November 9, 2021 Murat2

Financial Rules for Novice Investors

There are many ways to make a fortune. Some think that business is the easiest option, while others have no doubt that hitting a jackpot at the online casino Canada is the fastest opportunity for income. But regardless of the method you choose to be rich, you should start investing half of your money. Want to achieve better results? Then follow these tips. 

Asset Allocation

Finding a balance between potential return and risk is an investor’s primary concern when choosing assets. The key is diversification, that is, adding asset classes that are different in nature and behavior to a portfolio.

Different instruments can be used for diversification: stocks, bonds, cash equivalents, and alternative asset classes such as real estate, gold, commodities and luxury goods.

The combination of assets must meet the investor’s objective and conditions. But the very fact that the portfolio is diversified greatly reduces the risk and degree of its drawdown.

For example, let’s take the notional portfolio diversified by various assets used by J. P. Morgan in its market analysis.

Between 2006 and 2020, this notional portfolio yielded an average annual return of 6.7% with a volatility of 11.8%. At the same time, if an investor were to bet on any one asset class, he would take on much more risk and would not always win in terms of returns or win only slightly in terms of the risk taken.

For example, if an investor were to buy shares of emerging markets, he would receive a 6.9% yield, while the volatility is 23.3%. That is, the yield would have been 0.2 percentage points higher than in a diversified portfolio, but the assets would have been twice as volatile: they would have had to go through more frequent and severe drawdowns.

If you are an aggressive investor and your goal is to multiply your investments at any cost, allocate the bulk of your portfolio to equities.

An investor who is not psychologically ready for high volatility might want to invest more money in bonds. But in this case there is a risk that portfolio yields might not be enough to achieve the financial objective in due time.

Another conservative investor runs the risk of being hit harder by inflation, which will reduce his real returns. Under normal conditions, the inflation rate is a few percent per year, but it has a cumulative effect and on a strategic horizon of several decades will greatly affect the investor’s bottom line return. 

Analyzing historical and macroeconomic data is important for predicting the future returns of an investment strategy. Historical data does not guarantee repeat results in the future, but it provides a good basis to understand how to allocate and optimize asset shares.

Keep in mind that markets are cyclical and macroeconomic conditions can change, which is reflected in the performance of instruments. 

Exercise Discipline

Now your task is to follow it and not deviate from the intended path.

First, keep a cool mind during market turmoil. If you give in to emotions, you can make impulsive decisions. For example, during a market collapse such as what happened in February-March 2020, an investor might panic and start selling assets for cheap. In reality, it was a great buying opportunity, because prices turned around quickly and rallied.

Second, watch out for the preservation of the original asset allocation. The truth is that as time passes, the stakes in the portfolio become eroded: rapidly growing assets will start to pull the blanket over themselves. So, the portfolio will deviate from the chosen strategy and become more volatile. To restore the original proportions, periodically rebalance the assets.

If the investor is at the stage of capital accumulation and periodically deposits money into the brokerage account, he can buy more assets and thus even out the disturbed proportions.

But if the investor does not invest money for a long time or there are not enough of them to even out the proportions of instruments, then he may need a forced rebalancing – sale of part of expensive assets in favor of less profitable ones.

Studies show that rebalancing is most effective once every six months or a year, as well as by the 5% trigger – when a particular asset’s share deviates from the original by a specified percentage.

Another dangerous temptation in an investor’s path is to wait for the optimal entry point.

Numerous studies show that in most cases this is counterproductive because:

Statistically, most of the time the markets are rising, which means there’s no need to procrastinate in buying.

Stocks are riskier assets than bonds, and bonds are riskier than just money. As we know, risk and return in the stock market are interrelated, and a riskier asset has a higher expected return. By not buying securities and staying in cash for a long time, we miss out on returns. So, by expecting some perfect entry point, an investor also suffers a loss in the form of missed opportunities.

According to research, the strategy of determining the best entry point or tactical changes in asset shares according to technical signals can sometimes bring an investor above-market returns, but on average this approach is still inferior to benchmarks.