Appreciate the life-cycle consumption theory
Be cognizant of the life-cycle consumption (and saving) theory, because reaching your FSG at a desired age depends on adhering to the codes / rules of the four phases. As you are aware, this was given much deserved attention in the first main section. It is mentioned here again because it is so significant (and for the sake of completeness).
Appreciate the significance of the risk-free rate
An investment in government securities presents you with a return that is certain53 (the rfr). It is not wise to accept a return on a risky asset that is equal to or lower than the rfr. Your required rate of return (rrr) on a risky investment should be (rp = risk premium):
You need to decide on the rp, and it depends on the perceived risk.
Be aware of the principal-agent dilemma
Any institution that has a portfolio (i.e. a principal) cannot offer objective advice, because its advice is colored by its portfolio. There are a number of examples of investment banks that sold shares to individuals from their own portfolios, based on recommendations by them, because they wanted to disinvest from them. In at least one case a class action against the bank was undertaken and won, leading to reimbursement.
Thus, a bank or an insurer, for example, cannot give objective advice. The same applies to a broker-dealer which has a portfolio, unless the broker-dealer is acting as an agent or is undertaking transactions itself (dealing as a principal) that are proposed to you, and you are advised of this. Fund managers generally do not hold their own assets, and if they do, they are prohibited from transacting in these assets with clients.
Leave investing to the professionals
Successful investing requires in-depth research, which is undertaken in-house by fund managers or provided to them by broker-dealers in exchange for business (buy and sell deals for commission). Individuals rarely have the resources to undertake the research.
If one does decide to invest oneself, it should be a full-time occupation, and deals should be conducted through a broker that provides good research. The individual should also have a deep understanding of macroeconomics and research this area of economics continually (see next section). There are many individuals who are successful investors; all of them have a long-term investment horizon and undertake in-depth research.
There are also many individuals who are content to "earn the market", premised on the fact that few fund managers are able to outperform what the overall market delivers in returns. Individuals can do so by investing in investment vehicles, specifically ETFs which track the all-share (or similar) index.
Understand macroeconomics and mean reversion
As said in the preceding section, if one undertakes investing oneself, security analysis and a deep study of macroeconomics are important. We do not have the space to discuss macroeconomics here, and present instead the essence of macroeconomics (elucidation of the acronyms was presented earlier):
- C + I = GDE
- GDE + X - M = GDP (expenditure on).
- X - M = TAB = part of current account of BoP (CA-BoP).
- Counterpart of CaBoP = financial account of BoP (FaBoP).
- Forces of CaBoP and FaBoP = Aexchange rate.
- AMV = AP x ARGDP
- AM = ADBC + AFBC.
- Government expenditure > revenue = deficit (to be financed).
- Anominal GDP = Acompany profits = AFVP.
- Monetary policy and interest rates, which reflect and cause cycles.
Macroeconomics teaches us that there are economic cycles; they are innate and therefore inevitable. They are caused by the interplay of the above-mentioned. On cycles Dave Foord54 offers: "You should be aware that cycles do exist - they are a natural part of life, like the seasons, like the tides and like breathing in and out. Economic cycles also exist and it is important that you recognise this as fact. We find it surprising how many people still deny this. Standing in the way of market cycles, you will not only suffer the ignominy of a King Canute but you will do yourself serious financial harm. Market cycles are driven by interest rate cycles (valuation impact) and the business cycle (earnings impact). These two cycles are interconnected, but not exclusively so."
The cycles are anticipated by markets, and markets over-react and under-react, depending on many factors already mentioned, including human behaviour (mentioned before under the section on behavioural finance), as shown in Figure 22. The cycles in the share market are clear, as is the fact that share prices are extremely volatile in relation to nominal GDP. Notable in this chart is the average growth pa line: it is the average growth in both GDP and the all share index. This indicates what is called mean-reversion: in the long-term investment returns are linked to GDP growth (in nominal terms).
Figure 22: current GDP & all-share index (yoy)
Dave Foord in this regard says: "All investors should understand the concept of mean reversion...it refers to the assumption that both the high and low points in a variable's time series are temporary and that the variable will tend to move towards the long run average over time. Mean reversion is not only mathematically true (it has to be, in fact) but it can be used to good effect by investors. Because variables often take a long time to revert, it provides time and opportunity to take advantage of mispricing evident in the market."