There are many things in life to get excited about, become passionate about, look for excitement in, entertainment, enjoyment and so on. But let me be very clear about one thing. Investing is not one of those things! Sounds like a strange thing to say?
This year I have spoken with a number of people that have surprised me with their approach to investing – and not in a good way. I have been flummoxed by how some people can make such poor financial decisions.
Our theory (at ProSolution) on how to build wealth is very simple and clear and involves developing and implementing a core investment strategy – I’ll explain what a core investment strategy involves a little later. Before I get to that, let me share with you some of the mistakes that I have seen (and heard) people make this year and you can test if any of these sound like you.
Thrill seeking behaviour
It is very difficult to ignore your emotions when investing and it does take a great amount of discipline. You have heard me talk about the two dominant emotions (fear and greed) in the past. They are very powerful emotions and they manage to influence the majority of people – I see it every day. I think you’ll find that successful investors tend to be very disciplined people which means they stick to a proven approach and never divert from that approach no matter how exciting or attractive the investment (returns) look. Warren Buffett comes to mind as a perfect example of this but there aren’t many examples.
There is a simple solution to making sure that you always employ the same discipline that Mr Buffett does which I’ll discuss in a minute. Before I do, I’ll spend a minute sharing some of my ‘real life’, recent observations.
Wrong tactic at the wrong time
The wrong investment approach or tactic at the wrong time can be devastating for wealth accumulation. Consider property development as an example. Property development can be a very profitable venture. However, the extra profit doesn’t come without the extra risk. Therefore, you are generally only ready for a property development once you have bedded down your core strategy. Your biggest thing to lose however is not money. Time is your most valuable asset and the older I get the more valuable I realise time is (because the months now feel like weeks or even days sometimes. When we were kids the summer holidays seemed to last forever – remember?). You may be able to make up for lost money but you’ll never get lost time back.
The people that tend to be attracted to the higher risk propositions such as property development are often the people that are short of time. These are the people that can least afford to waste time and therefore least afford to take ill-considered, unacceptable risks. Often, the less wealth you have or the less time you have, the least amount of risk you can accept. If you are in this category, don’t go to the casino and put everything on black, close your eyes and wish for the best. You have to be more careful.
Speculation is another word for a gamble
There is a concept in economics called ‘diminishing marginal utility’. The concept suggests that you get less satisfaction from each unit of a product you consume. For example, if you have a craving for chocolate all day the first piece you have after dinner is the most enjoyable. If you manage to consume 200 pieces (I’m prepared to give this a go – because I’m committed to checking my facts!), the 200th piece gives you a lot less enjoyment than the first. This concept can be applied to investing. If you have little wealth then every marginal increase is wealth is more valuable or important. If you have $100,000 to your name and someone gives you $50,000, it makes a huge impact on your opportunities. Therefore, the lower your asset base, the least amount of risk you can afford to accept.
Conversely, if you have $10 million in net worth you can afford to take a punt on a few investments. Some ‘punts’ might pay off but probably more than half won’t – but this doesn’t really matter because your core investment goals have already been met with the $10 million you have accumulated so you can “afford” to lose some.
I met a client recently that owns one investment property and it’s located in a mining town.
It was actually a house and land package that he purchased so he’s ended up with a brand new home. This means he would be enjoying some strong depreciation tax benefits (remember, depreciation is a measure of the reduction in building value – is this really attractive?). Also, he was able to rent the property to a mining company for a huge 9% rental yield.
Since construction, it’s estimated that the property is worth 15% more 12 months later. Sounds like a good investment? It might turn out to be but it looks like an extremely high risk investment. The capital growth and rental income are solely dependent on the mining boom and one could argue that it’s already over inflated. If it was to subside, the value and rental would fall dramatically (crash). The property lacks the fundamentals necessary to underpin this performance and deliver perpetual growth; being scarcity, high land value (as a proportion of the property’s total value) and proven performance. If the investment was to go wrong, it would devastate this investor’s (and family’s) financial position – being their only asset.
A word of warning about bubbles: they never seem like they will end yet they do end nearly always comes without warning.
