There is Always a Trap in the Jungle of Money: Part Five Money Series
So, you have just finishing reading the most important decision to investing; asset allocation. You would have learnt how to allocate your investments among different types of classes of assets and to put chunks of money in separate buckets for security, growth, cash flow and lifestyle.
Now finally, I want to teach you a set of three simple skills. These skills will ensure you avoid the mistakes so many people make by trying to time the market.
The three skills I use in assessing any investment and executing it:
1. Asymmetrical risk reward
2. Protecting the downside (don’t lose money)
1. Asymmetrical risk
This is investing in things that have the least amount of risk with the highest amount of returns. I work on 1 - 5 as a minimum and strive for a 1 - 10 times. So in essence, I won’t risk $1 unless I can make $5. Each investment has to make 5 times the investment with one downside. So in essence you can get it wrong 5 times to be in same capital position.
2. Don’t lose money
How do I not lose money? How do I get the upside but no downside? The idea of losing money is so painful. I am obsessed by it now. I have had my share of losses from listening to the wrong people, trusting the wrong people. This is all my responsibility.
One thing you really need to take away from this is there is no such thing as HIGH RISK/HIGH RETURN. This is something we have all been conditioned to believe and accept - unfortunately. When investing in anything (business, property and other items) you need to think how do I protect my downside? What things can I put in place as part of the deal? Or what research do I need to do to ensure my downside is protected. You think that you can’t do that…well you can.
Learn from the greats like Richard Branson. When he started Virgin he took ALL risk out of the deal he did with Boeing. To obtain the aircraft fleet he needed from them he negotiated a money back guarantee after two years if the airline didn’t work. NO RISK to the downside (or very little).
Do not just allocate 50/50 between cash and shares. Allocate based on risk of assets. This is called RISK PARITY! Don’t balance your dollars balance your risk.
We have talked about asset allocation and diversifying across asset classes. But there is another dimension to diversification:
a. Diversify across the different asset classes
b. The timing of the investment
This is best explained with an example. Take property investment (as we all love it). You need to diversify with different property types (residential, commercial, land banking, industrial etc.) You cannot have one view on the world and asset type as there are forces and market conditions outside of your control.
In addition to this you need to diversify based on location of the investment into states, countries, and other markets. Stop thinking small and within your area of influence. For me I thought everything had to be in Newcastle, NSW. It has served me and served me well and I continue to invest here, but I think bigger and more globally now. The world is so small. Smaller than you think and until you start thinking this way you will continue to be at risk and limited in what you can achieve.
The next key is diversifying across time. This is dollar cost averaging. Asset allocation is the plan in theory and dollar cost averaging is how you execute it. It’s how you avoid letting your emotions screw up the great asset allocation plan you have put together by a) either delaying investing because you think the market is too high and hoping it will drop before you get in or b) by ignoring selling off the assets that aren’t producing great returns at the moment.
Dollar cost averaging seems counterintuitive, and you will feel like are making less money using it, but it’s to your advantage. Remember the goal is to take the emotion out of investing. Emotion is what so often destroys investing success, whether it is greed or fear. When you invest on a set schedule whether in property, shares, commodities etc., in accordance with your asset allocation plan, the fluctuations in the markets (all markets) work to increase your gains not decrease them.
Volatility through time will become your friend. You can’t pick the market and the goal is to protect what you have in addition to making wealth.
Which leads to the third point, rebalancing. To be a successful investor, you need to rebalance your portfolio at regular intervals. You have to take a look at your buckets and make sure your asset allocations are still in the right ration. From time to time, a particular part of one of your buckets may grow significantly and disproportionality to the rest of the portfolio and throw you out of balance.
Like dollar cost averaging, rebalancing is a technique that seems simple at first, but it can take a lot of discipline. And unless you remember how important and effective rebalancing is in maximising your profits and protecting against your losses, you’ll find yourself getting caught up in the momentum of what seems to be working at the time. You will be caught up in the illusion that your current investment successes will continue forever and the current market (stocks, real estate commodity market etc.) can go only in one direction: UP!
This pattern, or emotion and psychology, is what causes people to stay with an investment too long and end up losing the very gains they were proud of originally. It takes discipline to sell something when it’s still growing and invest that money into something that’s down in price or growing more slowly, but that willpower is what makes someone a great investor.
Look at the real estate market on the East Coast of Australia and compare it to the West. You could say it is booming in one part (East) and bust in the other (West). Rebalancing strategy in this example would be to liquidate some or all of the assets in the East and invest in the West. There are some assets that are 50% less value in the West. Something to think about…
The rules of rebalancing don’t guarantee you’re going to win every time. But rebalancing means you’re going to win more often. It increases your probabilities of success. And probabilities through time are what dominates the success or failure of your investment life.
So after 5 parts of the Money Series, you have the tools and strategies to go and create a sense of FREEDOM for yourself and your family. But I promise the best is yet to come. True freedom will come in Part 6: The Secret to Mastering the Jungle of Money.
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