As with most things, greater knowledge and understanding leads to better choices. Whilst professional investors can’t see the future any more than everyone else, they do have an extensive toolbox of analytical techniques at their disposal, and investment theory and practice has evolved quite a lot over the last thirty years. Read on to discover some of these tools for yourself.

Why is it that the world’s most sophisticated investors continually do better than the average investor? It has been said that “the rich get richer and the poor get the picture”, and whilst the growing global income divide is widely discussed, what is perhaps not discussed enough, is the knowledge gap between the average investor and the sophisticated, professional. In Australia, the rise of DIY super makes this even more of an issue than it is in countries where pension schemes are dominated by government programs.

The rise of DIY investing has been driven by the disillusionment of many private investors with the investment industry and the desire to take back control. While it is appealing to stay in control of your investments, private investors too often end up with decision-making paralysis, neglect their investments, and end up with a delayed or insufficiently funded retirement.

Does “money make money”? Well, most lottery winners end up broke, and many people without sophisticated financial knowledge lose inheritance windfalls. Growing wealth takes knowledge, skill, a team of good advisers, and consistent, disciplined implementation. In other words, successful investing is both an acquired skill and a process—and has little to do with luck or being born wealthy.

Look at a game of blackjack. Long term, the winner is always the person who owns the casino – the one with the mathematical advantage. The same theory applies to investing. Sophisticated investors know there are no certainties, but they do know how to tip the odds in their favour. You could say the casino and the sophisticated investor have both developed a strategic business plan to win the game, whereas the punter or typical investor just walk in with no plan and try their luck. (At least most people walking into a casino realise they will probably lose – not realising the same approach will serve them badly in their investing decisions).

So, as a private investor, how can you start to think and act like some of the world’s most sophisticated investors, and in the process construct a portfolio that achieves better returns with lower risk?

The winning tools of the sophisticated investor

  • Sophisticated financial knowledge. They have a much deeper understanding of all types of investments and important investment concepts, including: the importance of strategic asset allocation, what intelligent diversification really looks like, exactly how to use correlation to their advantage, the psychology of investing, hedge fund strategies, professional portfolio risk management, how to achieve the best possible risk-adjusted returns, etc.;
  • Broad understanding of their whole portfolio. They are obsessive about risk and managing the downside, but also view the risk from each investment in the context of their overall portfolio, rather than considering it only in isolation;
  • Large pool of possible investments. They have access to a wider range of investments to choose from, including sophisticated alternative investment strategies;
  • Clearly defined risk and return objectives. They carefully set their risk and return objectives for the investment portfolio, after thorough discussions with the various stakeholders regarding the desired outcomes for the portfolio;
  • Take expert advice when needed. They have the human, technological, and financial resources to accurately assess the merits of various investments, turning to expert advisers as required;
  • Sufficient compensation for risk. They seek out investments with high levels of potential returns for the level of risk they carry;
  • Use short strategies. They make use of leverage and short-selling, to expand their investment options, reduce their portfolio risk, and profit from falling asset prices;
  • Diversify their portfolio across asset classes. They carefully combine good investments that are characteristically different, so their portfolio will perform well under a wide range of economic conditions;
  • Build in downside protection. They ensure their portfolio has adequate downside protection, so it can perform well in both rising and falling markets and they are not reliant on rising asset prices;
  • Stress test – what if? They stress test their asset allocation under a wide range of previous economic events and hypothetical “what-if” scenarios;
  • More meaningful reviews. Once they select their investments, they review them at appropriate timeframes against pre-defined criteria, and any changes are made with regard to the long-term outlook for their investment, not short-term performance or media attention;
  • Add investments thoughtfully. They add new investments to their portfolio only if an investment demonstrably improves their overall portfolio, meaning it must either reduce risk, increase return, or both; and
  • Ensure they have an income stream. They draw a sustainable income stream (less than the long term projected real after-tax returns) from the investment portfolio, in order to steadily grow their capital base in real terms, i.e. after inflation and tax.

The mistakes of the typical investor

  • A blind preference for a certain asset class. Many investors only invest in one or two asset classes, such as property and shares. There’s the “bricks and mortar” brigade, who only invest in property, and the share investors, who prefer the liquidity and franked dividends offered by shares. Either way, these investors are over-exposed to a substantial correction in property or share prices;
  • Expecting asset prices will continue to rise. Most investors rely too heavily on rising asset prices – we call this being overweight good times;
  • Ignoring investment opportunities that aren’t familiar. Many investors don’t understand anything other than cash, shares and property, so they simply ignore other investment opportunities, even ones that could reduce their risk, increase their returns, or both;
  • Looking for the next big thing. Rather than conduct a thorough analysis of their risk and return objectives, asset allocation and investment opportunities, unsophisticated investors often look for hot stock tips, hoping to earn unrealistic rates of return, and often taking an unsustainable level of risk in the process;
  • Getting financial advice at a barbecue. Some investors take investment tips from friends and relatives, who may know little about investing, rather than seeking the counsel of professional advisers and knowledgeable investment industry participants; and
  • Not correctly understanding how diversification works. They mistakenly believe that if they put about a third of their money in cash, a third in shares and a third in property, they will have a good, balanced portfolio. However, combining the low returns offered by cash with the high risk of growth assets does not produce good risk-adjusted returns over the long term.

The bottom line is that investing is a complex profession and not the domain of weekend warriors. Sophisticated investors understand the complexity of managing long-term investments, and therefore they avoid the common pitfalls of the everyday investor. It’s strange how little importance many people place on investing and/or their superannuation, as failing to adequately manage their investments will mean that they have to work for longer or accept a lower-quality retirement than they otherwise would have. Very often, private investors approach investing like a hobby, but managing your life savings is not a hobby – it’s a serious undertaking, no different from working through a complex legal matter, or dealing with a serious medical issue. Just as it would be unwise to grapple with complex legal matters without the assistance of a lawyer, or perform your own surgery, it is inadvisable to assume that navigating the complexities of the financial markets is something anyone can do with minimal knowledge or experience.