Another common mistake is to enter into an investment with the expectation of high returns. The next sentence is the most important thing I will write. The last thing someone with a small asset base (net worth) can afford is an investment with high returns. Why? Because high returns always means high risk. Therefore, if you are looking at a project promising (you believe) high returns, you either shouldn’t be doing it (because it’s too high risk) or you have an unrealistic expectation of what the returns will be.
I spoke to someone recently that was considering undertaking a property development. They had some cash savings (no existing property assets) which they would contribute. Their expectation (worse case) was that they would double their net worth. The development was worth a few million dollars and there are literally many things that could go wrong including time delays, cost blowouts, inability to sell the completed properties for the expected amount and so on. Whilst they could meet their target return of doubling this money, they have equal (or greater) chance of actually reducing their net worth (i.e. losing money). This is one of the most obvious examples of investing way outside their risk profile.
Interestingly, people with a lower net worth feel they need to take higher risks to ‘make up for lost time’. However, I’d argue that they should be spending far more time on risk mitigation and minimisation because they can’t afford to make mistakes. The golden rule here in my opinion is aim for consistent normalised returns each and every year. Total investment returns (income and capital) of approximately 10% to 13% are achievable without unacceptable risk and if you get this annualised over the long term (as well as manage risk astutely), you’ll do very well. This is one of the fundamental principles of our core investment strategy.
Dress it up to make it look sexy
My last ‘real life’ observation is probably the most insidious in that it appears that the investor is doing the right thing but they definitely aren’t. This mistake involves employing a fundamentally sound approach to property investment (e.g. investing in assets with scarcity, land value and proven performance – sounds good so far?) but adds a “pinch” of their own likes or preferences. Doing so and without realising it, they water down the fundamental approach and probably end up investing in the wrong property.
Perhaps I can better explain this with an example. An investor was explaining to me his approach and thought process behind an investment property he selected. He explained that he thought it was a good investment because it has a good land value, its proximity to water and schools was good and so on. It sounded like he had considered all the right things except he said at the end that he selected this asset “also because it’s on a corner block therefore it can be easily sub-divided in the future”. Don’t get me wrong.
Having the ability to sub-divide and maximise the value of property is fantastic and I’m not against it at all. However, what happens when investors try and squeeze too many “requirements” into their search for an investment property (e.g. high capital growth and development opportunity) is they often end up buying an asset that rates “average” across all their requirements (but not exceptional in any). If the investment is part of your core investment strategy then you must have a single-minded focus on capital growth and invest in the highest quality asset possible and not get “distracted” by other opportunities or add-on’s. Stick to the proven approach and don’t try and dress it up.
The problem: sexy sells more often
There is a simple formula to building a financial services or property business which involves developing a product and/or service that looks sexy. Something that looks like it’s out-smarting the common investor. It’s leading edge. Not available to all investors. It promises above average returns and it makes investors feel like above average investors. Sell the promise of the dream, not the product. These sort of marketing activities are proven to work very well and appeal to the greed motivator in most people. There are millions of examples of this with the failed “financial planner” Storm Financial being an obvious one.
Boring doesn’t sell half as well as sexy does. If you tell someone that you will achieve normal returns over the long term, take the least risk as possible and stick to proven fundamentals you’ll probably send most people off to sleep. I know some people will read this and say “I disagree Stuart. I like low risk”. My point is not everyone will fall under the spell of a sales pitch involving a sexy investment product or strategy. However, many more people will be attracted to this than a boring investment approach which is a problem. Beware of a slick sales pitch – they are everywhere in my industry.
Boring is the new sexy
No one likes to be stuck talking to the boring person at parties (I can hear my staff think “that’s you Stuart”). In many facets of life, boring is just that – boring! However, when it comes to investing, boring is the new sexy.
Boring means low risk. Boring means certainty. Boring probably means you’ll meet your financial goals and there’s nothing unattractive or unexciting about that. If you are looking for thrills, go skydiving. Don’t mix business (investing) with pleasure. Stay as unemotionally attached to your investments and strategy as humanly possible. I have never met an investor that has doubled their net worth (slowly) over 10 years and been unhappy with that performance. However, I have met plenty of unhappy “investors” (read speculators) that have tried to double their wealth in 5 years and failed.
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