What is the equity risk premium?

To compensate for their greater short-term volatility and risk of loss, shares should provide a return differential over a ‘risk free’ asset like government bonds over the long term. This return differential is referred to as the equity risk premium (ERP) and used to be thought of as being around 5% pa or more as this is what it had been for much of the post World War Two war period. But thanks largely to the 2007-09 global financial crisis (GFC), global shares have underperformed global bonds by around 1% pa over the last decade and Australian shares have underperformed Australian bonds by around 2.1% pa. Does this mean the equity risk premium concept is meaningless and that shares are a dud? The answer is no.

As the ERP concept relates to the very long term, the last decade or so proves nothing about its merits. Unfortunately, much confusion and disagreement surrounds the ERP. This is largely because it can refer to three different things: the historically realised return gap between equities and bonds; the gap required by investors to attract them to invest in equities; and the prospective (or likely) long-term gap based on current valuations. A key issue is not what equities have done relative to bonds in the past but what their potential is going forward. These concepts can move in opposite directions.

The historical (or ex post) equity risk premium

Many analysts tend to focus on historical data as a guide to what sort of return premium investors require for shares over bonds and to what it will be in future. However, while a useful starting point, this approach has limitations. Firstly, the historically realised return differential between equities and bonds varies significantly over time. As can be seen in the next table, between 1950 and 1999 the ERP was 8.4% pa in the US. But if the period is extended to 2016, the ERP falls to 6.2% pa. Similarly the realised ERP for Australian shares was 5.4% pa over the 50 years from 1950, but if the period is extended to 2016 it drops to 4.4% pa.

Nominal returns, % pa

Source: Global Financial Database, Thomson Financial, AMP Capital

The instability of the realised ERP is highlighted below. Over rolling 10-year periods, the excess return from shares over bonds has varied from around -10% to +20% pa in the US and from around -7% to +17% pa in Australia. So the negative or low equity risk premium experienced in recent times is not unusual in an historic context. There is also a degree of mean reversion in the chart, with periods of low excess returns from shares being followed by periods of high excess returns, and vice versa. So the poor performance of shares versus bonds over the last decade globally and in Australia suggests there is a good chance of shares outperforming bonds over the decade ahead (just as the US share market has already shown).

Source: Global Financial Data, Thomson Reuters, AMP Capital

Obviously, the starting and end point valuation for markets for any period can heavily affect the size of the realised risk premium, even over long periods. For example, over the 50 years from 1950, equity returns were boosted by the fact that shares were depressed relative to earnings in 1950 (in the aftermath of the Great Depression and WWII) and so generated strong capital gains over the next 50 years as share prices rose relative to earnings. As a result, over the 1950 to 1999 period shares outperformed bonds by a very wide margin. However, by changing the end point to the end of 2016, the return from shares has been reduced thanks to the tech wreck and GFC. The point is that even when measuring over long periods the starting point and end point have a big impact on the measured equity risk premium.

Secondly, to the extent valuation changes (rising price to earnings multiples) boosted the realised ERP over the post-war period, this would have not been expected by investors and hence the measured ERP over that period is not a good guide to what they would have required to invest in shares.

Thirdly, in any case it is difficult to justify why investors would have demanded such a large premium (ie, 8.4% pa in the US and 5.4% pa in Australia over the 50 years from 1950). This would imply an implausibly high degree of risk aversion. It’s interesting to note that if we go way back to 1810, the US equity risk premium is just 3.1% pa.

Finally, historical equity data for countries like the US and Australia suffers from a survival bias. An investor who bought into German and Japanese shares in 1900 would have been wiped out along the way.

For these reasons, while an analysis of the past is a good starting point it does not provide a definitive guide as to what the equity risk premium should be or will be.

The required equity risk premium

We have already noted the historically realised ERP is not a good guide as to what investors actually require to invest in shares. The 5% plus ERP achieved in much of the post-war period was in large part due to a windfall gain to equity investors they were not expecting or requiring. Several considerations suggest that the required ERP has fallen and is now well below this, including:

• improved regulatory and legal protection for investors, which means less risk from investing in shares;

• lower trading costs in equities, greater scope to spread risk via diversification and improved market liquidity making it much easier to get out when desired;

• increased demand for shares from pension funds helped by tax concessions on retirement savings;

• the fall in inflation from the 1970s and 1980s, which has likely resulted in a higher quality of earnings;

• this and less regular recessions should have reduced economic uncertainty – although this may have been partly reversed following the GFC and the constrained and fragile growth profile seen since then;

• a greater feeling of global political security with no major wars since the end of WW2 and the end of the Cold War – although again this may have been partly reversed following the rise of terrorism and populist/nationalist politics.

