Nicolas Overloop ~ CEO of Horizon65
Institutional and HNWI investors have known for ages how to structure investments to survive crises like the current inflation crisis with your net wealth intact, or at the very least rebounding after the crises past.
Building your own portfolio and keeping it balanced require a solid understanding of the fundamental factors that make up a good investment portfolio, the downside of doing so would be obviously harmful to your wealth.
That said, it is not easy as many different risks can materialize and you have to keep on top of your portfolio to make sure you know just what risks you are running and ensure you have appropriate countermeasures in place (hedges). It is possible to gain such knowledge through your own experience, however learning by doing is often an unprofitable way to go about it.
We will set out here the Big Four, the uncontested fundamentals of long-term investing. They are not great secrets, that will turn you into a star-investor, nor are they financial advice that promises ridiculous returns. It is basic knowledge that is the foundation of a solid investment strategy.
Inflation
Very relevant in todays’ world of (hopefully temporary) 8% inflation rates.
Practically, inflation occurs when there is too much money chasing too few goods & services leading to higher prices for those goods & services. Today’s inflation cycle is driven however by the ballooning cost of energy, supply-chain disruptions due to china’s zero-covid policy and the large amount of consumer spending coming out of lockdowns.
In simple terms, it means rising prices and lower buying power for the money you do have on hand.
Central banks are tasked with managing the amount of money in the economy and are trying to keep inflation at 2% which is the rate you have to take into account when building your investment strategy.
In most cases, the best way to not only reduce your losses, but to turn inflation into a benefit for your fortune, is the use of “real assets” or “non-financial assets”. These are investments like stocks, real estate or commodities, that represent real ownership of a tangible object as backing. Since their prices also rise they either remain their value or profit over time.
If you do buy non-real assets (savings accounts, bonds or other fixed income) then make sure the interest rate on those exceeds the inflation-rate as otherwise you are losing money. e.g. a UK government bond has an interest rate of 2.3%, if you deduct 2% inflation losses from that you can expect a “real return” of 0.3% for buying a 10Y UK government bond today.
You will have to live for a very long time if you want to get rich buying those bonds.
Compound Interest
Interest is often called with different names like Yield or Return and is often displayed on an annual basis e.g. a 5% yield means that a 100 euro investment will be worth 105 euro in one year time.
Things get much more interesting (and profitable) when you take into account compound interest.
Understanding compounding is very important to any wealth strategy, even Albert Einstein said that “compound interest is the most powerful force in the universe. He who understands it, earns it; he who doesn’t, pays it.”
In essence, you can take advantage of compound interest when you continuously reinvest the gains you made in your portfolio. If you are pursuing a long-term investment strategy then compound interest will eventually become the vast majority of your wealth.
So what happens if you continuously reinvest?
Your portfolio will have two sources of capital mixed together (compounded):
1/ the reinvested profits past investments
2/ your original investment.
For some investments, you have to take no action as the gains of last year are already priced into (e.g. stocks, real-estate) but many investments also generate cash returns such as stocks, rent or interest.
These returns are far smaller than the initial investment and everything over 5 % per year is already exceptional.
If you take these gains and buy even more assets, you will gain even more revenue in the next year, and even more in the year after that. Your fortune will start to grow exponentially. If we take the 5 % as an example, it is possible to more than double the initial investment in only 15 years. Just by reinvesting the profit.
If you invest for your retirement which is often a 25-year time horizon, you should take compound interest into account for any investment strategy.
Diversification
Many investors start out investing in very few assets such as buying only 2 stocks or investing everything in one property. However, the key to realize the compound interests is to build a portfolio that can cope with losses.
After all, if you invest long enough then every single risk will materialize (e.g. a pandemic, an oil shock, high inflation, …). No matter how strongly you believe the investment is sound, your net wealth doesn’t only rely on you believing it is sound but other people believing that too.
So what is diversification, it is a tradition to describe the underlying principle with an egg-basket. If you put all your eggs in one basket and you lose this basket, you lost all your eggs. However, if you divide the eggs into many baskets, you would only lose a few of them. If you are selling the eggs, you may even still make a profit if you lose one or two baskets.
Basically you should spread your investments to as many assets as possible (e.g. through ETFs) so that if one of the investments goes down in value, your portfolio will still go up in value.
In practice, this can be quite hard because the value of investments often move together with the flow of the market, which is why selecting assets that are unlikely to influence each other is an art of its own.
Building a diversified portfolio is the best way to make sure you realize a gain every year, even during pandemic years and recession years so that you can fully leverage compound interest effects.
