The last Q & A post I compiled from my Quora page has proved pretty popular, so for better or worse, here’s part two.
Is there a limit to how much you can invest in index funds?
From a purely practical perspective, there is absolutely no limit to your investment amounts. The more the merrier! That being said, from the viewpoint of building an investment portfolio, I would however certainly suggest that there should be a limit.
Index investments are currently the ‘new black’ for investors. This can be attributed to their very cheap fees, the use of Robo distribution and above all else, a bull market in its 10th year.
But it hasn’t always been the case. Index funds have been around since 1976, so they are certainly not a new, innovative or groundbreaking product.
Rather, as the world emerged from the wreckage of the GFC, active fund managers were under siege having lost huge value within their funds and in numerous cases, forced fund closures or withdrawal moratoriums. Investors were certainly not happy.
So as markets gathered upward momentum, as they inevitably do after crashes, investors began searching for simpler and more cost-effective methods to jump on the ‘gravy train’! And funds’ man- agement marketing departments sensed this shift in attitude and responded accordingly by dusting off and relaunching their old index funds.
Hey, presto, there was a product that captured every ounce of upward market movement, was as cheap as chips to run and could satisfy just about every investor proclivity.
And hallelujah, an index fund is also tailor-made for the new method of distribution – Robo advice. Compliance could finally be automated and all of a sudden the fund’s management industry entered the do-it-yourself world.
So by ticking all the boxes for investors; digital distribution, cost-effective and most importantly, performance-driven, fund managers again came back into favor, albeit this time as passive rather than active.
The result has been a flooding of the market with just about every index known to mankind, no doubt warming the heart of the late and great, Jack Bogle. Additionally, app-driven investment derivations began spreading across smartphone screens faster than a ‘flu virus in a crowded elevator’ relegating the complexities of investment into the realms of ‘throwing loose change into a jar’.
So it’s therefore, no wonder that index investing has well and truly taken the investing public by storm. And really, is there anything wrong with that?
Mmm, maybe just one thing.
A lot of new index investors have never experienced a market collapse. Rather they have entered markets via the ashes of the GFC rather than having endured the effects from its fire! As a result, in- vesting has been a rather pleasing and rewarding pastime. Over the past 10 years, it is has been one record after another across global markets, driving investor confidence!
But as is often the case during booms, particularly during their late stages, confidence is often re- placed by hubris, resulting in investment decision making that often foregoes proper process.
As a result, a prolonged market downturn will provide fuel for some severe investor dissatisfaction. Initially, with the product, they are in, then subsequently with the overall market. This is the point that rational thought disappears and investment satisfaction is replaced by discomfort, then concern and finally fear.
And many investors experiencing severe market downturns for the first time will move to a state of fear pretty quickly. They are concerned about losing all their money. And their lack of real market knowledge makes them take hasty action, which in most cases is to sell.
Now markets don’t actually move by themselves, rather it’s the reaction of investors responding to external forces that move them. So when negative events occur that can move people ‘en masse’, expect some severe downward volatility.
And because an index’s primary function is to track performance, one doesn’t need to be Warren Buffet to realize the consequences this will have on all that money invested via those same indexes!
And it is here that the problem is. The huge volume of funds invested within index funds will suddenly begin an exodus from fear, creating downward pressure which in turn will stimulate further redemption action. And this will continue until finally, even the hardiest of investors capitulate and sell out.
Now I am certainly no Michael Burry, predicting catastrophe as a result of index investments. Rather I believe the boom in index funds is failing investors by not addressing standard portfolio design. That is, self-directed investors’ particularly using Robo advice distribution seem to be satisfied by geographic diversification across indexes as their method of risk mitigation.
But what they are failing to see is the importance of including a negative correlation between portfolio assets to truly protect themselves from the effects of market downside.
Whilst global markets continue their record-breaking runs there are no problems. But when we enter a bear phase, which we certainly will at some point in the future, a correctly constructed portfolio will be able to withstand such an event and continue into the next bull phase. Whilst badly constructed portfolios – vis a vis, exclusively index funds, will have long been abandoned before any recovery occurs.
So to answer your question in a more succinct manner, there are certainly no limits to index fund in- vestment however there most certainly is a limit when that investment occurs as part of a well-con- structed investment portfolio.
Why do financial advisors feel entitled to cheat their clients out of many thousands of dollars with little risk of criminal penalties when they have been given specific primary instructions by the client to protect their money by minimizing risk?
