We have 4 main analysis tools.
- Risk versus Reward
- Statistics and Financial Modelling
- Investment Time Lines & Timing
- Financial Analysis and Tax
Risk v Reward
In order to invest you need to understand that on average your return will increase with increased risk. You need to adopt a measured approach to investing which mitigates risk but do not try to avoid/fear risk, since that will impact returns.
Remember when investing very low returns are in themselves risky since inflation and indeed taxation mean low risk investments today are little better than placing your money under a mattress. Indeed at least with money under the mattress the government won't appropriate that money from your bank or limit your access to it.
The key to managing risk is diversifying your investments. Aim to never hold more than 10% of your assets in more than one single asset class or company, however attractive the investment looks. In following this rule also remember to include what I would call hidden assets. That is assets you may not think of as investments. Examples are the house you live in (if you own it / have a mortgage on it), your pension and your job (if you are an employee).
If you are an employee don't buy shares in your employer. You are already highly leveraged as an employee to risk of redundancy. If your employer has problems don't exacerbate this by buy buying shares in that company.
If you own a house don't invest in residential buy to let property.
When balancing risk and reward firstly ensure you retain around 9-12 months of your normal expenditure, in cash. I would define cash as money you can access within a month with no risk of the money going down (or up) in value. This safety net investment needs to be held in traditional bank accounts, with little return.
Beyond this safety net I would recommend the following portfolio class mix:
Statistics & Financial Modelling
When approaching investing you initially see a wall of often confusing and conflicting statistics and financial modelling. Below I briefly summarise how to navigate and make sense of this surfeit of detail.
Firstly I follow the rule that being right is not a democracy. That is at least with investing following the crowd is rarely correct. Contrarian investments are more lucrative.
Secondly look to fundamentals with investments. That is how in the long term does a company generate income and does it / will they, realistically cover their costs.
Thirdly you are after investments that are cheap or fairly valued in reasonable run companies. Avoid investments in expensive companies even if they are well run organisations. The entry price is very important.
In summary when looking at a company / investment take time to investigate there accounts and always question and find out what are the risks and potential problem areas. Ensure the company recognise these problem areas and investigate how they are dealing with them. Avoid any company that attempts to ignore problem areas.
On Financial Models my general advice is always avoid organisations who say they have a system or model that predicts the market and will make you money.
There is a rule in economics called the Goodhart Law (named after Charles Goodhart) which states that any financial model that accurately predicts the future, breakdowns after a short period. This happens because even if a model does correctly predict a future financial outcome, the very existence of the model undermines its own predictive ability.
In simple terms models in pure science work since the participants in the events they predict, do not learn or change their behaviour due to the existence of the model. In Finance participants are self aware and do learn, so if a model seems to accurately predict an event they will buy or sell according to what the model tells them and adapt their prior behaviour. Effectively leading to market bubbles.
In my view Financial Models are thus flawed and should be avoided. Indeed avoid any asset which a model is predicting is a good investment. It's probably a bubble waiting to burst.
In summary most Financial Models don't work anyway and even if they do work in the short term the Goodhart Law will apply.
Time Lines & Timing
You must be realistic in setting time lines for an investment. I look to holding share investments for at least 3 years and more commonly upwards of 5 years.
It is vital to consider investments as longer term value opportunities, not short term bets on the market.
On timing as an investor you need to accept you will never get your timing perfect. Indeed if you did you will probably get investigated for insider trading.
Instead accept that your timing will always be imperfect. Given your investment is for 5 years it does not matter. To make a profit you just need to follow the correct broad strategy, perfection is not required.
Purchase & sell equities over time with a target entry and exit price rather than purchasing or selling in one go. This ensures the prices you achieve are averaged out and by setting a target price you know when to start and stop buying. This helps to stop emotional purchasing / selling of shares.
Finally over time you need to accept that markets are volatile and there will be times when your investments are under water. Don't panic, stick to the fundamentals of the investment. Indeed a market down turn is often a buying opportunity.
Financial Analysis & Taxation
When looking at equity investments you do need to do your financial homework and read the detail.
This takes time, but invariably investment mistakes can be avoided or at least mitigated if you read the detail.
Always look at a company's financial results and commentary with a critical head on. Ask what could go wrong and if it does what will happen.
Remember financial statements are written by Company Director's who wish to place a positive spin on their achievements. As such see you review as very much how a Teacher might grade a pupil's piece of work.
Examine how the Financial results of the company are likely to be impacted in the future, by the high level drivers I mention in the next section. For example if you are looking at a company performing well, but in a declining sector avoid the investment. Eventually the company will be impacted by the global prevailing environment.
Finally on Financials look at the Asset / Liability Base (Balance Sheet) as well as the Profit / Loss.
Markets in the short to medium term often pay too much attention to the Profits and ignore the Asset base. This is a huge flaw, your investment is in the value of the Company (the Assets). As you will see in my investment recommendations this focus on the Balance Sheet highlights buying opportunities and warns you off problem companies.
Finally on Tax. Investors seem to focus way too much on this area. This probably arises from how much Tax Advisor's earn from selling their wares, but it is also cultural. No one likes paying tax.
However the simple fact remains the most important investment result is to make a profit, not whether it is taxable. In addition most supposedly tax efficient vehicles involve v high fees and indeed just defer the payment of tax rather than avoid it (e.g. Pensions). Deferring tax might sound great but in the end unless the tax rate falls in the future, it does not save a penny. Indeed with Tax Advisor Fees you will lose out.