crevelingandcreveling.com.
Copyright © 2013 Creveling & Creveling Private Wealth Advisory, All rights reserved. The articles and writings are not recommendations or solicitations, and guest articles express the opinion of the author; which may or may not reflect the views of Creveling & Creveling.