While the GFC, the rise of terrorism and populism and a more risk-averse older population may have partly offset some of these favourable factors, the broad trend is still positive and suggests investors should demand a lower risk premium than, say, 50 or 100 years ago. Our assessment is that the appropriate equity risk premium going forward for US and global equities is somewhere around 3%. For Australian shares, fewer opportunities for diversification justify a slightly higher premium of around 3.5%, and for Asian shares greater economic and market volatility suggest a required ERP of around 4%. However, what will actually be delivered going forward is a different matter.

The prospective (or ex ante) equity risk premium

A simple way to think of the prospective (or likely) ERP for the next five to 10 years at any point in time is as follows:

Likely ERP = Dividend Yld plus Growth Rate less Bond Yld

The Growth Rate is the growth rate in share prices and this is assumed to equal the long run growth rate in listed company earnings. This in turn is assumed to equal long-term nominal growth in the economy (with some adjustments). This approach makes sense as the return on shares equals dividend income plus capital growth. The table below provides current figures for each of these, the prospective ERP in the second last column and our estimate of the required ERP in the final column.

* Average of Germany, France, Italy & Spain. ** US bond yield. Source: Bloomberg, AMP Capital

This suggests that likely ERPs for shares are above what we think is required. This is particularly so for Europe, Asia and Australia but less so for the US (which has outperformed in recent years) and Japan (thanks to poor growth prospects). Of course, this calculation of the prospective risk premium assumes that bond yields are unchanged. The risk over the next few years is that bond yields rise towards more normal levels as central banks raise interest rates and inflation picks up. This will result in capital losses on government bond investments and hence a potentially higher excess return from shares over bonds. Of course if bond yields rise rapidly this could negatively impact share markets but this is unlikely given still low underlying inflation pressures globally and only a gradual removal of still easy monetary conditions. And the positive gap between the prospective and required equity risk premiums indicates shares have a bit of a buffer on this front.

Concluding comments

• The historical record does not provide a definitive guide as to the risk premium that shares should or will offer over bonds. Just as the recent negative excess return from global and Australian shares over the last decade understates the return from shares over bonds, longer-term perceptions of a 5% plus return excess based on history exaggerate it;

• A range of factors suggests the required ERP is somewhere around 3-4% pa;

• Current estimates suggest the prospective ERP is above this, particularly for European, Asian and Australian shares.

While stocks are vulnerable to a correction after their sharp gains since February last year, their attractive risk premium compared to bonds along with the favourable outlook for growth and profits suggests that any short-term pullback in shares will simply be a correction in a still rising trend.

Source: AMP Capital 3 May 2017

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Despite numerous geopolitical threats (Eurozone elections, tensions between the US and China, North Korea, etc.), worries about the demise of the so-called “Trump trade” and shares being overbought and due for a correction at the start of the year, share markets have proved to be remarkably resilient with only a minor pull back into their recent lows. This despite a more significant fall back in bond yields. Partly this is because the geopolitical threats have not proven to be major problems (at least so far) and Trump remains focussed on his pro-business policy agenda (he has already embarked on deregulation and his tax reform proposals – while lacking in details – indicate that tax reform remains a key objective). More fundamentally though, markets have been underpinned by an improvement in global growth. This is likely to continue.

Global economy best in years

Numerous indicators point to a stronger global economy.

• Business condition indicators – commonly called purchasing managers’ indexes or PMIs – have moved up to their highest since the post GFC bounce.

Source: Bloomberg, AMP Capital

This is the case for manufacturing and services sectors and for advanced and emerging countries. This generally points to stronger growth ahead. Believe it or not the Eurozone currently looks to be the star performer on this front.

Source: Bloomberg, AMP Capital

• The OECD’s leading economic indicators (basically a combination of economic indicators that lead economic growth) have turned up decisively.

Source: OECD, Bloomberg, AMP Capital

• Consistent with improving global economic conditions, measures of unemployment are heading down in the major advanced countries (albeit they still have further to go in Europe).

