Initial public offerings are back. Medibank Private is on the block in Australia. How should you approach IPOs and how can you tell a good one from a bad one?

An IPO is when a company first sells stock to the public. Sometimes, these offerings are by smaller companies seeking capital to expand. Other times, they involve large privately owned companies where the principals and other insiders are seeking to cash out of some of their investment.

In the case of the sale of Medibank, the IPO is a privatisation. This is when a government, often seeking to repair its budget or increase efficiency, sells a publicly owned asset. Small investors and institutions can buy shares and own a stake of the enterprise.

The bigger initial public offerings or company “floats” are often accompanied by slick publicity campaigns. These can include paid advertising, mail-outs and exclusive “drops” to financial journalists who are used to market the offer and maximise the price.

So there are lots of vested interests involved. The owners want the highest possible price, the underwriters and brokers want maximum publicity so they can clear the stock, the public relations and advertising companies want the business and the media wants the story.

Naturally, individual investors, when confronted by all the hype around IPOs, will ask their advisors whether it is worth buying stock in the initial offer.

The truth is no-one really knows whether the initial price is the “right” price or whether the stock will be a good long-term investment. It often takes a significant period of a stock trading in the secondary market before a number of structural issues related to the float are out.

These can include lock-up periods which prevent the principals and other insiders of a company selling their stock on-market. Knowing of this over-hang from potential future sales, the market can sometimes discount a stock in the months after the IPO.

On other occasions, the underwriters to the float may be contracted by the promoters to provide support for the stock in the initial months. So, again, it can take time for the security to fully reflect the risk and return characteristics of the company.

A third common issue is that institutional investors find they get generous allocations to less popular public offerings and minimal allocations to the really sought-after ones. When supply exceeds demand, think about what happens to the price.

Finally, the evidence around the performance of IPOs is mixed. Some companies do well. An example locally is Aurizon Holdings, the rail freight company floated by the Queensland government at $2.55 a share four years ago. It reached record highs this year above $5 a share.

On the other hand, there have also been some high-profile disasters. One of them was department store retailer Myer Holdings, which was offered five years ago at $4.10 a share, sank on debut and has never recovered that price since. It was recently trading around $1.79.

Many more Australian investors were burnt by the second instalment of the federal government’s sale of Telstra, what became known as “T2”. In that case, investors paid $7.40 a share across two instalments, but waited more than a decade before they could sell without making a loss.

The academic evidence around IPO performance is mixed, depending on time periods and other factors. But it’s plain that there is a lot of uncertainty around individual issues and it really is a crapshoot whether the stock does well or not after the offering.

By the way, none of this implies that Medibank or any of the other recent high-profile floats won’t be good long-term investments. It just suggests that there is often a lot of “noise” around the IPO process that makes it hard to get a good lock on a company’s underlying market value.

What’s the right approach? Firstly, it’s wise not to get overly fixated on individual stocks in building an investment portfolio. The most important influence on returns is your portfolio structure and how much you are allocated to the broader dimensions of return.

In pondering investing in IPOs, the assumption many people make is whether they can make a quick “stag” profit, which means capitalising on a short-term spike in the stock after listing. This is the equivalent of people buying apartments off the plan and “flipping” them.

That approach is more about speculation than investment. It’s akin to taking a punt on a horse. You might get lucky. Or you might not. The point is it’s not a systematic way to invest.

For its part, Dimensional’s approach with IPOs is to exclude recent offerings from its equity strategies, in most cases for a minimum of 12 months. The reasons for doing so we listed above—because of the lock-up periods and post-offering activities. We want to wait to see the prices reflect as much as possible the expected risk and return characteristics of the company.

As we have seen, the danger for many people around IPOs is they get caught up in all the publicity and media hype and feel compelled to buy in at the start. The alternative approach is to wait and see.

Ultimately, though, these decisions around IPOs are best left to an individual advisor aware of each client’s risk preferences, goals and investment horizons.

Volatility is back. Just as many people were starting to think markets only ever move in one direction, the pendulum has swung back the other way. Anxiety is a completely natural response to these events. Acting on those emotions, though, can end up doing us more harm than good.

There are a number of tidy-sounding theories about why markets have suddenly become more volatile. Among the issues frequently splashed across newspaper front pages are global growth fears, policy uncertainty, geopolitical risk and even the Ebola virus.