I can certainly understand the contributing factors that would have formed your question. As a member of the advice industry for the last 30 years, I have seen some pretty irresponsible acts in the name of advice.
And as is often the case in today’s quickfire information age, it is mostly these sensational stories that get any traction. Which means the public will often only see the bad side of the profession.
I can assure you, that there are far more stories of advisers helping clients with their financial fu- tures than stuffing them around. But that is their role, and what journalist is ever going to write a story about how well someone has actually carried out their job! None to be exact. On the other hand, they will quickly open ‘Word’ in order to publish something about them lying, cheating, or stealing!
Now don’t get me wrong, I have also been a vehement critic of the industry over the years, many times to my own detriment. But I have found that the surfeit of morally corrupt behaviors you allude too, can actually be laid directly at the feet of management. It is senior management who create the
corporate culture blueprint, and middle management who execute those blueprints without question.
Corporate culture shapes employee behaviors. And sadly over the last 10 years or so, the cultural architects for our financial institutions’ have failed miserably in both the moral and ethical areas. It is these senior executives you should be ridiculing and not the advisers.
Shouldn’t dividends be the ultimate goal of owning shares? Isn’t buying them hoping they will grow a “pyramid scheme”?
Buying shares in a company is very similar to buying a business. The biggest difference being management input. Shareholders have no influence over management decision making where a business owner does.
That being said, both are entered into for exactly the same reasons. To reap the rewards of yearly profitability, dividends, and share in the expanded value of the business as it grows.
Some businesses lend themselves to generating greater yearly profits rather than growing their over- all value, whilst others are better to do the opposite.
It is, therefore, a reasonably easy matter for both types of investors to determine exactly the type of investment they want. A shareholder can certainly differentiate between income-producing shares and those that are growth orientated. Whilst business owners can also determine if a prospective business will generate income rather than large resale value and vice versa.
As such, defining the ultimate goal of share ownership as being purely for purposes of income production, is denying the other very profitable feature they possess.
Both steady income and value growth is engineered by having the right products, in the right markets, sold for the right price after being advertised to the right buyers! It is therefore not luck or a ‘pyramid scheme.’ It should be, however, the ‘responsibility’ of the investor prior to investing, to conduct enough prudent research to ensure this actually remains the case.
What is it like to outlive your retirement savings?
I vividly recall my late father in law saying these exact words. Back then longevity wasn’t seen as a real ‘risk’ to retirement funds. He lived till age 90 and always said he ran out of money 5 years be- fore! Thank goodness for a well-developed government pension system.
In actual fact his lifestyle didn’t alter, nor was he denied anything. He still lived in his own house and lived a comfortable life commensurate with what his age allowed him to do.
But it’s certainly a reminder to those approaching retirement that because modern medical science is pushing the outer limits of life they should be addressing this in their investment strategy.
An allocation to growth investments is essential to ensure funds don’t dwindle over the years. Time is a great emulsifier of investment volatility and it appears we are getting more and more of this thanks to advances in medicine. So make sure you take advantage of both your increased lifespan and, investment horizon!
Is it advisable to be inherently suspicious of anyone trying to convince you to use them as your investment advisor?
Every single product on the market is trying to convince you to buy it! Each TV/radio/magazine/facebook advertisement, twitter post, Instagram influencer post, and everything else, have only one purpose; to convince you to buy the product. If they can’t do that, they make no money.
A financial adviser is absolutely no different than MacDonald’s, KFC, Coke, J & J, Toyota, Tom Cruise’s latest movie, a resort in the Maldives, flavored milk, et al!
It will be up to the consumer to devise strategies in order to assess the veracity of the claims being made.
I am certainly amazed though, during my 30 years in the industry, by the huge number of caring, loving, considerate, client-centric, honest, capable, empathic, adorable, ethical, etc. people who inhabit the realms of advice. The financial advice industry seems to only attract people that would put Mother Therese to shame! (Yes, tongue in cheek)
What does an investment advisor have to do to gain your trust?
A great deal of trust between the adviser and client is actually developed during the initial meeting. An adviser definitely needs to be cognisant of this otherwise they will certainly fail in gaining a new client.
How is trust built?
There are three main elements an adviser needs to demonstrate to a client in order for the client to listen to advice from a new adviser.
