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Investment Strategy
Friday, November 27, 2015 - 08:59
Mix and match

“When investing, it is imperative to match your investment strategy with your investment horizon,” says Mike Browne of Seed Investments. “Investors who are able to match these two (and who can refrain from acting on emotion in the interim) will increase the probability of their investment experience matching their investment goals.”
For the purpose of this report, I have used the local stock market (ALSI) since 1960 (i.e. just over 55 years) to display how an investor’s experience would range depending on their starting point and investment horizon.
Interestingly, ‘investors’ (more like speculators) with a one-day horizon will only generate a positive return just over 50% of the time, which means that the odds of success aren’t very high! “As investors take a longer horizon, their probability of success increases and the variability of their returns decreases,” says Browne. In the below analysis I have loosely defined ‘success’ as a positive return. Inflation and dividend reinvestment haven’t been taken into account as their long term history is not readily available. These factors would influence the end result, but the broad concept would remain unchanged.
The chart below displays the historic probability of generating a positive return over various time periods on the ALSI. Simplistically, based on this chart, one should have an investment horizon of at least 3 years in order to be confident of generating a positive return ‘most’ of the time (i.e. nearly 90% of the time).

While the above chart shows how often one would generate positive and negative returns, it does not quantify the range of investment returns received. “For investment periods of one year and longer I have looked at the possible range of annual returns an investor would have received.” Naturally, the variability in returns reduces as one’s investment horizon increases. Here it is interesting to note that while a 3-year investment horizon would have generated a positive return 88% of the time, an investor that got his timing wrong would have experienced a return of -18% pa over the 3-year period! From this it would seem wise to have an investment horizon of at least five years when investing into local equities.
By overlaying a simple valuation metric (market PE ratio) for an investor with a 5-year investment horizon, the return experience can be greatly enhanced. By investing when the market was cheap (lowest 25% of PE observations) an investor was not only able to improve his average return by 8% per annum but also greatly improve his ‘worst case scenario’. Likewise, investors who invested when the market was expensive (high PE) both lowered their average return and increased the probability of generating a negative return. The chart below shows the investor experience over the entire period, low PE, normal PE, and high PE scenarios.
“At Seed we view investing as a process of continuously improving the probability of generating satisfactory returns. We therefore ensure that there is a match between the assets and investment horizons of our various Funds,” he explains. “We further attempt to improve our probability of success by taking valuations into account in our investment process.”

Copyright © Insurance Times and Investments® Vol:28.11 1st November, 2015
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