In many cases, though, these issues are not new. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing. Much of Europe has been struggling with sluggish growth or recession for years and there are always geopolitical tensions somewhere.

In some ways, the increase in volatility in recent weeks could be just as much a reflection of the fact that volatility has been very low for some time. Investors in aggregate were satisfied earlier this year with a low price on risk, but now are applying a higher discount rate to risky assets.

So at base, the increase in market volatility is an expression of uncertainty. Markets do not move in one direction. If they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry.

As to what happens next, no-one knows for sure. That is the nature of risk. Investors in the meantime can protect themselves by diversifying broadly across and within asset classes. We have seen the benefit of that in recent weeks as bonds have rallied strongly.

For those still anxious, here are seven simple truths to help you live with volatility:

1. Don’t make presumptions.

   Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.

2. Someone is buying.

   Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks”, remember someone is buying them. Those people are often the long-term investors.

3. Market timing is hard.

   Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was at its worst—the US S&P-500 turned and put in seven consecutive months of gains totalling almost 80 per cent. This is not to predict that a similarly vertically shaped recovery is on the cards every time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

4. Never forget the power of diversification.

   While equity markets have turned rocky again, highly-rated government bonds have flourished. This limits the damage to balanced fund investors. So diversification spreads risk and can lessen the bumps in the road.

5. Markets and economies are different things.

   The world economy is forever changing and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector, but good for consumers. New economic forces are emerging as global measures of poverty, education and health improve. A recent OECD study shows how far the world has come in the past 200 years.¹

6. Nothing lasts forever.

   Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

7. Discipline is rewarded.

   The market volatility is worrisome, no doubt. The feelings being generated are completely understandable and familiar to those who have seen this before. But through discipline, diversification and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites re-awaken and for those who acknowledged their emotions without acting on them, relief replaces anxiety.

There’s a school of thought that the best way to manage a fixed income portfolio is to base your investment decisions on where you think interest rates are headed. But what if expectations are changing all the time?

Market expectations about interest rates change because of news. This makes it very, very difficult to build a coherent investment strategy around a forecast.

In a recent article, Bloomberg News noted that the rally in the US Treasury market in 2014 was stronger than every economist surveyed by its journalists had predicted.¹

US 10-year yields were around 2.3% at the end of August, down from just over 3% at the end of 2013. Yields fall as prices rise, so those who heeded economists’ forecasts and backed out of bonds have missed part of this capital return.

But this isn’t just a US story. Japan’s 10-year government bond yield hit its lowest levels in 16 months in late August, European bond yields tumbled to record lows and Australian bond yields were close to their lowest levels this year.

Why did many economists get their interest rate calls wrong? It could be due to a variety of reasons. Economic growth and inflation may have been below their assumptions. Geopolitical strains may have dampened risk appetites. Central banks may have adjusted their timetable for withdrawing monetary stimulus.

The important point is that market prices change on news and unless you have a way of forecasting news, you are unlikely to enjoy consistent success in basing your fixed income strategy on anticipating changes in interest rates.

Luckily, there is another way of managing fixed income, one that doesn’t require predicting interest rates. It involves diversifying globally and using the information in the market at any one time to work out which parts of the market to invest in.

The benefits of diversification come from the fact that interest rate cycles can vary across economies, reflecting differences in expectations for inflation, economic growth and other indicators.

For example, while benchmark rates in many economies remain at record lows, New Zealand raised its cash rate four times since March. Elsewhere, while markets anticipate the Bank of England raising rates, there has been speculation the European Central Bank will announce further stimulus to ward off deflation.

The non-correlated nature of interest rate movements implies that spreading fixed income risk globally can reduce volatility in an overall portfolio. This is the argument for global diversification—not betting everything on a single market.

The second part of this non-forecasting approach is to vary maturities in a portfolio depending on the state of the yield curve today. The yield curve is a graph that compares the yields of similar sorts of bonds of different maturities.

A normally sloped yield curve is upward sloping—reflecting the additional return investors require for committing their capital for longer periods. This is called “term risk”. Sometimes, yield curves can flatten or invert. This is when there is little or no premium on offer for tying up your money for longer periods.

So if the yield curve is upward sloping, it may pay to take more of this term risk because you are being compensated for it. Conversely, if the curve is flat or inverted, there is little or no compensation for taking on the term risk, so you may stay in shorter-dated bonds.