1. Propriety
First impressions are lasting, so the top layer of building trust is the impression an adviser gives a client when first meeting them. Propriety can be defined as ‘conformity to conventionally accepted standards of behavior or morals.’ amongst other similar definitions.
A client will expect to be meeting with an adviser for the first time, whom they feel looks, and acts, as they imagined an adviser should. How the adviser is dressed? How they’re greeted? And, just as importantly, the adviser’s office environment and surroundings. These should all contribute to an adviser’s propriety in the client’s eyes. And after building a relationship these areas will drop away in importance.
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Integrity
The next element required when building trust is integrity. This can be defined as ‘the quality of being honest and having strong moral principles’. It’s a very important characteristic for any client when they’re choosing an adviser. An adviser will also need to display their empathy which is a key emotion for this situation. An adviser needs to be able to enunciate both to a potential client.
Often the best way is to be open and honest with the processes to be undertaken in order to give pertinent advice. Thus, they need to explain their interview process; the type of questions, the need for a written record and finally the presentation of a written advice document. The client will then have a complete understanding of what they’re getting into and will have no surprises along the way.
Additionally, integrity will also be demonstrated in the adviser’s actions. They need to remain focused solely on the client and their body language and verbal communication need to reflect this at all times.
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Knowledge
Finally, showing a client that you are a good person to deal with is important, but you also need to display to them that you’re actually able to solve their problems. So you need to ‘wheel’ out your qualifications, your experience in the industry and the time spent with your current employer.
When these three elements are portrayed to a client correctly it will build trust with a client enabling an adviser to move effortlessly to the more analytical and advice oriented stages of the relationship.
What is your investment strategy?
Overall my investment ethos is to buy and hold. My objective is to create a liveable income stream. In doing so I am looking for regular growing dividends from the companies I invest in.
And I reinvest those dividends back into, either, more of the same or other shares that match my investment criteria.
I monitor my portfolio daily, but that’s purely from my absolute fascination with share markets. I will, however, review my investments six-monthly to make decisions about performance based on my objectives.
Although I am a long term investor, during these reviews I am certainly not averse to selling any shares that have failed to perform over the last 3-5 years or are under stress through management error or incompetence.
How much should I start investing in the Australian stock market as an 18-year-old?
Before you undertake any investment, make sure you spend some time bolstering your market and investment knowledge. This is easily done through a wide reading of books, newspapers, and blogs.
To the uninitiated, share market investment is often done with no real knowledge of what is actually being undertaken. (And rest assured this occurs within all age groups!) So an understanding of the vagaries of markets puts you in good stead and stops you running for the ‘exits’ at the first signs of trouble. Market volatility has been a constant in share markets for the past 500 years and it’ll certainly be the same for the next 500!
To quote one of the world’s greatest investors, “The stock market is a device for transferring money from the impatient to the patient.” so ensure you make time for your investments to grow and flourish. I can assure you, share investing is all about getting rich slowly rather than quickly.
And finally, make sure you have a plan for your investment. Exactly what it is you are wanting to achieve with your investment funds? By setting an investment goal right at the start and formulating the strategies to achieve it, ensures you are directing your money in a cohesive fashion.
Otherwise, you will end up either jumping onto the investing version of the ‘flavor of the month’, will listen and act on the advice being peddled by market pundits, actually believe the advertising messages of the major institutions and worse of all, take investment advice from a friend or acquaintance! (Presuming Warren Buffett, John Templeton, et al, are not within your current circle of friends)
And how much should you start investing? After doing all of the above (and more), you’ll know.
What do people misunderstand about diversifying their investments?
Diversification is not purely about spreading your portfolio across different assets and geographic markets but also ensuring there is a degree of negative correlation between these assets. That is when one asset goes down another goes up thus smoothing out portfolio returns.
For example, Gorton and Rouwenhorst (2005)investigated the long-term ownership of gold shares and physical gold to discover which one achieved the best returns. Within their study, they com- pared returns between 1962 and 2003. and discovered that over the 41 years investigated the average rate of return on physical gold was greater than gold mining shares.
Additionally, they found that for only 40% of the time both were correlated moving in a tandem fashion. In contrast, they noted that gold mining stocks correlated with the stock market 57% of the time concluding that gold mining shares acted more in line with stock market movements and not gold price fluctuations.
Thus, physical gold provided a better choice of diversification than gold mining securities. Oh, by the way, if you enjoyed this post, check out the first instalment here.
