“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:
Diversification
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.
Long Term Outlook
Investing requires making informed decisions based on things that have yet to happen. Past data can indicate things to come, but it’s never guaranteed.
In his 1989 book “One Up on Wall Street” Peter Lynch stated: “If I’d bothered to ask myself, ‘How can this stock possibly go higher?’ I would never have bought Subaru after it already had gone up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that.” It is important to invest based on future potential versus past performance.
While large short-term profits can often entice market neophytes, long-term investing is essential to greater success. And while active trading short-term trading can make money, this involves greater risk than buy-and-hold strategies.
The “Secret Sauce” – Dividends
In his most recent (annual) letter to the shareholders of Berkshire Hathaway, Warren Buffet, made a note of discussing the “secret sauce” of investing, namely dividends. Many investors focus only on the short-term capital appreciation of their investments and ignore the dividend component of their returns, but dividends are a great way of not only increasing your wealth, through regular income payments (share dividends or managed fund distributions) but are a barometer of where your investment may head in the future.
Here is an example (albeit on a much larger scale) from the 2023 Berkshire Hathaway letter to investors”
In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire.
The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.
Not only do you receive the annual dividend/distribution payments, which you can use to buy more shares or units in a fund but the market over the long term will reward those companies that continue to pay increased dividends.
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.
Income and Growth are both important aspects of your total return and by using a Core-Satellite approach, along with keeping an eye on dividends and distributions you can grow your wealth over the long term.
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.