Four rule you must follow to ensure you prosper 5 years from now

investment rules

I wrote a blog in May warning investors to prepare for lots of bad news, uncertainty and market volatility. My thesis was that rising inflation, supply chain issues and rising rates would cause economic pain. Unfortunately, my prediction was correct, and we should expect the volatility to continue for many more months to come.

It is possible that all you may see are risks and problems at the moment. But in 5 years from now, it is likely you’ll look back and see lots of (missed) opportunities because the rear vision mirror is always clearer than the windscreen.

I’d like to share four rules which can help guide you to make great investment decisions over the course of the next year, and the rest of your life.

Missing the best days of the market is a good lesson and a perfect metaphor

There are lots of charts that demonstrate that if you miss the 10 best days in the share market over a long period of time (say 10 years), it will have a dramatic negative impact on your overall investment returns i.e., you will earn half the returns or less. This chart is a good example.

The lesson is that no one can pick the best days and the worst days. Therefore, if you sell your investments because you are concerned about volatility, you will inevitably miss the best days (best returns) and your overall performance will suffer.

Another way to look at it is, that the best returns come in the years following a stock market decline. The chart below, which covers almost one century of data, illustrates this very eloquently (produced by Dimensional).

This concept applies to all markets and asset classes including residential property.

Understand that volatility is normal

The event or issue that causes volatility (i.e., market uncertainty) is always unique and unpredictable. An event must be unpredictable to cause the market to fall dramatically because predictable events/issues are already systematically reflected in share prices.

Volatility is normal and it should be expected. Volatility is a very important part of price discovery which ensures the market adequately reflects risks and opportunities. Volatility also aids investment strategies through long horizon mean reversion and/or dollar cost averaging. It is something that should be embraced, not feared.

No one can tell you what will happen in the short term

No one in the world has ever developed a reliable methodology to predict short-term asset class returns. The truth is that no one knows what will happen over the next few months. This chart demonstrates how random returns are. Therefore, that must be your starting assumption when making any investment decisions i.e., you don’t know what will happen in the short term.

If you agree that we cannot predict what will happen in the short-term, then your only option is to ignore the short term and focus on the long run.

Investment rules to help you through volatile times

An investment rules-based approach towards investing is easy to adopt because it guides clear decision making and avoids your decisions being unhelpfully influenced by emotions. And if the investment rules that you follow are routed in evidence-based methodologies, it further helps reduce your risks, as I’ve discussed here.

Here are 4 rules that you can adopt to help you make great investment decisions over the coming months.

(1) Play the long game

I’ve written about this rule literally hundreds of times. Playing the long game is simple but not easy. It’s a simple concept to understand and is routed in sound logic and evidence. But it can be difficult to execute because there always seems to be good reasons why you should consider all the short-term negative rhetoric. We think maybe this time is different. Maybe the doomsday predictions will be correct. This is why we should never make financial decisions based on emotions. It is proven that our cognitive abilities reduce significantly when we are in an emotional state.

Instead, focus on a 5+ year time horizon. Ask yourself what the best investment is you can make today that will generate good returns in 5+ years from now.

(2) Buy assets that are relatively cheap and/or that allow you to manufacture growth

The best way to minimise your risk is to buy assets that are relatively cheap or assets that you can improve to manufacture growth (investment returns). Put differently, paying a full price for assets that have limited upside is risky.

When it comes to investing in shares, target investment methodologies that focus on value or markets that are relatively cheap. For example, Google is trading on a PE multiple of 20 times which is pretty good value for a high-growth, high profit margin company. There’s a number of value factor index funds that will allow you to get exposure to lots of companies like Google. Alternatively, emerging markets are relatively cheap at the moment trading on a PE of 10 times versus 17+ times for developed markets.

When it comes to investing in investment-grade direct property, it’s a lot more challenging to buy for below intrinsic value because quality property is usually sort-after, which means you must compete with other buyers. Although, in times of higher uncertainty, it’s not impossible as I’ve discussed here. But if you must pay fair value for an investment-grade property, then buy something that you can add value to that will allow you to manufacture/create equity. Put differently, spend all your money on land value because you can always improve the dwelling down the track, but you can never improve the land.

(3) Don’t try to time markets

No one can pick the bottom of the market, so don’t bother trying. If you are investing in shares, spread your investment across many months to diversify your timing risk. Of course, that is not possible to do with property, so the best thing to do is make sure you don’t pay any more than a fair price and understand that properties that provide scope to add value are lower risk.

I came across the quote below recently and it really resonated with me.

“Unless you buy a stock at the exact bottom (which is next to impossible), you will be down at some point after you make every investment. Your success entirely depends on how dispassionate you are towards short term stock price fluctuations.” 

-Joel Greenblatt

This rule is intrinsically linked to rule # 1.

(4) Have faith that fundamentals don’t change

It is always tempting to believe that big events might create permanent change. But they rarely do. I recall watching US financial shows during the GFC almost 14 years ago and commentators saying that the way companies do business has changed forever. Given we were in a financial meltdown, this prediction was quite believable. But hindsight confirms that nothing really changed.

Of course, things like aggressively rising interest, Covid and the like will create some permanent changes. But in the main, investment fundamentals will remain intact and basing investment decisions on said fundamentals will continue to be a sound approach. Five years from now, many of todays “risks” won’t matter.

Stay the course

Once you have a sound, long-term investment strategy, the only thing that matters is that you have the discipline to stay the course and that you don’t get distracted by any short-term rhetoric. Hopefully, these four evidence-based rules will help you do that.