Is there a wrong way to invest?

One of the fears that plagues beginners after taking a first look into most investment opportunities is the fear of doing something wrong. This is of course closely related to fears of losing money, making errors with taxes and other technical issues, but at heart, a large part of this fear can be attributed to the fear of making mistakes.

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What is the definition of  a mistake?

1. an error in action, calculation, opinion, or judgment caused by poor reasoning, carelessness, insufficient knowledge, etc.

If you look at the dictionary definition then you can clearly see what causes mistakes – lack of knowledge that leads to poor reasoning or leads to careless decisions. This means that mistakes are relatively easy to learn from – if you have done something wrong, then gaining extra knowledge is the way to make better decisions in the future.

The bigger problem is, how do you know that you have made a mistake? If you’re working on your portfolio, then no one will helpfully point out mistakes in your strategy, nor are bad returns a good indicator of having made mistakes since even perfect decisions can lead to temporary losses in bad market situations.

How do I know that I have made a mistake?

I get asked quite often to give my assessment of a person’s portfolio so they’d know if they’re doing the right thing. Other than the inherent problems that accompany such a broad question, assessing whether you’re doing something right is mostly based on one fundamental question:

How well is your portfolio doing compared to market averages?

If you are a real estate investor and your objects are returning an average of 3% per year then it’s likely that something might be problematic. Taking a look into overall investment returns for real estate you should probably assume a 5-7% return on lower risk projects and 9-12% for higher risk projects. If you’re not earning that then it’s time to look into your own portfolio – are the objects rented for under market price? Are your expenses too high? Is the location undesirable? Is the vacancy rate too high? Could you get better loan terms? Is the risk and returns level reasonably tied? If your object is super safe, has had the same renter for 6 years who hasn’t caused any issues, then 3% might even be an OK return when it comes to keeping property value.

If you are investing into crowdfunding based instruments then comparing yourself to market averages becomes more difficult. There isn’t really a set standard and a lot of comparisons are actually historically done compared to stock indexes. A good benchmark here might be the 11-12% generally used for SP500, if you have a more risky portfolio, then a higher target might be reasonable. Quite often people end up thinking their portfolio is underperforming because they have read from some forum that someone is making 30% returns on their social lending portfolio and are disappointed that they aren’t doing that well, without knowing anything about the truth of the issue or the risk profile of that person’s investment portfolio.

For a stock market based investor assessing returns is highly dependent on which part of the market cycle we’re at. If the global market is dropping, then your portfolio is likely to drop as well, and if you have stocks in your portfolio that make your portfolio allocation differ from indexes, for example you’re more focused on different industries, then it can become problematic to tell if you’re doing “well”. The same problem arises with a bear market, some stocks might be flying high, while your portfolio is slowly lagging behind, but you won’t be able to tell how big of an issue that is unless you balance your moderate turns to what are likely to be more moderate losses as well. Unless you’re using some very generic strategy, then it takes a full cycle to assess your returns, since then you will have lived through both a rise and a drop in the market.

Is it possible to avoid mistakes?

Let’s go with a resounding “no” on that question. We’re all only people, and making a perfect decision in all situations is virtually impossible. You will never have enough time, enough information and enough knowledge to make a fully informed decision. The more important issue is, to think about what the potential consequences of mistakes are.

When it comes to investing the cost is generally paid in effectiveness. If you make a bad call, then you will likely receive lower returns. If you make a fundamental error somewhere, then you will have to accept a loss of some size. This is where probability comes to play – if you constantly educate yourself, read up on what’s happening and don’t start testing out some obscure investment logics, then are you likely go make more reasonable decisions or more terrible decisions?

I’d say unless you are phenomenally unlucky at life, then you are likely to make more good decisions then bad ones, especially if you start reasonably conservatively (as in, not with high risk instruments like Forex, bitcoin etc.). While the loss in returns might be a hit (especially once you figure out what you managed to mess up), then even a low return of a couple of per cent is always better than no returns since you didn’t gather up the courage to do anything.

Of portfolio balance

There are many different portfolio balance theories out there in the world of personal finance. Some are based on risk management, some based on diversification, and some have a logic so complex that it takes a while to even figure it out. Whichever portfolio strategy you use, one idea is constantly emphasised – you must diversify between different asset classes and markets.

Why diversify across asset classes?

The somewhat classical theories focus on three main asset classes – stocks, real estate and loans. Other options include metals, entrepreneurship etc. The idea behind diversifying asset classes is that they behave differently in different market situations. While stocks can be quick to drop, they can also generate incredible short term returns and are considered relatively stable long term.

With real estate the main value is the idea that you own a physical asset – while a company may go bankrupt then you still own an apartment or a house and while it may drop in value, it won’t completely drop to zero. Real estate and loans also help generate cash flow in a way that stocks generally don’t.

This means that to reduce risk levels you should have different asset classes in your portfolio because in case one asset loses value the others may keep theirs for longer. In the case of a big economic crisis of course all parts of the market drop, but different asset classes recover at different speeds and being able to generate cash flow while you wait for capital growth recovery is valuable.

Why diversify across markets/geographically?

In the case of social lending diversifying across hundreds of loans helps you manage risks by betting on the fact that not all regions of the country lose jobs at the same rate. In case of a crisis it’s clear that the less wealthy regions of Estonia will be hit harder while the bigger cities are likely to have more job opportunities therefore people will be more likely to pay back their loans.

For stock markets geographical diversification in its broadest sense means picking different markets. I invest both into the Baltic market and into the US market. Maybe soon I’ll add in general European markets as well. The benefit of this is easy to see – if you take side by side the growth charts of Europe and USA, then you can clearly see that they don’t always move in a similar direction, which means more stability for your portfolio.

Why diversify across different risk classes?

Everyone who invests wants high returns. It is however important to keep in mind that higher returns are linked to higher risks as well. This means that while you may enjoy higher returns when the market is climbing upwards then higher risk investments also mean a much bigger hit when the market takes a steep downwards turn.

Generally stock indexes are considered much safer than individual stocks due to the lowered risk provided by higher diversification rates. Social lending is inherently riskier than real estate backed loans where you have less of a chance of walking away empty handed.  The same way smaller apartments close to city centres are generally considered lower risk since they’re likely to maintain renters’ interest even in the case of an economic downfall.

How to assess your portfolio?

The easiest way to look at whether your portfolio is balanced is to either write it down in numbers or have a visual outline of your portfolio. Taavi I. wrote a nice piece of code that allows you to visualise your portfolio and I must say I quite like the visual aspect of it.

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For example the image above is the balance of my current portfolio. It lists all social lending, stocks, indexes and crowdfunding. As you can see, my portfolio is very heavily influenced by whether or not Bondora does well (Bondora used to be 75% of my portfolio) so I’ve been working hard to push it down to 50% overall portfolio value.

Ideally your portfolio should be close the 1/3 in each asset class. In my case what is arguably missing is real estate (since Crowdestate is not pure real estate), which is why I set the goal of getting into rental real estate this year. Overall though, you can see that my portfolio is getting better in terms of overall balance. While my portfolio isn’t all that big yet, then getting into the habit of it being balanced will help a lot in the long run.