“Predicting rain doesn’t count. Building arks does” – Warren Buffet
This is such a simple saying but when it comes from of one of the world’s greatest investors we should all take note.
Whilst we can predict if it will rain today or tomorrow, we have no idea if it will rain next month, next year or in the next decade and the same goes for predicting investment markets. You will hear many professionals and non-professionals give you their prediction of where the economy or stock market will be in 12 months or 5 years but no one can tell with any certainty. Our philosophy is not to worry about when the rain will come but to be best prepared for it just like Noah did when he built his ark.
So how do we do this? The following explains our philosophy for investing:
According to Investopedia.com:
“Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk“
Here, we look at why this is true, and how to accomplish diversification in your portfolio.
Firstly you need to diversify amongst the different asset classes such as Australian Shares, Global Shares, Property, Fixed Income (i.e. Bonds) and Cash.
Secondly you need to diversify within each asset class. For example if you invest in Australian Shares and all you held were shares in National Australia Bank, ANZ, Westpac and Commonwealth Bank you would not have diversification within the Australian Shares asset class as you are invested only in Banks. In other words, all of the stocks you own shouldn’t be limited to one sector inside an asset class.
Each category of business is called a sector. The idea is to focus on several different sectors and find the best companies in each. Let’s say you were going to invest in five stocks. You might want a bank, a utility, a healthcare company, a tech company, and a consumer goods company.
Investing this way means that, even when bad things happen, your entire portfolio doesn’t have to go down. For instance, while Australian stocks and real estate trusts declined heavily during the GFC, precious metals like gold and silver went up significantly. Having something from each asset class can soften the blow when things go downhill. Having some cash and money in safe investments like savings accounts and term deposits may be a good idea as well.
Active vs. Passive Investing
You may hear some advisors, firms and fund managers promoting an active or passive approach to investing and they will all put forward their theory and their proof that one is better than the other. So what is Active Investing and what is Passive Investing?
Active Investing: According to Investopedia.com – “The use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. The opposite of active management is called passive management, better known as “indexing”.”
Passive Investing: According to Investopedia.com – “Also known as a buy-and-hold or couch potato strategy, passive investing requires good initial research, patience and a well-diversified portfolio. Unlike active investors, passive investors buy a security and typically don’t actively attempt to profit from short-term price fluctuations. Passive investors instead rely on their belief that in the long term the investment will be profitable.”
So which is the right approach? Active or Passive? Our belief is that both schools of thought can and should be used in a portfolio.
Our Approach – Core and Satellite
Core-satellite investing is a method of portfolio construction designed to minimise costs, tax liability and volatility while providing an opportunity to outperform the broad market as a whole. The core of the portfolio consists of passive investments that track major market indices, such as the Standard and Poor’s/ASX 200 Index (S&P/ASX 200). Additional positions, known as satellites, are added to the portfolio in the form of actively managed investments or direct stocks.
The following graph is courtesy of Vanguard Investments:
As you can see above the maroon part of the graph is your ‘core’ – which is mainly made up of passive investments in each asset class and the grey is your ‘satellite’ – which is mainly made up of actively managed funds and/or direct stocks. Please note that in some instances the entire ‘core’ could be made up of an active strategy, and this will be dependent on the economic and market environment of the time.
The Bottom Line
The core-satellite approach provides an opportunity to access the best of all worlds. Better-than-average performance, limited volatility and cost control all come together in a flexible package that can be designed specifically to cater to your needs.
And with that we will finish off with another Warren Buffet quote:
Someone’s sitting in the shade today because someone planted a tree a long time ago.
This website contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider you financial situation and needs before making any decisions based on this information.