Investors, don’t be a second-day skier

Beginner skiers often share a common trait. 

Their first day spent traversing the slopes is one of caution. They’re learning the ropes, being careful not to fall over and making sure they’ve figured out how to stop and start.

The following day things start to change. Having spent a day sussing out the whole skiing thing, they start to believe they’ve figured it all out and act like they’ll be one of the gold medal contenders at the next Winter Olympics.

Soon they’re speeding down the most dangerous slope at the resort and, a bit like Icarus flying too close to the sun, getting wiped out on a small jump. 

‍

Is there really a best investment strategy?

Learning about this phenomenon called to mind some feedback from a reader on one of our investment guides.

Said reader was frustrated there weren’t specific instructions, in percentage terms, on how much to invest each month.

This wasn’t an unreasonable request to make but it points to a common problem investors face. They often want to ‘figure it all out’ and create a catch-all solution that will tell them things, like what to buy or how much of their wealth they should invest.

One of the frustrating things about investing, and perhaps life in general, is that such solutions are rarely — if at all — forthcoming. 

As individuals we each have unique financial needs that will inform our investment decisions. 

Then you have constant fluctuations in the market, economy and wider world, which all make it impossible to pinpoint a particular stock or asset class and say it’s always going to be a winner.

That frustration can end up creating a few second-day skiers in the market, who get a bit fed up and plough into a strategy before they’ve really assessed if it’s truly right for them.

That might be sheer bloody-mindedness but it also reflects how unaware we are of risk or how it changes without us even knowing it.

‍

Managing investment risk

As an example of that, we need only look back a couple of decades. Common wisdom had it that a split of bonds and stocks was likely to ensure you saw a safe, stable return on your investments.

Central bank policies since the financial crisis in the late 2000s have effectively blown that model out of the water. 

Interest rates are now so low that the return on many government bonds is often below inflation, meaning you’d actually be losing money in real-terms by investing in them.

At the same time, the inflationary model which most central banks operate under hasn’t changed. 

The result has been a flight to stocks, and equity income, that seems to have only increased during the pandemic, as monetary policymakers continue to make cuts to already microscopic interest rates.

Finding lower risk assets

All of this makes it easy to forget that stocks have traditionally been regarded as riskier assets.

But the wider economic reality we’re faced with means they currently seem like the best option available to us. 

They’re much more accessible and affordable than something like real estate and carry less risk than some of the wilder asset classes, like crypto.

We also have to remember that all stocks are not created equal in terms of the risk they carry. 

Yield-hungry investors have made the step into dividend-paying equities since 2008 and started treating them as a kind of bond proxy. These often enormous global leaders with strong pricing power and loyal customer bases can bare little, if any, resemblance to a high-flying biotech or AIM gold miner.

You have a wide spectrum of investments on offer to you and should use that to your advantage, in terms of shielding yourself from potential losses.

Alternative income investments

One way investors have been doing this, and also looking to replicate the income they received from bonds in the past, is via alternative investments.

This includes things like aircraft leasing, music royalties or housing projects. Real estate investment trust Civitas Social Housing, for example, specifically aims to provide inflation-linked income to its investors.

Part of the reason these sorts of companies have appealed to investors is they are perceived as providing some of the stability that bonds used to, along with a similar stream of income.

But it’s also because they are a neat way of diversifying your investments and cutting the overexposure you may have to a given sector.

Music royalties and aircraft leasing don’t have much in common, nor do they share many traits with the tech and renewable energy stocks so many people have been buying into over the past few years.

Diversifying your portfolio

This links into the clichéd reminder to diversify your holdings. Holding a range of stocks would be advisable even if there were a wider range of safer investment options available to us.

But if you are only investing in the stock market then this is something you really need to keep on top of.

Diversification usually has a couple of meanings. The first is to hold stocks in a range of sectors that don’t share features which could result in them rising and falling in unison. And the other is to mix up the geographical regions the companies are active in.

‍

Read more:

• Five alternative income sources for investors
• Three investment trusts for emerging markets
• Invest like ARK’s Cathie Wood

‍

You shouldn’t do this for the sake of it. There’s no point in investing in a rubbish Japanese company, for example, just because it will give you exposure to the country. The goal is to have a mix of quality assets that aren’t strongly correlated.

The simplest way to do this is probably to invest in thematic or index ETFs. Some of L&G’s ETFs, for example, cover things like the robotics industry and the cybersecurity sector. 

Similarly, there are plenty of ETFs focused on regions or individual countries. Some of these are more niche. For instance, the iShares Asia Property ETF tracks, unsurprisingly, Asian real estate companies. Others, like the Vanguard APAC or iShares EM Latin America ETFs, track a broader range of companies in a given region.

Investment trusts are also a popular option here and are a simple way of accessing a varied set of companies. JPMorgan’s China Growth & Income trust is one example. 

The fund is popular with investors looking to gain exposure to companies in the world’s second-largest economy and there are plenty of trusts doing similar things with a specific region or sector in mind.

Be prepared to change your investment strategy

These instruments represent some of the methods investors are using to manage risk in our low interest rate world.

But that doesn’t mean you have to imitate them exactly or should be beholden to them at all times. As we’ve seen already, there are no cookie cutter answers here and you might have to craft your own methodology to manage risk.

It should also go without saying that stocks and bonds are not the only asset classes out there. The fact that the latter currently provide poor returns also doesn’t mean you have to put all your money into the stock market. 

Keeping part of your savings in cash, for example, is never a bad idea. It can help provide some dry powder if a buying opportunity comes up. Just don’t hold too much of it or for too long - cash drag is a real thing and can dampen the returns you’re making elsewhere in your portfolio.

On top of that, we also have to be conscious of any changes which may take place that would shift things around again. 

Nothing lasts forever and, just as the bond/equities split got torn asunder by central banks, so too could the existing low interest rate environment come to an end. 

Such a change could easily come about if policymakers decide to turn the heat off on the economy and bring interest rates back up again. Unlikely though this may be for now, it’s very much a possibility down the line. The Fed recently made a few noises to suggest a slow and steady rise might be on the table by 2023.

That’s both the annoying and interesting part of being an investor. Nothing is constant and widespread change is always possible, meaning we have to be nimble and think about how we can shake up what we’re doing if something happens.

Like the skier who believes he’s got it all figured out, thinking that you can come up with a solution that’s going to work in perpetuity leaves you more fragile than you realise. And it will probably mean your portfolio gets hit hard when a crisis comes.

As is the answer to most things in life, compromise and preparing for risk before it happens are key. Take things at your own pace and let your tolerance for risk, time horizon and financial goals dictate your asset mix. Leave the adrenaline at home.

‍

Had some second-day skier experience of your own? Talk about any lessons you learned with other Freetrade customers on the community forum:

Learn how to make better investment decisions with our collection of guides. They explain in simple language how to start investing if you are a beginner, how to buy and sell shares and how dividends work. We’ve covered investment accounts too, and how an ISA or a SIPP could be good places to grow your investments over the long term.

‍

‍