Arun Abey: Power of four can defeat our worst enemy - ourselves

We are enduring the greatest turmoil in investment markets for two decades. Many factors are driving this and, as always, the markets' short-term path is uncertain and confusing. But none of this is likely to undermine the path and attractive returns of a sensibly constructed investment portfolio.

The reality for most investors is that the enemy lurks within us, through our mental mistakes and behaviour, rather than in the external forces that influence markets. Whether investing in shares, property or plain old cash deposits, we often make irrational decisions when managing our money. Yet there are simple, effective strategies which strip out the emotional human element of investing that we can use to overcome these hardwired instincts.

The first and most important way to protect against mental mistakes is to have a sound investment framework based on four golden principles: Quality, Value, Diversity and Time.

Portfolios based on these principles sometimes deliver lower returns for a period, but rarely result in any significant permanent capital loss and have provided a more reliable long-term payoff. For example, during the technology stock bubble of the late 1990s the global technology sector returned 60 per cent to investors in 1998 alone, and rose 130 per cent more to the peak of the market in March 2000, as measured by the Nasdaq Composite Index.

This bubble surpassed even the "Nifty Fifty" growth stocks of the early 1970s, when investors treated companies like Kodak, Avon and Xerox as shares that you could buy and hold forever. This worked perfectly until stagflation and recession set in and these shares fell 46 per cent in 1973-74. Some lost 80 per cent of their value. Three years later, not one Nifty Fifty stock had recovered, and they under-performed for the rest of the decade.

Many portfolios that focused on the Nifty Fifty in the 1970s or the technology sector in the 1990s recorded real and permanent losses. They didn't understand the meaning of Quality and Value. Well diversified portfolios eventually recovered.

Quality

The only way to identify quality companies is through rigorous analysis - and even professional analysts don't always get it right.

First, there is always a clear reason why quality companies make profits and pay dividends, and do so consistently. They are not slaves to market fashion.

Quality companies may range from new players with fresh ideas to well-established concerns. Typical attributes include sound longer-term earnings potential; good return on equity; capable management with a solid track record; a sound balance sheet; and reliable core business franchises. They can be household names like Coca-Cola or American Express, or smaller and less well-known companies.

Quality companies, bought at the right price, will generally get through even a severe market downturn.

Value

The second principle of sensible investing, Value, is a function of quality and price. Some of the worst disasters have arisen from people paying too much for what are, essentially, quality assets.

Entrepreneur Alan Bond, who led the syndicate that wrested the America's Cup from the New York Yacht Club in 1983, learned this the hard way. In the mid-80s he bought Australia's Nine TV from media mogul Kerry Packer for a huge sum.

Within a few years he sold it back to Packer for a fraction of the price. The Nine Network was a quality company, both when Bond bought it and when he sold it. The difference was that Packer better understood its value, and this understanding helped him to become one of the world's richest people.

The key to assessing Value and Quality is to know whether an asset can produce an attractive return relative to its risk.

Diversity

Diversification is about having investments across different asset classes, countries and funds.

While many people start investing in a diversified portfolio, they typically end up keeping investments that have delivered the best returns and weeding out those that have delivered low returns. They are often left with a portfolio of over-valued assets which is then highly vulnerable in a market downturn.

The sub-prime mortgage crisis, which started in 2007 and coincided with a large rise in energy prices, saw investors abandon financial stocks, while pushing energy stocks to record levels. Investors whose portfolios have excessive exposure to a sector like energy shares, no matter how good its recent performance, are taking a big risk.

Time

The ultimate test of a successful portfolio comes with Time.

While the first three of the four golden principles were not fully rewarded in the late 1990s, they re-emerged with the collapse of the technology share bubble. Investors who focused on such shares achieved bumper returns in the late 1990s, followed by a catastrophic crash and then a marginal recovery.

Investors who focused on the broader sharemarket still suffered during one of the worst bear markets in history, but the pain was far less severe and the recovery far swifter.

Since it's essential to take a long-term view, develop a plan that takes into account your entire investment time horizon, rather than focusing on the return in your latest portfolio report. The long term is made up of lots of short-terms, one after another. Some of them will be good, and others bad, but it's only the trend over time that you need to worry about.

Instil automatic discipline into your investment strategy, to help avoid knee-jerk reactions to new circumstances. Commit to a regular savings plan whereby a set amount is automatically invested each month, irrespective of market conditions.

Similarly, set your portfolio so it rebalances periodically between the various asset classes. This means when shares have been particularly strong relative to other investments you own, you automatically reduce your holdings slightly and when shares have been weak, you top them up. This way you increase your chances of buying low and selling high.

The key here is automation, which reduces the risk that behavioural biases will lead to poor decisions.

Investing in a Diverse range of Quality investments at prices that represent good Value, and investing this for sufficient Time is a reliable way to build wealth.

Arun Abey is executive chairman of financial planning firm ipac, head of strategy for AXA in the Asia Pacific and a director of the Spicers Portfolio Management advisory board. He is also the author of How Much is Enough?

www.howmuchisenough.net