Source: Bloomberg, AMP Capital

• Asian economies which are always a good barometer of the health of the global economy are seeing a solid rebound in export growth. So much for all the talk that world trade and globalisation had peaked!

Source: Bloomberg, AMP Capital

• Reflecting the improvement in global growth, for the first time in years the IMF’s latest World Economic Outlook update revised up its global growth forecast for the current year (2017) to 3.5% from 3.4% rather than revised it down as had become the norm.

Source: IMF, AMP Capital

Of course, there is one qualification to all these positive signs (there is always something!) and that is that the US economy looks to have seen a soft start to the year as measured by GDP growth. However, March quarters in the US seem to regularly come in on the soft side initially only to get revised up later and be followed by a bounce back in growth suggesting a seasonal adjustment problem. US unemployment claims running around their lowest since the early 1970s – no mean feat given that the US economy and population are much bigger today – tell us that the US economy remains strong despite a soft March quarter.

So why the turn for the better in global growth?

There are a bunch of factors driving healthier global growth including:

• Years of ultra-easy monetary policy – zero and even negative rates and money printing – have finally got traction.

• Fiscal austerity has largely come to an end.

• Memories of the global financial crisis (GFC) and hence fears of another re-run are gradually receding – after all it is now 9-10 years ago (shares peaked in 2007!) – and so the negative impact on confidence is gradually receding too.

• Deleveraging (or the desire to reduce debt ratios) post the GFC – to the extent that it occurred – has arguably run its course.

Investment implications

The pick-up in global growth is not so strong as to tell us that we are near the peak of the cycle. Spare capacity remains in labour markets, factories are still not running at full capacity, wages growth remains relatively weak (albeit it’s trending up a bit in the US) and core inflation remains low (just 0.7% year on year in the Eurozone, 0.1% in Japan, 1.8% in the US and 2.3% in China). Out of interest the US Leading Economic Indicator has only just surpassed its pre GFC high and historically it’s then taken six years on average for the next recession to start.

In other words we are a long way from boom times that then give way to a bust. Nevertheless, the implications of the healthier global economy are likely to be:

• Ongoing support for share markets – as stronger growth underpins further gains in profits – which should mean reasonable returns from shares.

• Support for commodity prices – although it’s doubtful they will take off given the lagged impact of rising supply but it should mean we have seen the lows.

• A bottoming in the global interest rate cycle. The Fed will continue its gradual tightening in monetary policy in the US with two more rate hikes likely this year and a start to reversing quantitative easing later this year via a phased reduction in the Fed rolling over its bond holdings as they mature. China is likely to continue tightening gradually as well. Other countries will eventually follow (albeit very slowly in Europe and then in Japan – but that could be years away).

• A resumption of the rising trend in government bond yields – after the pause seen since December – which is likely to mean low returns from government bonds.

• A rising trend in bond yields – albeit a gradual one – will weigh on bond proxies such as global real estate investment trusts and listed infrastructure assets constraining their returns relative to the double digit gains they have seen over the last five years in response to the prior plunge in bond yields.

For Australia, the stronger global growth back drop is a positive in supporting export demand and confidence which in turn should help support Australian economic growth pick up towards 3%. Which in turn adds to confidence that the official cash rate has bottomed. However, with downside risks to growth remaining as mining investment is still falling, underemployment remaining very high, wages growth still ultra-weak, the $A remaining relatively strong and core inflation remaining below target we remain of the view that an RBA rate hike is unlikely until the second half of 2018.

Source: AMP Capital 27 April 2017

Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

The RBA provided no surprises following its April board meeting leaving the official cash rate on hold at 1.5%.The RBA remains more confident regarding global growth, sees Australian economic growth as moderate, regards the labour market as being mixed, sees a gradual rise in underlying inflation and continues to see conditions in the housing market as varying considerably across the country, but sees recent regulatory measures as reducing the risks associated with high and rising household debt. This note looks at the outlook for the cash rate, the impact of bank rate hikes and the implications for investors.

RBA likely on hold well into 2018

Our assessment is the cash rate has probably hit bottom after falling from 4.75% in 2011 to a record low of 1.5% last year and that the next move will be a rate hike but not until second half 2018. Another rate cut looks unlikely because:

• economic growth is okay – having bounced back in the December quarter after a temporary slump;

• national income is up from its lows thanks to higher commodity prices;

• the RBA expects underlying inflation will gradually rise; and

• the Sydney and Melbourne residential property markets are uncomfortably hot with prices up 19% and 16% respectively over the last year and 75% and 50% respectively over the last five years posing financial stability risks if prices and household debt continue to rise.

