Investment fundamentals to consider in volatile times

Sharp share market falls are stressful for investors as no one likes to see their investments fall in value. But at times like these, there are number of key things for investors to bear in mind.

Compounding

Compound interest is magical! The value of $1 invested in 1900, allowing for the reinvestment of dividends and interest along the way, by the end of May this year would have been worth $243 if invested in cash, $901 if invested in bonds, and $757,136 if invested in shares. Of course, this is pre-tax and fees but the relativities remain the same. The higher end point for shares reflects their higher long term return. So, to grow our wealth we need to have a long term exposure to growth assets like shares.

It’s cyclical

Sharp falls in share markets as we are now seeing are not nice, but they are a regular occurrence and the price we pay for the higher returns they provide over the longer term compared to assets like cash and bonds. The key is to recognise that these setbacks are part of the cycle. So, the key is to not get thrown off by the higher returns that shares and other growth assets provide over the longer-term by cyclical falls.

Diversify

The best performing asset class each year can vary dramatically. Last year’s top performer is no guide to the year ahead. So it’s important to have a combination of asset classes in your portfolio. This particularly applies to assets that have low correlation, i.e. that don't just move in lock step with each other. A well-diversified portfolio is less volatile.

Understand risk and return

Put simply: the higher the risk of an asset, the higher the return you should expect to achieve over the long-term, and vice versa. There is no free lunch, and you should always allow for the risk and return characteristics of each asset in which you invest. If you don’t mind short-term risk, you can take advantage of the higher returns growth assets offer over long periods.

Time-in, not timing

In times of uncertainty like the present it’s tempting to try to time the market. But without a proven asset allocation or stock picking process, it’s next to impossible. Market timing is great if you can get it right, but without a process, the risk of getting it wrong is very high and can destroy your longer-term returns. Selling after big share market falls can feel comfortable given all the noise is negative but it locks in a loss and makes it much harder to recover.

Time is on your side

Since 1900 there are no negative returns over rolling 20-year periods for Australian shares. Short-term share returns can sometimes see violent swings, but the longer the time horizon, the greater the chance your investments will meet their goals. When it comes to investing, time is on your side, so invest for the long-term.

Remove the emotion

Emotion plays a huge roll in amplifying the investment cycle, both up and down. Avoid assets where the crowd is euphoric and convinced it’s a sure thing. Favour assets where the crowd is depressed, and the asset is under-loved. Don’t get sucked into the emotional roller coaster.

The wall of worry

It seems there’s plenty for investors to worry about at the moment. While this is real and creates uncertainty, in a long-term context it’s mostly noise. The global and Australian economies have had plenty of worries over the past century, but they got over them. Australian shares have returned 11.8 per cent per annum since 1900.

So, it’s best to turn down the noise around the short-term movements in investment markets.

Source: AMP