Investors’ worst enemy (themselves?)

Striking a balance between wealth protection and growth is both science and art. Finance is a technical field, but it’s also driven by emotions. Benjamin Graham, one of the founding fathers of modern investing, once said: “The investor’s chief problem, and even his worst enemy, is likely to be himself”. In rising markets, an investor’s fear of missing out leads to irrational exuberance. In falling markets, selling to avoid losses and attempting to buy again at a lower price might seem like a good idea, but it’s near impossible to time the market correctly every time. So, what should investors do? Let’s have a look.

The first pillar of our investment philosophy is wealth protection and growth. It’s a delicate balance: protect too little, and you may face more volatile peaks and troughs in the value of your investments; protect too much, and your assets may not grow enough to beat inflation. Below, I explore three ways an investor can think about protecting and growing wealth.

1. How do you protect yourself from severe volatility? Diversify your portfolio and don’t just chase the winners.

The first thing you should do to limit volatility is to ensure that portfolios are well-diversified by spreading your investments around. This means that your exposure to any one type of asset isn’t that big.

By diversifying, you expose your portfolio to a diverse range of assets that perform differently in different scenarios. You can balance the poorly performing investments with those doing better, and local events (say, tensions in the Middle East) could have less impact.

No strategy can guarantee that the value of a portfolio increases without setbacks, as no one can make markets trend higher. However, diversification can reduce the volatility of portfolios and potentially help them perform better than strategies focused solely on a few asset classes and geographies.

An example is our strategic asset allocation: we’re long-term investors across the major regions and asset classes. We back-tested this strategy to the mid-2000s and found that this allocation would have outperformed equity/bond portfolios with a narrower regional focus, such as Europe-only.

Of course, while useful as an illustration, we take any back-test with a pinch of salt ourselves. Remember, nothing can substitute real-life investment and market experience and, as always, past performance isn’t a guarantee of future returns.

2. How do you protect yourself from inflation eroding your returns? Stay invested and let compounding unfold.

If inflation is 2% a year, then 100 euros, pounds or dollars today will only be worth 60 after 25 years. At 4%, the value drops to 36. When asked what mankind’s greatest invention was, Albert Einstein replied: “Compound interest”. Einstein is said to have called compounding the 8th Wonder of the World. To outpace inflation, the use of compound interest is helpful.

Compound investing is simple and powerful. It’s when you reinvest the returns of your investments rather than banking the income. Any growth could multiply; small amounts of money could grow into larger amounts over time.

Compounding works best when you avoid overreacting to short-term market movements and leave your money invested. This is because any increases build upon themselves over the long term.

Consider the rule of 72, a back-of-the-envelope method to estimate an investment’s doubling time. Let’s say someone offered you the chance to invest 100 units of your currency in real estate for a 10% annual return. Divide 72 by ten, and you get 7.2. This is the number of years it would take for you to double the value of your money if you remained invested. If you banked your 10% annual return each year for 7.2 years without reinvesting, you’d only earn 172.

With everything you read in the papers, such as the situation in the Middle East or Russia’s invasion of Ukraine, it’s natural to be cautious. But, while it may seem low risk to bank all of your returns every time there’s a new headline, you could be missing out and fail to grow your capital enough to beat inflation. 

The use of compounding is why our investment strategy’s biggest engine of return is our long-term asset allocation, which remains invested for – you guessed it – the long term. 

3. How do you protect yourself from taking excessive risks? Act with moderation and conviction.

A long-term strategy can benefit from tilting portfolios in one direction or another based on shorter-term convictions. But when thinking about mitigating downside risks, the key is moderation. It’s impossible to protect yourself from all risks because, with any protection strategy, you risk being wrong.

Let’s say you believe equities will perform well over the long term but, in the short term, the prospect of a recession means that you think equities might do less well than bonds. You may want to protect yourself from the risk of equities falling by selling your equities and buying bonds. If you sell all of your equities and they don’t fall, you lose out. If you sell none and equities do fall, you lose out. This is where moderation comes in.

We tilt portfolios in a particular direction based on our convictions backed by research; we don’t overhaul them entirely. Think of it as not putting all your eggs in one basket: if you do, you risk losing it all; conversely, if you diversify your investments (put your eggs in multiple baskets) you won’t win as big, but you also won’t lose as big. 

How does this look in the context of our portfolios? 

At this stage, we own more government bonds, fewer equities and less riskier credit relative to our long-term allocation. Let’s take equities as an example. While a compelling asset class over the medium term, we hold fewer equities than normal (and more high-quality government bonds) because we believe the broader equity market could face higher volatility in the short term. 

However, we’re still invested in equities because we want diversified exposure to assets that perform differently at different times (point 1). We also want to benefit from compounding the returns from the equities we remain invested in (point 2). Finally, we’re mitigating the short-term risk of slowing economic growth and geopolitical tensions by investing in low-volatility equities across the US and Europe, which tend to do better than the broader market in these scenarios (point 3).