Are you thinking about investing in your future by putting some of your spare cash to work? If images of Bradley Cooper in Limitless just popped into your head, I have some news for you. Unless you have, in fact, developed your own mind-enhancing pill, getting great returns on your investments does not mean following in the high-adrenaline footsteps of a day trader.
There are vital lessons we can learn from the investment industry that will ensure we get reliable results from our investments. In this blog, I look at the four most important ones: minimising risk, beating the market, diversification, and costs.
Investing probably isn’t what you think it is
For many laypersons, investment conversations revolve around hot tips and the next big thing. “You should invest in Bank of Ireland.” “Apple stocks are definitely going up.” These are fine personal musing, but this simply isn’t how investment works at scale. There’s a huge gulf between what the normal person on the street thinks investing is about and how industry professionals approach investing. Their vocabulary is completely different too. Words we use in our daily lives – like risk, margin, leverage, hedge, or volatility – have very different meanings when it comes to investment. This may go some way to explaining our misconceptions regarding investment principles, strategies, and the financial markets.
Four transformative insider investment principles
1. Understanding how risk works
When investment fund companies talk about risk, they mean something quite different to what we think. In the industry, products come with a risk profile between 1 (low risk) and 5 (high risk). It’s an established fact that the stock market provides the best return over a long period of time (20 years). But from an investment perspective, the stock market is classified as a level 5 risk because every five years or so you can expect it to drop by around 30%.
Now, these things are cyclical, and it will bounce back. But if you’re going for a short-term investment, you don’t want the risk of being at that point in the cycle and losing 30% of your money if you have to cash in. That’s why it’s considered a high risk. If you’re taking a much longer-term view of things, higher risk investment would offer the best return. Pension funds, which are long-term investments, accept the higher risk profile because the fund will be making an annual return of maybe 15% as opposed to 2%, and over time this amounts to a significant difference.
2. Beating the market
No one today knows how much a share in Apple will cost at 6 pm on 10th November 2024. Professional traders invest a lot of time and money trying to understand the stock market, but its complex and multifaceted nature means that it is inherently volatile in the short term. That’s not to say there aren’t trends in the market and subsequently some universal truths worth accepting. One is that no one can outperform the market. People are sometimes lucky and get a better return than the average return, but they cannot do it consistently. That’s why the goal of investment companies is simply do as well as the market, which they do by buying across all the top shares in the market. As the market goes up, their fund goes up. It’s as simple as that. They’re happy to move with the market rather than trying to second guess it, because they know that stock markets have historically shown an upward trend, whereas individual companies come and go.
3. The principle of diversification
When you read the advice from the investment gurus, none of them talk about diversification or matching market returns. They all claim to hold the secret to success based on fanciful notions about single shares, single stocks, or single geographic areas. But this breaks all the rules of investing. Investment funds, for instance, would never stake their fortunes on individual stocks. Diversification is king in the investment industry. Every action is diversified to eliminate as much risk as possible. This isn’t merely a hedge against volatility but a foundational principle that ensures resilience and growth over time.
Individual investors, on the other hand, hardly ever diversify to that level. This means they’re taking discretionary risk on their investments. Why do that?! You’ll often see individuals speculating in a mere handful of stocks, confident that somehow they can predict what the most seasoned professional cannot. Whereas I may check on my investment fund a couple of times a year, I’ve seen people checking in on their hand-picked shares as often as they check their WhatsApp, trapped on an emotional roller-coaster as they watch the value of their money bouncing up and down like a tennis ball.
4. Controlling your costs
The final lesson we can learn from the professionals is cost. The cost of an investment will significantly impact your returns. The funds you can buy into all have annual management fees, typically a percentage of the assets under management (AUM) which could range from 0.5% to 3%. While these percentages might seem small, they compound over time and can consume a significant portion of investment returns. At 0.5%, most of the return will come into your pocket, but at 3% a lot of your return will go back to the investment fund company.
Let’s say you have an investment of €50,000 in a fund with an annual return of 6% before fees. After 20 years and a management fee of 0.5%, the value of your investment would be approximately €145,887. However, with a 3% annual fee, the future value of the same investment would be approximately €90,305. That’s a stark difference and underlines the importance of shopping around to get a good deal.
Invest like a pro, not a gambler
If you’re serious about getting a return from investing, it makes sense to model your approach on what the industry does at scale. It all starts with a decision about your timelines, and from that you can decide what would be a good risk profile. Remember, as I explained above, risk in investment has a particular meaning. If you’re looking at an investment vehicle with a risk profile of 3, it’s probable that the investment firm is simply spreading your risk by putting half your money in the stock market and keeping half in cash. It’s not rocket science, just using diversification to minimise risk and essentially giving you a sliding scale of return: a greater return over a longer period (meaning periodically it will drop, so you wouldn’t want to cash in at that point) or a very secure and even return with less overall gain.
Whether the risk profile is 1 or 5, these investment funds are still very safe options. What investment funds are not doing it speculating in specific stocks, which unfortunately too many individuals are doing. Whether through a misunderstanding of how investment works, FOMO, or the influence of sensationalist media stories, some people ignore the established wisdom of the market and essentially become speculators rather than investors. They are essentially gambling. In fact, we can see the same psychological elements at play when people get hooked on this type of investment game, namely:
- the dopamine release that gives them a high whenever there is a win
- chasing behaviour, which is an attempt to recover the win that must be ‘due’ after a loss
- the illusion of control (a cognitive bias) leading them to overestimate their influence on the outcome
The path to investment success
As you can see, successful investing is less ‘buy buy, sell sell’ and more informed decision-making, emotional discipline, and strategic foresight. There is no secret formula, no perfect trade. The allure of quick gains, often magnified by media hype and societal pressures, can lead even the most rational minds into the quagmire of speculative investing. Understanding the nuanced nature of risk, the importance of cost-efficiency in investment choices, and the psychological traps that ensnare unwary investors is crucial.
In the world of investing, the tortoise often beats the hare – wisdom, not speed, is the key to unlocking the true potential of your financial future!
