We started this series last month focused on managing your wealth. As a quick reminder, to manage your wealth you would need to make investments – financial investments are key to growing your wealth from whatever level you start from. We covered an introduction to the basics and highlighted the six basic principles you must know to get you started on your financial investment journey namely:
1. Assess your risk appetite
2. Diversify your investments
3. Determine your timing
4. Use averaging to your advantage
5. Start investing early and re-invest your gains
6. Regularly review and re-balance your portfolio
We have already covered the first two principles in some detail and now look at the other four in today’s article.
Determine your timing
Time is a key component which can affect your investment returns. There are two ways in which time affects your investments.
a) Time in the Market (Time Horizon): Any investment we make may fluctuate in value in the short term, and we refer to this as volatility.
Such volatility can, however, be smoothed out if you hold the investment over a longer time period. In fact, a well-managed portfolio of investments – including the different types of investments we discussed previously – tends to show higher gains over the long term versus the short term.
b) Timing the Market: “Buying low and selling high” may sound like a good investing rule-of-thumb, but if you try to “time the market” (grabbing the lowest and highest points in the market to buy and sell, respectively) it may lead to risky investment behaviour and may result in lower than expected gains or losses to the principal amount invested. It is not so simple to time the market by “buying low and selling high”. If you try this, you may end up doing the opposite (that is, buying high and selling low). Rather, if your investment decision is to simply buy and hold on to an investment over a longer time-period, you may have the opportunity to receive better investment returns by participating in the market’s best performing cycles.
Use averaging to your advantage
Time can serve you in another way when making investment decisions if you are able to utilize the concept of dollar cost averaging. With dollar cost averaging, you are committing to buy a fixed sum of a particular investment on a regular schedule. When prices go up, fewer units will be bought, and when prices go down, more units will be purchased.
The cost of each unit acquired can then be averaged out over time. In this way, you may be able to build up a desired investment position by making a gradual and disciplined entry into the market, avoiding the need to commit the entire capital upfront, or risk investing a large sum at an unexpectedly dis-advantageous time.
This is a particularly important principle to follow when investing in financial markets which permit retail purchase of investments. A regular savings plan in investment securities applies this principle very effectively. In the long run, even if the prices of the securities being purchased increases, you would have benefited from the appreciation in value of the units already held.
Start investing early and re-invest your gains
The power of compounding/compound interest comes into play very strongly for those who are able to apply this principle. You may potentially maximise your returns by consistently re-investing any gains you receive back into your investment when making your investment decisions. This way, you are continuously putting a larger amount of capital to work, and your investment return will be compounded – and may be maximized – over time.
Utilised properly, compounding may help you grow a small sum of money into a substantial amount over a longer time horizon. To illustrate with an example – an 18 year-old enters the workforce and starts saving GHS20,000 a year for the next 7 years till age 25. Then let’s say they stop saving and those savings (whether parked in a bank deposit or through other investments) continue to compound at a rate of 10 per cent a year.
A simple calculation will show that by saving a total of GHS140,000 in the first 7 years of their working life, they would have about GHS1,000,000 by age 66 -roughly 40 years later. Contrast this with someone who is 26 years old and decides to copy the same and starts saving at 26. They would have to save GHS20,000 every year till they are 66 in order to achieve the same outcome (GHS1,000,000) even if the money is saved in the same investment compounding at 10 per cent a year!
Regularly review and re-balance your portfolio
As part of your process in making your investment decisions, you should keep in mind the evaluation and fine-tuning of your investment portfolio at regularly scheduled reviews (3-4 times a year). This evaluation and fine-tuning may help to ensure your portfolio continues to be aligned with your desired risk-return profile, and that it is well positioned to achieve your target performance.
At each review, ask yourself if your personal and financial situations have changed, and whether the investment performance of your portfolio has affected your goals. When monitoring your investment performance, resist making impulse driven changes in response to short-term market fluctuations (and incur transaction costs in the process). Instead, keep in mind the investment goal and time horizon you have set for yourself, before deciding if there is a real need to re-balance and re-adjust your portfolio investments.
Finally, it’s quite important to emphasise the professional services of a financial advisor can be most valuable in working through these principles. He or she will be able to help monitor your investments, help you understand if your portfolio is performing to expectations, identify new investment opportunities, and recommend portfolio adjustments