What is investing?
‘Investing is simple, but not easy’ – Warren Buffett
This famous quote by the world’s most successful long-term investor neatly sums up why some people struggle to make decent returns from investments.
Investing is indeed ‘simple’ in principle. An investment is an exchange of your cash for some other type of asset in the expectation that it will either return you more cash, increase in value, or ideally, a combination of the two. The ‘not easy’ part is deciding what assets to buy, and when.
The three most commonly held assets, besides cash, are Equities (company shares), Fixed Interest (gilts and bonds) and Property. Each of these may provide you with a cash return now – in the form of dividends, interest or rent – as well as the potential to increase (or decrease) in value. Then there are assets which might collectively be dubbed ‘Alternatives’ – commodities, currencies, art, wine, etc. None of these would normally pay you a cash return now, but they might rise (or fall) in price.
Over the decades, various investment styles and strategies have also been developed, from the mainstream ‘value’, ‘growth’ and ‘quality’, to the more technical – ‘momentum’, ‘event-driven’, ‘arbitrage’, ‘shorting’, ‘options’ etc.
Given this complexity and jargon, how do we decide what to invest in? At Wise, we tend to avoid investing in the alternatives mentioned above because we have very little to go on when trying to work out whether they are cheap or expensive. They don’t make profits or generate cashflow. The return simply depends on whether you can sell them on to someone else at a higher price.
So, we mainly invest in the traditional assets of equities, fixed interest and property. Owning shares, for example, provides part ownership of a business, and the right to a fraction of its long-term profits. If a business can increase this over time, it can provide a ‘capital’ return by means of a rise in its share price, while many also pay periodic ‘income’ returns in the form of dividends.
By investing in assets listed on stock markets, we can easily sell them if needed. However, this ‘liquidity’ also means their price can fluctuate up or down in the short term depending on market expectations and the resulting supply and demand for that investment. This volatility is helpful in that it provides windows of opportunity to either take or dispose of positions. Yet, potential falls in value also mean you should only invest if you are unlikely to need your capital in the short term, and ideally can hold on for the long term.
Analysing individual investments is highly technical and resource intensive, so that’s why we prefer to invest using funds, which have dedicated management and research teams, and hold a range of different assets, providing diversification and helping mitigate specific risks.
Usually, a fund will have a well-defined strategy and framework for identifying which investments it would like to own. The approaches that have been proven to work over the long term include:
Value – hunting for assets whose market price is lower than the fair valuation of its expected future returns. Often these are found in sectors or regions that have fallen out of favour with investors, causing prices to fall.
Quality – looking for investments with secure financial positions, resilient business models, and resistant to competition due to perhaps brand or market dominance.
Growth – identifying businesses that are likely to grow their revenues and profits rapidly, thus making the company more valuable.
To decide which funds to own, we look for two main characteristics – a sensible stock selection strategy such as those mentioned above, and experienced and dedicated managers, who are likely to manage the fund for the foreseeable future and stick to their defined processes.
In summary, there are many factors involved in achieving good long-term investment returns. We believe the most important ones are:
- Careful research and selection of good quality, robust investments.
- Only investing in areas which look reasonably valued at the time of purchase.
- Moving out of investments that have become expensive.
- As far as possible, avoiding investments that can suffer a permanent loss of capital (as distinct from a temporary decline in market value).
- Avoiding fads and fashions, which tend to be expensive and often lead to significant losses (e.g. technology in the late 1990s, commodities in 2005-2007).
- Ignoring short term market and media ‘noise’.
- Accepting that price volatility is inevitable. While uncomfortable, it may provide opportunities to buy good investments at low prices.
Prices of assets, especially shares, can fall sharply in difficult times, even if there’s little wrong with the investment itself. Many people have lost money by selling out in difficult markets to avoid further declines, and therefore missed out on the subsequent recovery. At outset, you should be willing and able to stay the course, even through the most difficult of circumstances.
Which leads us back to Buffett:
- ‘Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it’.
- ‘The stock market is designed to transfer money from the active to the patient’.
We very much prefer to be patient.
This article is intended for information only, and does not constitute advice. All information is based on our understanding of current law and practice, which may be subject to change in the future.
Past performance in not an indication of future performance. Any investments you make and any income, can go down as well as up – you might not get back the full amount invested.
Wise Investments Limited is authorised and regulated by the Financial Conduct Authority, FCA no. 230553.