The article below is a timely one from Dimensional Fund Advisor's (DFA) Jim Parker, VP of DFA Australia. Though Ireland is a country there are many lessons to be learned from Ireland's missteps by the individual investor.
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Reaching understanding on the right way to invest often starts with studying bad investment decisions. But the lessons are far less painful when they are built on others’ experiences.
Recent events in Europe provide case studies on what can go wrong when a wealth-building strategy is built on too much debt, too little diversification and too little awareness of risk.
Ireland in recent years, for whatever reason, became heavily dependent on a couple of industries – namely construction and banking. The IMF1 in a report this year described the causes of these imbalances as “rapid credit growth, inflated property prices and high wage and price levels”.
Now, an economy is clearly much more complex than any individual and the ability of governments to control the composition of growth is limited. But there still are lessons here for individuals if they fail to spread their wealth-building strategies across different asset classes and diversify within those asset classes.
Becoming more diversified leaves you less open to idiosyncratic risks that are related to one sector or one company or one asset class. And you can do this without significantly compromising your expected return.
Another lesson from Ireland is not to base your investment strategy only on what happens during the good times or only in the bad.
Real interest rates in Ireland were very low before the crisis, which encouraged people to load up on debt. That debt now has to be repaid in an environment of falling prices, higher real interest rates and sluggish growth. The problem was too much focus on return and not enough on risk.
For individuals, the take-out is that leverage, while increasing the potential upside in boom times, magnifies the downside in the bust. So people swing from greed to fear and back again.
A better approach is to have a realistic, measured and long-term approach to risk. This means that during rising markets, you don’t take on more risk than you originally intended. And it means that during falling markets, you don’t become more risk averse than you first planned.
A third lesson is the importance of liquidity. This means you can quickly turn your investments back into hard cash if you need to.
Ireland’s banks got into trouble because their loan portfolios were dominated by speculative property ventures. When the crisis hit, their recourse to short-term funding dried up and they were unable to call in loans because of the illiquid nature of the assets.
For individuals, the lesson is there is value in having portfolios with sufficient liquidity. That means publicly traded equity and fixed income securities that can be turned into cash if needed.
So Ireland has some lessons for all of us:
• Holding concentrated portfolios exposes you to risks you don’t need to take. Diversification is the answer, both across and within asset classes.
• Basing your strategy only on the good times means you can end up taking more risk than you intended. And grounding your strategy only on the bad times means you can miss real opportunity. A balanced approach to risk and return is the answer.
• Finally, staking everything on illiquid assets can leave you high and dry when you need quick access to cash. So keep a proportion of your portfolio in liquid investments.
• All these strategic decisions are ones you should make in consultation with an advisor who understands your risk appetite, personal situation and goals.
Just don’t count on the luck of the Irish.
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Kevin Kroskey CFP, MBA
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Reaching understanding on the right way to invest often starts with studying bad investment decisions. But the lessons are far less painful when they are built on others’ experiences.
Recent events in Europe provide case studies on what can go wrong when a wealth-building strategy is built on too much debt, too little diversification and too little awareness of risk.
Ireland in recent years, for whatever reason, became heavily dependent on a couple of industries – namely construction and banking. The IMF1 in a report this year described the causes of these imbalances as “rapid credit growth, inflated property prices and high wage and price levels”.
Now, an economy is clearly much more complex than any individual and the ability of governments to control the composition of growth is limited. But there still are lessons here for individuals if they fail to spread their wealth-building strategies across different asset classes and diversify within those asset classes.
Becoming more diversified leaves you less open to idiosyncratic risks that are related to one sector or one company or one asset class. And you can do this without significantly compromising your expected return.
Another lesson from Ireland is not to base your investment strategy only on what happens during the good times or only in the bad.
Real interest rates in Ireland were very low before the crisis, which encouraged people to load up on debt. That debt now has to be repaid in an environment of falling prices, higher real interest rates and sluggish growth. The problem was too much focus on return and not enough on risk.
For individuals, the take-out is that leverage, while increasing the potential upside in boom times, magnifies the downside in the bust. So people swing from greed to fear and back again.
A better approach is to have a realistic, measured and long-term approach to risk. This means that during rising markets, you don’t take on more risk than you originally intended. And it means that during falling markets, you don’t become more risk averse than you first planned.
A third lesson is the importance of liquidity. This means you can quickly turn your investments back into hard cash if you need to.
Ireland’s banks got into trouble because their loan portfolios were dominated by speculative property ventures. When the crisis hit, their recourse to short-term funding dried up and they were unable to call in loans because of the illiquid nature of the assets.
For individuals, the lesson is there is value in having portfolios with sufficient liquidity. That means publicly traded equity and fixed income securities that can be turned into cash if needed.
So Ireland has some lessons for all of us:
• Holding concentrated portfolios exposes you to risks you don’t need to take. Diversification is the answer, both across and within asset classes.
• Basing your strategy only on the good times means you can end up taking more risk than you intended. And grounding your strategy only on the bad times means you can miss real opportunity. A balanced approach to risk and return is the answer.
• Finally, staking everything on illiquid assets can leave you high and dry when you need quick access to cash. So keep a proportion of your portfolio in liquid investments.
• All these strategic decisions are ones you should make in consultation with an advisor who understands your risk appetite, personal situation and goals.
Just don’t count on the luck of the Irish.
-----------
Kevin Kroskey CFP, MBA