By the same token it’s too early to be thinking about hikes as:

• unemployment and underemployment (ie. labour underutilisation) at over 14% are way too high;

• this is maintaining downwards pressure on wages growth which is at record low of 1.9% year on year (in terms of the historical record for the Wage Price Index);

Source: ABS, Bloomberg

• the $A remains too high and is up from January last year;

• underlying inflation risks staying below target for longer – reflecting low wages, the rise in the $A and competition;

• there are risks around economic growth as the contribution to growth from home building is likely to slow this year and retail sales growth is weak at a time when mining investment is still falling; and

• bank “out of cycle” mortgage rate hikes have delivered a (“modest”) de facto monetary tightening any way.

The RBA has to set interest rates for the average of Australia so raising interest rates just to slow the hot Sydney and Melbourne property markets would be complete madness at a time when overall growth is still fragile, underlying inflation is well below target and property price growth elsewhere is benign or weak. The best way to deal with the hot Sydney and Melbourne property markets and excessive growth in property investor lending into those markets is through tightening lending standards, which APRA has just moved again to do.

By the second half of 2018 the drag on growth from falling mining investment is likely to have ended, stronger global growth should have started to help Australian growth and stronger employment growth should have started to benefit full time jobs and wages and the threat around below target underlying inflation should have subsided. All of which should allow the RBA to start raising interest rates. But on current indications it’s hard to justify RBA rate hikes before then.

But what about bank out of cycle rate hikes?

The banks have recently raised rates for property investors and on interest only loans by around 0.25% and for principal and interest owner occupier loans by around 0.03%. The stated drivers were higher funding costs (presumably following the back up in global bond yields over the last six months) and regulatory pressure to slow lending to investors and higher risk borrowers. More moves may lie ahead if global borrowing costs rise further but again would be focussed on investors & interest only mortgages and in the absence of RBA rate hikes are likely to be small as only 20-30% of bank funding is sourced globally. But it’s worth putting “out of cycle” moves in context:

• The RBA is still in control. “Out of cycle” bank moves have been a regular occurrence since the GFC and yet this did not stop mortgage rates falling to record lows in response to RBA rate cuts. As can be seen in the chart below the virtually fixed 1.8% gap between the standard variable mortgage rate and the cash rate only applied from 1997 to 2007, prior to that the relationship was far less stable so “out of cycle” moves are nothing new. The chart shows that changes in the cash rate remain the main driver of mortgage rates. If the RBA wants to lower mortgage rates again it can just cut the cash rate till it gets the mortgage rates it wants.

Source: RBA, AMP Capital

• So far the changes in owner occupier rates are unlikely to have much economic impact because 3 basis points is trivial compared to the 200 basis point rise in mortgage rates that occurred in the 2009-10 monetary tightening cycle. So don’t expect much impact on consumer spending albeit there is negative psychological impact.

• Changes in investor rates have less impact on spending in the economy because they are tax deductible and investors are less sensitive to rate moves. That said investor rates have gone up by around 0.52% compared to owner occupier rates since 2015 and this will eventually have some dampening impact on investor demand.

House prices

While strong population growth means that underlying property demand remains strong, the threats to the hot Sydney and Melbourne property markets are building: more macro-prudential measures to slow lending to investors and to more risky borrowers have been announced; the banks are raising rates out of cycle particularly for investors; the May budget is likely to see a reduction in the capital gains tax discount; all at a time when the supply of units is surging; and home prices are ridiculous. Taken together these moves are likely to result in a significant dampening impact on home price growth.

Source: CoreLogic, AMP Capital

We continue to expect a significant cooling in price growth in Sydney and Melbourne this year followed by 5-10% price falls commencing sometime in 2018 after the RBA starts to hike rates. By contrast Perth and Darwin are getting close to bottoming (as the mining investment slumps nears its low) and other capital cities are likely to see continued moderate growth. Unit prices are most at risk given the increasing supply of units.

Will rate hikes crash the economy?

