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Investing: Five Key Lessons

Investing : Five Key Principles

Every bull or bear provides opportunities for investors to improve their process for investing. The best thing to do is learn from past events and apply those lessons to your future investment strategies and circumstances. Here are the top five lessons we took away from recent market trends.

Lesson 1: Diversification still works.

Without the knowledge of which asset classes or sectors will outperform, the key is to diversify. Trying to pick the best-performing asset class of the year is very risky, considering that one year's best performing asset class can just as easily end up as the next year's worst performer. For example, Australian real estate investment trusts have been both the top-performing and worst-performing asset class more than once over the last decade.

We believe that a sound, well-diversified portfolio with a long-term focus will help reduce volatility and provide steady, consistent returns over the years.

Lesson 2: Stay invested.

While short-term market falls are hard to ignore, it's essential to stay invested. In fact, long-term investment discipline is more important than ever in a market crisis. We know that markets move in cycles, and that historically each bear market has been followed by a bull market. Therefore, if you remove your investment during a down market, you won't benefit when the market rebounds.

Exhibit 2 shows six potential outcomes of investing $10,000 in the Australian share market from February 1980 to 31 July 2015. Pursuing a 'buy and hold' strategy resulted in the original investment being worth $495,894. The chart shows the effects on the investment of missing the best performing months – the difference is quite substantial.

The investor who incorrectly attempted to time the market and missed the single best month over a 35-year period ended up with $422,289, almost 15% less than the investor who pursued the buy and hold strategy. Sitting on the sidelines and missing the best 10 months over the same period resulted in $149,726; that is, 70% less than the patient, 'buy and hold' investor's end value.

Lesson 3: Keep your resolve.

This is the most important learning from recent times. Through market cycles, it’s easy for investors to react emotionally –through overconfidence in rising markets or, equally, reacting with fear in falling markets.

We know that the best way to reach your financial goals is to remain cool and stick to your long-term investment strategies. History has shown us that markets tend to recover just as quickly as they fall, as we saw in 2009 when the Australian share market enjoyed a significant recovery from March through to December.

Let's look at two investors to ask the question; "Does staying the course make sense?"

The blue line in Exhibit 1 shows the growth of a $10,000 sample 70/30 balanced portfolio from 1 July 2005 until 31 July 2015. The chart shows what happens to the portfolio's value as the result of two different scenarios:

Investor 1: This investor kept their cool and decided to stay the course. Despite news reports of a potential market sell off, Investor 1 made no changes to their investment strategy. By the end of July 2015, their balance would have been $18,540.

Investor 2: This investor reacted in fear to talk of an imminent market sell off and switched their investment to cash. Unfortunately for them, the market sell off didn’t happen — and the market never 'bottomed'.

By switching to cash, the investor missed out on the long-term upward market trend.

The problem with trying to 'time' the markets is that you never know when the market has peaked or troughed. This investor's money was now worth only $15,386 at the end of July 2015; a difference of more than $3,000.

As Exhibit 1 shows, when investors keep their cool and stick to their long-term strategy, their portfolio can recover short-term losses and even gain a greater percentage than the value lost — and at a faster rate — than when they switched to a cash investment.

Exhibit 1

Source: Russell Investments, Morningstar Direct

Lesson 4: Investing in the markets is the primary way to meet retirement and other financial goals.

The markets can be tough on your nerves, but despite this, it's important to discount short-term market performance when considering your longer-term financial objectives. Although the Australian share market fell 39% in 2008, it gained 38% in 20091. Investing is still the most prudent approach to beat inflation and help realise your long- term financial objectives.

As seen in Exhibit 1, a diversified investment has significantly outpaced the growth of cash.

Lesson 5: Whatever goes down will likely come back up again.

Following six years of solid growth by the Australian share market, investors were reminded in 2008 that markets do in fact fall.

This we know: Markets follow cycles of ups and downs. What we don't know is their timing or duration.

As discussed in Lesson 4, the Australian share market experienced strong gains in 2009 following the downturn which commenced in late 2007. The point is that markets typically recover. Over the medium to long term, despite the ups and downs, the Australian share market has returned positive results.

What we've learned.

With recent market volatility in 2015, investors may consider making changes to their investment strategy and perhaps exiting markets altogether. However, years of lows and highs – such as 2008 and 2009 – help to demonstrate what we think are the key principles of investing:

  • Diversify - it's essential to have a well-diversified portfolio to help lessen the impact of market downturns.

  • Stay invested - don't miss your opportunity for financial gains when the market recovers. You have to be in it to win it.

  • Concentrate on the long term - short-term market returns shouldn't concern the long-term investor.

  • Don't try to time the markets, or pick next year's winner - no one knows when markets will peak and trough, and which asset class will outperform is a risky behaviour.

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