This approach uses no forecasting or market timing or assumptions about the direction of interest rates. It uses today’s yield curve to work out where to allocate term risk in a portfolio. And treating bonds as a global asset class provides a larger set of yield curves to choose from—more opportunity, more diversification.

Dimensional employs this approach. Essentially, we are using today’s market prices to form efficient strategies based on the information that is already out there. There is significant evidence that correctly forecasting interest rates with any consistency is impossible. But we can control risk, cost and diversification.

Of course, everyone has an opinion about the interest rate outlook. That’s fine. The problems arise when we base long-term investment decisions on expectations for interest rates, only to see them confounded by the curve ball of new information.

1. ‘Treasury Market Rally Stronger than Every Economist Predicted’, Bloomberg, Aug 30, 2014

Stock picking makes sense if you believe investing is all about spotting successful companies. But identifying good businesses is one thing. Predicting that those companies’ securities will beat the prices set by the market is another.

The media every day is full of analysts’ views about the merits of one stock over another. This multiplicity of opinions takes in management quality, competitive advantage, product differentiation, balance sheet strength, industry margins and on and on.

The implication in the media coverage is that individual investors should sift through all the opinions to come up with their own views about which companies are the best businesses with the best prospects—and build their portfolios from that information.

It’s a daunting task. And it’s entirely unnecessary. That’s because the market, collectively, has already integrated the views of thousands of highly informed and highly expert investors about each company’s prospects.

All that information and analysis is reflected every day in prices. And every day, those prices change as newinformation comes into the market. So even if you assemble a highly considered, deeply thought-out analysis of a company’s worth, you can easily get it wrong.

Take Australian insurance company QBE. Five years ago, QBE was being widely touted by brokers and journalists as a great long-term buy for investors.

In its ‘Brokers Tips’ column, Australia’s biggest selling newspaper The Herald Sun described the insurer as a good buy at its then price of $23.88.¹

“QBE is one of the best-managed insurance groups in the global general insurance and re-insurance industry, with an enviable track record of strong earnings testifying to a first-class business model and conservatism,” the newspaper said.

Around the same time, another newspaper, The Australian Financial Review, described QBE as the safe bet in the insurance sector.²

“Insurance is the management of risk and for investors who want insurance exposure in their portfolio, the play with the least surprises has always been QBE,” the newspaper said, noting that the company had delivered “five years of solid earnings per share growth”.

Now while there is nothing to suggest that any of that analysis was wrong at the time, it didn’t really tell us anything about how QBE might perform over the ensuing years.

In fact, in the five years from September 2009, QBE has fallen by 37%, making it one of the biggest detractors from Australia’s benchmark S&P/ASX 300 accumulation index in that period and contrasting with a 37% rise in the overall market.

Facing significant difficulties in its international businesses, the company has downgraded its earnings outlook four times in two years and recently announced a major asset sales program and capital restructuring to bolster its balance sheet. Remember, this is the stock being touted as the “safe play” in insurance five years ago. Analysts back then had studied the firm’s characteristics and expected future cash flows and applied a required discount rate to derive a fair price for the stock.

Of course, you can get lucky basing an investment strategy around perceived mispricing and forecasts about the economy and market conditions. But that approach rests on a couple of big assumptions—that the market collectively will eventually come around to your way of thinking and that the economy and particular industry will pan out as you imagine.

Still, this view remains the dominant approach in fund management around the world. You gather together a few good ideas about individual stocks and you concentrate your portfolio around those “bargains”.

The problem is there is little evidence that trying to outguess the market prices adds value in the long term. And even if the individual stock ideas do come good, there’s no evidence that traditional managers can do this well enough to cover their costs.

Keep in mind, also, that building concentrated portfolios around perceived mispricing can lead to managers missing out on the best performers. So it’s not just about which stocks they pick, it’s also about which ones they leave out.

An alternative approach is to accept current market prices as a fair reflection of the combined views of participants in a highly competitive marketplace. If you start with the prices, you can begin to identify the securities with higher expected returns.

Diversifying broadly and rebalancing as prices and circumstances change mean you are not requiring just a handful of stocks to do all the work and you are less at risk from stock-specific or industry-specific factors that can blow a big hole in your strategy.