There seems to be a view that household debt is now so high that any hike in interest rates will cause mass defaults and crash the economy. This is nonsense. Yes household debt is up but not dramatically since the GFC and interest payments as a share of household disposable income are at their lowest since 2003. Mortgage rates would need to rise by nearly 2% to get the interest servicing ratio back to its most recent 2011 high – which slowed but did not crash the economy. And most Australians are ahead on their debt payments.

Source: RBA, AMP Capital

Finally, the RBA will move gradually when it does start to raise rates and knows households are now more sensitive to rate moves and so it probably won’t have to hike rates as much as in the past to cool any overheating in the economy.

Implications for investors

There are several implications for investors. First, bank term deposit rates are set to remain very low. As a result, there is an ongoing need to consider alternative sources of income. Second, be cautious of the Sydney and Melbourne property markets, particularly units. Third, remain a little bit wary of the $A as an on hold RBA at a time when the Fed is likely to hike rates another two or three times this year could put downwards pressure on the $A. So retain some exposure to unhedged global shares. Finally, with low interest rates growth assets providing decent yields will remain attractive. This includes unlisted commercial property and infrastructure but also Australian shares which continue to offer much higher income yields relative to bank term deposits.

Source: RBA, Bloomberg, AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

The basics of successful investing are timeless and some investors (often the best) have a knack of encapsulating these into a sentence or two that brings them to life in a way that’s easy to understand. Over the last few years I have written two insights on investment quotes I find useful (see “21 great investment quotes”, Oliver’s Insights, April 2014 and “Another 21 great investment quotes”, Oliver’s Insights, February 2015). Here are some more. Just considering them helps bring us back to the basics of investing which is critical at a time when we are being increasingly bombarded by noise around the next best thing or the next disaster about to hit investment markets.

Having a goal

“If you don’t know where you’re going any road will take you there.” Lewis Carroll paraphrased, George Harrison song “Any road”

The first thing to do when embarking on investing is to work out what your financial goals are, how much risk you are prepared to take, your desire for income versus capital growth, how active you want to be in managing your investments, etc. This may entail seeking advice. But if you don’t work out these things you will be vulnerable to all sorts of distractions which will take you a long way from your goals.

“Saving is a great habit, but without investing and tracking it just sleeps.” Manoj Arora

There is a big difference between saving and investing with the former often implying putting money aside in a bank deposit. This may be fine for short term spending requirements and rainy days but it won’t grow your wealth for which the more deliberate and considered process of investing is required.

The market

“Investing is the intersection of economics and psychology.” Seth Klarman

The point is that asset prices rarely reflect some rational fundamental value. Instead, the influence of various behavioural biases on thousands and millions of investors will often act to push prices well away from fundamentally justified levels.

“Sometimes [Mr Market’s] idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.” Benjamin Graham

In other words, the market can be like a manic depressive. Several insights flow from the Mr Market metaphor for financial markets. First, avoid getting sucked in during good times and spat out during bad. Second, it’s the manic swings that create opportunities. Third, make sure that you respect the market as the silly prices it throws up can sometimes linger longer than you can remain solvent (to borrow from John Maynard Keynes).

Contrarian investing

“Nearly every time I have strayed from the herd, I’ve made a lot of money. Wandering away from the action is the way to find the new action.” Jim Rogers

In the roller coaster of investor emotion that characterises investor psychology through a share market cycle the best financial opportunities are found after a period of sharp falls when shares have become undervalued and under loved by the investing crowd, ie, when investors are depressed. And vice versa for when shares are overvalued and investors euphoric.

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

“Generally the greater the stigma or revulsion, the better the bargain.” Seth Klarman

The more an asset has fallen out of favour to the point where no one will touch it with a barge poll is usually the point its value and return potential is probably the greatest.

“Cash combined with courage in a time of crisis is priceless.” Warren Buffett

To take advantage of the buying opportunities thrown up by a sharp fall in markets requires not only spare cash but a lot of courage because this is invariably the time when the news flow is at its worst – with talk of economic crisis, falling profits, high unemployment, etc – but also when the crowd around you is convinced that it’s a crazy time to invest.

