Recently I caught myself on the brink of doing just that – borrowing a million dollars to purchase an asset that had gone up 90% over the last four years! As I put my hand up to make just one higher bid the words ‘irrational exuberance’ pulled me back.
Whether I will thank my sense of rationality or spend the future pining for the picture of the kids tumbling on the freshly mowed lawn with their beautiful, new Labrador puppy, only time will tell.
This article is not about the Sydney property market but rather the lack of rationality of the human race.
We fall in love with the wrong people and we make financial decisions with our heart rather than our head. This leads to mispricing. Asset prices can move significantly away from their fundamental values over substantial periods of time. After a bubble there is often a crash.
There is also much disagreement as to what the fundamental value of as asset actually is. Are Sydney house prices quite reasonable when we take into account the shortage of supply and high levels of immigration? Or are they insane? And if they are insane, when will they correct?
While over the long term we can make pretty accurate predictions, over the short to medium term we stand less chance than getting front row tickets to see Adele.
One of my favourite studies (allow me a little nerd moment) was one produced by Legg Mason in the US. They conducted a survey whereby they asked a large sample of economists what they would predict for the economy over the next year – up or down. They then compared the average prediction to what actually happened. They repeated this survey over 24 years. Guess how many they got right – only 8. Two thirds of the predictions were wrong. Did I mention that these are professionals -people who get paid to study market movements.
I am sure that you have heard this before, but the only way to get around the poor short term unpredictability is to have a well-diversified portfolio. The concept is easy – if you just sell ice-cream, you are going to run into problems on a rainy day. If you sell ice-cream and hot chocolate you have a better chance of success. If you then add in some banana bread, smoothies and sandwiches, you can cater for different weather patterns and customer tastes – smoothing out your revenue. But how do you apply this to investment.
Having spent most of my career advising large institutions how to construct their portfolios, this is my area of specialisation. I have to admit that I really enjoy it (nerd moment number 2). Understanding what drives the returns of different investments and then figuring out how to combine them to achieve the desired outcome – fun, fun, fun. (I won’t go into any further detail for fear of never receiving another dinner invitation)
If we didn’t fall in love with the wrong men, we may not be riding through the dessert on the back of a Harley, but we would probably have reasonably content and happy lives. If we have well diversified portfolios, we can expect to accumulate wealth consistently over the long-term and be financially secure.
If you get the concept, but don’t know how to implement it, please get in touch.