Ultimately, investment is about the future, not the past. Prices are forward-looking and are determined by the expectations of thousands of highly skilled, highly motivated and well informed experts.

So rather than trying to outguess the market, you start by using today’s prices to identify differences in expected returns. Put another way, instead of deciding on desired outcomes and betting against prices, you use the information in prices to improve expected outcomes.

1. ‘Brokers Tips’, Herald Sun, Sept 18, 2009

2. ‘How QBE Plays it Safe in a Risky World’, Australian Financial Review, Sept 22, 2009

What a difference five years can make. Contrast, the fortunes of the S&P/ASX200 Index (prices only) and the S&P/ASX200 Accumulation Index (share price plus dividends) over this period.

Five years ago on July 16, 2009, the S&P/ASX200 closed at 3995.6 points with further to fall in the depths of the GFC. Move forward to July 16, 2014 when this index closed at 5518.9 points – a rise of 38 per cent.

By contrast on July 16, 2009, the S&P/ASX200 Accumulation Index closed at 27,332.5. And move forward again to July 16, 2014, this index closed at 47,043.6 – a rise of 72 per cent.

In short, the accumulation index passed its pre-GFC high almost a year ago and hit an all-time high this month. Meanwhile, the S&P/ASX200 (price only) is still way below its pre-GFC high.

The differing performance of the two indices reinforces some of the principles of sound investment practice.

These include why investors should understand the rewards of compounding with income being earned on past income as well as on the original capital and why investors should focus on their total return – not solely on price movements.

It is worth emphasising that investors who automatically reinvest dividends from direct shares or distributions from a share fund (including an Exchange Traded Fund) are really practising the discipline of dollar-cost averaging.

Rather than trying to pick the best time to buy shares or units in a share fund, investors who reinvest their dividends are buying more shares twice a year at dividend time, no matter the market conditions.

With this approach, investors obtain more shares when prices are lower and fewer when prices are high, averaging out their buying costs of the over the long term.

‘Ten Stocks for Ten Years’ – that was the headline in The Australian Financial Review nearly 5 years ago. The paper had interviewed analysts to identify 10 stocks to ride out the next decade with. Nearly half way through, how are they going?

Resource and energy stocks topped the AFR’s December 2009 list of the 10 stocks tipped to perform the best over the coming decade in Australia. They included BHP Billiton, Rio Tinto, Woodside Petroleum, Santos and Origin Energy.¹

“Given the voracious appetite of China and other developing Asian nations for Australia’s resources, it’s a sure bet that punting on the right explorers and miners will deliver superlative returns,” the newspaper said.

Well, actually no. It wasn’t a sure bet. In fact, from the end of December 2009 to the end of June 2014, those five stocks have all lagged the market, some significantly so. And, remember, these were chosen as the best stocks for the next decade.

The return of Santos over that period was +13%. But before you open the champers, keep in mind the return of the market itself, as measured by the S&P/ASX-300 Accumulation index, over that same time frame was nearly 34%.

Even less impressive in a comparative sense from the AFR list were Origin Energy and Woodside Petroleum, which managed returns of around 5% and 3% respectively in this four-and-a-half-year period.

But wait! There’s more! The big heavyweight diversified miners, BHP Billiton and Rio Tinto, have not just failed to match the index in that period. They have gone backwards, delivering negative returns of 5% and 12% respectively.

Now recall, these were the stocks that were going to “shoot the lights out” in the coming decade, the ones you could really count on.

To be fair, the other half of the AFR’s top-10 list performed much better, with Woolworths, James Hardie, Navitas, Sonic Healthcare and Campbell Brothers (now ALS Ltd) delivering returns above the index.

But why would you have staked everything on just 10 stocks, with all the stock and industry specific factors in play, when simply owning the market gave you a solid return with much less idiosyncratic risk? It doesn’t make any sense.

Despite all the evidence to the contrary, the financial media wants you to believe that successful long-term investing is about making forecasts. They do this because it’s fun and exciting to write about individual stocks and industries.

The reality is you don’t need to take those sorts of risks. And in any case, the media inevitably hypes up sector and stock stories that are already factored into prices, so if you act on their tips you end up buying at or near the top.

The alternative approach is less of a gamble, but also a little boring. And that’s why it doesn’t feature in the media much.