Pessimism

“Pessimistic visions about anything usually strike the public as more erudite than optimistic ones.” Joseph Schumpeter

The evolution of the human brain through the Pleistocene era when the key was to avoid being eaten by a sabre tooth tiger or squashed by a woolly mammoth has left us hard wired to be on the lookout for risks. So bad news sells and a financial loss is felt more distastefully than the beneficial impact of the same sized gain. Consequently, prognosticators of doom are more likely to be revered as deep thinkers than optimists. Therefore, we seem to be perpetually bombarded with warnings about the next disaster to hit investment markets. But when it comes to investing, giving too much attention to pessimists doesn’t pay. Historically, since 1900 shares have had positive returns seven years out of 10 in the US and eight years out of 10 in Australia.

Process

“Investing is simple. It’s the financial industry that works hard to make it complex!” Robert Rolih

Unfortunately, there is an element of truth in this, although in the industry’s’ defence often the complexity arises from the desire to protect against a particular risk (eg, options) or make it easier to gain access to a certain exposure and remove others (eg, hedging currency risk from global exposures). But frequently this leads to unnecessary complexity and at times the industry itself has not properly understood what it has created (eg, the risks around sub-prime debt in the US prior to the GFC). Maybe it’s just human nature to want to make the simple complex. But the bottom line is: don’t overcomplicate your investments. Avoid investments you don’t understand and keep your investment process relatively simple and commensurate with the amount of effort you want to put in.

“Trying to pick the stocks that outperform the average is like trying to find a needle in a haystack.” Robert Rolih

Jack Bogle (the founder of Vanguard) says just buy the haystack. The point is that trying to pick stocks that will outperform the market is not easy and requires a lot of effort. The key to growing wealth over time is to get a broad exposure to the market and let compound interest do its job.

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.” Benjamin Graham

If you are trying to pick stocks to outperform the market the key is to look for value rather than glamour.

“The individual investor should act consistently as an investor and not as a speculator. This means,,,that she should be able to justify every purchase she makes and each price she pays by impersonal, objective reasoning that satisfies that she is getting more than her money’s worth for her purchase.” Benjamin Graham

In other words you need a process that filters stocks & enables you to assemble a portfolio as opposed to just taking a punt.

“Good investing is boring.” George Soros

Successful investing can take discipline and time and sometimes it can take years to pay off. This can be boring. If you want bright lights, excitement and instant riches (or more likely, losses) the casino is the place to go.

“It is remarkable how much long term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Charlie Munger

This is very important. You don’t need a super high IQ to be a successful investor. In fact, Charles Ellis wisely related investing to a “losers game” like amateur tennis or boxing after several rounds where you win by not trying to be smart but by not making stupid mistakes. In other words you win by not losing.

Knowledge, wisdom and noise

“Information is not knowledge, knowledge is not wisdom.” Frank Zappa (and maybe some others)

The information revolution and particularly the explosion of social media has made available to us a wealth of information and opinion around investments. But we need to recognise that much of this is ill-informed and that there is a big difference between information and wisdom when it comes to investing.

“An investment in knowledge pays the best interest.” Benjamin Franklin

There is not much to add to this. You have to do research and analysis before making investment making decisions. And with knowledge will come the wisdom to be able to screen out what doesn’t matter from the noise that surrounds us.

“When an investor focuses on short term investments, he or she is observing the variability of the portfolio, not the returns – in short being fooled by randomness.” Nassim Nicholas Taleb

Focussing on short term fluctuations in investment markets can be very distracting and risks blowing you off course from your strategy. Much of it is just random noise. On a day to day basis its pretty much a coin toss as to whether you will get good news or bad from share markets but the longer the time horizon you take the greater the probability of a positive return. On a calendar year basis its around 70-80% and on a decade by decade basis its actually 100% for Australian shares. In other words, time is on your side and the more you have of it the better. So turn down the day to day noise and avoid looking at your investments too frequently to avoid being disappointed.

Daily and monthly data from 1995, data for years and decades from 1900. Source: Global Financial Data, AMP Capital

Right mindset

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Mark Twain

If you want to be a successful investor you have to check your ego at the door and be humble.

Another perspective

“Always borrow money from a pessimist – she doesn’t expect to be paid back.” Anon

Or just make sure you don’t take on too much debt such that you lose control over your investments just at the wrong time.

“Money is not the most important thing in the world. Love is. Fortunately, I love money.” Jackie Mason

The Beatles wisely realised that “money can’t buy me love” and in the end the love you take is equal to the love you make.

“Money, if it does not bring you happiness, will at least help you be miserable in comfort.” Helen Gurley Brown

Well I guess that’s a good second best!

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.