In my last post, I spoke about the first psychological component for long term success.
The 2nd psychological component to a good investment strategy is that for every four good investment periods, there should be only one bad investment period.
The idea is inspired by The Power of Bad by John Tierney and Roy Baumeister.
The central thesis of the book is that anything negative about an experience will, generally speaking, tar the overall experience so badly that a significant number of positives will not be able to balance it out.
This plays out very much in modern marriages.
Psychologists who observe married couples found that the marriages that tend to last have 4 pleasant interactions to 1 bad interaction. Consequently, marriages that have less than 2 pleasant interactions to 1 bad interaction tend to result in divorce.
We can use this “4 Good to 1 Bad” rule of thumb to design an investment strategy for beginners. An investment rookie must be able to sustain an investment portfolio long enough to benefit from compound interest. If it overly stresses him/her out, the investor will move onto a something else in life, something such as putting more effort into their day jobs and quitting investing entirely. It does not help human nature is designed to be turned off so much by negativity than be attracted by positive outcomes.
Remember that we want an initial strategy to provide a superior performance over the medium term while the student can develop the higher-end skills to evolve into a seasoned retail investor. So for beginners, superior investment performance is important but not the sole objective of strategy design.
Buying Singapore Stocks without a proper strategy
The local stock market, is a wild wild west frontier for the retail investor. To create an investable set of stocks, we typically remove all REITs, China counters and small stocks below $50 million in market capitalisation, this collapses a set of stocks from 700 counters to merely 300+ counters.
Back-testing the period for the past 10 years ending 31 December 2019, we have a return of 2.84% and a semivariance of 9.48%.
Arranging the probability distributions in a function, this means a 37% chance of losing money in one year, almost 1 bad year for every 2 good years. Even though this strategy may eventually be successful, but may have so much volatility, it’s almost akin to a bad marriage.
What About Buying The STI Index?
Buying Singapore blue chips is the next safe haven for retail investors. If you buy Singapore’s most iconic companies, you are playing it safe and essentially tilting your portfolio towards larger market capitalisation.
Buying the STI ETF will net you 4.07% with a semi-variance approximating 10.85%.
The chances of getting a negative year shrinks to 34%. Still not too good – 1 bad year to 2 good years.
The effects of this model are clearly felt by retail ETF holders over the years. It is not unusual to hear ETF buyers complain about how difficult it is to make money owing the STI ETF these days even though the PE ratio the Singapore market is quite low compared to other markets.
What about buying all the REITs?
What happens if an investor is rich enough to buy every REIT in the market for the past 10 years? The performance improves dramatically. You can earn 12.67% at a lower downside risk of 8.47%.
REITs have the basic components of a good investment for beginners. This creates 19 good years over 1 bad year, thanks likely to a regular stream of dividends for the REITs holder.
So do we just sit on our hands and buy REITs?
The answer is no.
As there are 40+ REITs traded over SGX, a starting portfolio needs to pick a subset of REITs that can outperform even against an equally weighted REIT portfolio.
There is also another problem – REITS have been great investments for far too long and now there are concerns over whether this outperformance will remain consistent. If REIT naysayers are right, returns moving forward may normalise to equity returns.
Finally, REITs are also more sensitive to rising interest rates than other equities. Return and semivariance may change in an era of rising interest rates.
A rookie portfolio can contain REITs as its core, but introducing safe blue-chips and business trusts to lower volatility further and balance out some interest rate risk is vital to creating a sustainable portfolio for a rookie investor.
The good news is that with 19 good years to 1 bad year, there is ample room to sacrifice psychological comfort for long term gains and hedging against rising inflation rates.
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