This is the third instalment in a four-part Wealth First Principles series. The first two blogs examined how wealth is genuinely created and the role of property. Shares serve a fundamentally different purpose within a portfolio. They provide liquidity, diversification, reliable income with minimal costs, and access to global growth themes that property simply cannot deliver. But investors tend to use low to no leverage when investing in shares, unlike property.
The investment approach also differs. Property success hinges on selecting the right asset. In contrast, attempting to pick individual winning stocks or fund managers is the wrong strategy with shares. The objective is to gain broad exposure to the entire market. However, in both asset classes, long-term success depends on applying an evidence-based approach and avoiding the common traps that lead many investors to underperform.
This blog sets out a practical framework for investing in shares, grounded in long-term empirical data and the principles I have been writing about for more than two decades.
A simple, evidence-based strategy works consistently
For most investors, a simple, rules-based investment strategy using low-cost index funds or diversified ETFs will produce better long-term results than stock selection or active fund management. The evidence is unequivocal. Global studies, including the SPIVA reports, consistently show that the majority of active fund managers fail to outperform the index they are compared against over long periods.
This underperformance is not the result of poor skill. It is structural. High fees, high turnover, behavioural pressure, and market efficiency work against active managers. In contrast, an index fund or diversified ETF delivers broad exposure to the market at very low cost, allowing the investor to capture the market return with minimal friction.
This does not mean index investing is exciting. Its effectiveness comes precisely from its simplicity and lack of activity. Investors must separate entertainment from investing. Share investing is about discipline, not stimulation.
Understand what drives return
Share markets compensate investors for bearing risk. This is the basis of the Equity Risk Premium (ERP). It is the return above the “risk-free rate” that shareholders expect to receive for tolerating volatility and uncertainty. Over short periods, the ERP can be negative or highly variable. Over long horizons, it tends to assert itself.
Understanding the ERP is crucial because it explains why long-term share investors are rewarded, despite periods of volatility. Volatility is not a flaw; it is the price of admission. Investors who try to avoid volatility often forgo the very return they are seeking.
Shares also generate returns from multiple sources: capital growth, dividends, and franking credits. For Australian investors, franking credits are a meaningful component of return, though they should not be the primary driver of portfolio design. A well-diversified global portfolio provides the best balance between risk and long-term performance, even if franking credits are lower outside Australia.
Avoid the pitfalls that derail most investors
Many investors fail not because of poor strategy but because of poor execution. There are four common mistakes that lead to zero or even negative long-term results: over-trading, attempting to time the market, chasing recent performance, and abandoning a strategy when markets become volatile.
Each of these behaviours destroys the compounding effect that share investing relies upon. For example, attempting to time the market requires being right twice – on exit and entry – and the evidence overwhelmingly proves that even professional investors (fund managers) rarely succeed consistently. Likewise, chasing last year’s winners often results in buying overpriced assets. Over-trading increases costs and taxes, both of which compound negatively over time.
A disciplined, rules-based approach solves these problems. It reduces the number of decisions required and removes emotion from the process. Consistency, not cleverness, is the driver of long-term return.
Look beyond traditional market cap indexing, when appropriate
While traditional market-capitalisation-weighted index funds are effective, they have limitations. They overweight companies that have already risen substantially in price and underweight those that may represent better value. This concentration risk can be meaningful, particularly in markets dominated by a small number of very large companies, like in the US.
Alternative rules-based, evidence-based indexing strategies aim to address these limitations. These include equal-weight, value-tilted, quality, and other factor-based indices. These strategies still avoid stock picking and maintain rules-based discipline, but they allocate capital differently to reduce concentration and improve risk-adjusted returns.
These alternatives are not necessary all the time (but they are now), and they are not a shortcut to higher short-term returns. They require the same discipline and long-term perspective as traditional indexing. However, for investors who want to improve portfolio robustness or diversify return drivers, these strategies are very valuable.
Diversify globally rather than relying on the domestic market
It is important to have exposure to global markets because the Australian share market represents only about 1.7% of the value of developed global markets. By investing solely in Australia, you are effectively excluding more than 98% of available investment opportunities, many of which have historically delivered higher growth than Australian shares. The local market has also underperformed global markets for extended periods. It is heavily concentrated in just a few sectors, primarily banking and resources, and offers limited exposure to major global growth industries such as technology, healthcare, and leading consumer brands.
Relying too heavily on the domestic market increases concentration risk and limits opportunity. A globally diversified portfolio spreads risk across countries, sectors, and currencies. It also aligns the investor with the global economy, which grows more steadily and broadly than any one domestic market.
Currency movements will influence short-term returns, but over long periods these effects typically even out. What remains is exposure to a much broader set of investment opportunities.
A practical blueprint for building a share portfolio
Building a share portfolio does not require complexity. It requires clarity and discipline. A practical framework includes:
- Clarifying long-term goals and time horizon
- Determining overall asset allocation, including the role of shares relative to property and cash.
- Choosing the right investment structure: low-cost index funds, diversified ETFs (such as DHHF and VDAL) or rules-based alternative indices – see episode 380 for more.
- Ensuring global diversification rather than relying on domestic concentration.
Rebalancing periodically according to a predetermined policy, not short-term market movements.
- Maintaining discipline during periods of volatility.
This framework allows investors to benefit from market returns without the stress and guesswork often associated with share investing.
Address the common doubts you hear from investors
It is natural for investors to question whether share investing is too risky, too volatile, or too complicated. Each concern has a rational response when viewed through evidence rather than emotion.
Volatility and market downturns are not failures. They are inherent to the investment. Long-term investors have always been rewarded for tolerating volatility through the ERP. Attempting to avoid volatility results in lower long-term returns.
Concerns about “missing out” by not picking individual stocks are unfounded. Broad diversification ensures exposure to winning companies without requiring foresight. Historically, a small number of companies drive a disproportionately large share of market returns. Indexing ensures investors own them without needing to predict which ones they will be. In the short term, a small number of shares will inevitably outperform the index, but over the long term, the index remains the most reliable way to achieve consistent returns.
Global diversification is sometimes perceived as riskier or more complex, but in reality, it reduces concentration risk and enhances long-term performance. Currency movements are inherently unpredictable, but like volatility, they are simply a normal part of investing.
Discipline, evidence and time will deliver the result
Share market investing rewards discipline. The investor who stays invested through cycles, avoids unnecessary trading, and adheres to a clear strategy will generally outperform those who try to outsmart the market. Long-term wealth accumulation relies on capturing market returns consistently, not occasionally.
The share market is a powerful wealth-building tool when approached correctly. It complements property, provides diversification, liquidity, and enhances overall portfolio resilience.
By focusing on evidence-based strategies, maintaining discipline, and allowing time to do the heavy lifting, investors can build a share portfolio that works for decades.