In a nutshell, this other approach involves structuring a diversified portfolio around many stocks, many sectors and many countries. As we don’t know where the next big fish are going to come from, you use a dragnet instead of a single line.

This other approach involves assuming prices are fair. Instead of trying to “beat” the market and identify pricing “mistakes”, you’re going with the market’s flow and seeking to secure the returns that are there for the taking.

Sure, compiling top 10 lists is fun. If you’re right, you look like a hero and you have something to brag about at the next barbecue. But that’s speculation. It’s not investment.

The fact is no-one knows what the top 10 stocks will be over the next decade. If they did know, there would be little risk involved. And without risk, there is no return.

Whatever the decade, that doesn’t change.

1. ’10 Stocks for the Next 10 Years’, Australian Financial Review, Dec 23, 2009

“Buckle up and Brace for a Volatile Ride!” That was the headline in The Australian newspaper as the 2013/14 financial year got underway 12 months ago. Well, how did that forecast turn out?

The view in much of the financial media in July 2013 was that Australian markets faced a difficult 12 months amid global economic uncertainty, a peaking commodity cycle, slowing domestic growth and political volatility.

Sentiment at the time was swinging back and forth over the future of the US Federal Reserve’s monetary stimulus. As well, China was grappling with rebalancing its economy away from exports and Europe was still seen as a mess.

Here in Australia, the local dollar was broadly viewed as likely to continue on a slippery slide as commodity prices fell, the Chinese economic juggernaut slowed and Australia’s interest rate advantage narrowed.¹

Added to this difficult mix were a febrile domestic political climate and the prospect of a change of federal government.

The upshot of all this was a volatile start to the 2013/14 financial year. In the first three days of the year, the Australian benchmark S&P/ASX 300 index had consecutive falls and rallies of around 2% – hence the excitable headlines.

Twelve months on, though, the picture looks a little different than what was forecast by many. Yes, many of the same uncertainties are still with us. But in the meantime, the Australian share market has posted double-digit gains for the year. In developed markets globally, we have seen returns of 20% or more.

The Australian dollar, far from continuing on a slippery slope downwards, rose back to around 97 US cents last October, before declining to a three-and-a-half-year low of around 87c in late January and then moving back to the mid-90c levels.

Now, as the new financial year gets underway, you should get set for another round of speculation about the economy and markets in the coming 12 months.

The media runs these annual “outlook” supplements because it’s easier and cheaper to muse about what hasn’t happened yet than to look at what actually has happened. It doesn’t involve any actual time-consuming research or interviews.

Looking to 2015, you can be sure that there will be much sage musing about how after two solid years of gains, it is now a climate for canny stock pickers.

Speculation about what happens when monetary stimulus is withdrawn is another hardy media perennial, as is conjecture about geopolitical risk, the rebalancing of growth, the impact of ageing populations and the search for yield.

This isn’t to deny that many of these issues aren’t real and the subject of some uncertainty. The real point, though, is whether individual investors can do anything about them beyond diversifying and focusing on their own circumstances and goals.

The fact is nothing we do as individuals is going to have any bearing on the outcome of the big issues. In reality, all the uncertainties you read about in the newspapers at the beginning of every financial year are already reflected in prices.

Some people will have a gloomy outlook. Others will see opportunity. They will meet somewhere in the middle and agree on a price. That’s just the way it works.

Of course, it’s fun to speculate about markets and the economy and politics. Everyone has an opinion. And there’s nothing wrong with that. But you shouldn’t let somebody else’s opinion dictate your long-term investment objectives.

In the meantime, happy financial new year!

A frequent complaint from would-be investors is that “uncertainty” is what keeps them out of the financial markets. “I’ll stay in cash until the direction becomes clearer,” they will say. So when has there ever been total clarity?

Alternatively, people who are already in the market after a strong rally, as we have seen in recent years, nervously eye media commentary about possible pullbacks and say “maybe now is a good time to move to the sidelines”.

While these kneejerk, emotion-driven swings in asset allocation based on market and media commentary are understandable, they are also unnecessary. Strategic rebalancing provides a solution, which we will explain more of in a moment.

But first, think back to March, 2009. With equity markets deep into an 18-month bear phase, the Associated Press provided its readers with five signs the stock market had bottomed out and followed that up with five signs that it hadn’t.¹

The case for a turn was convincing. Volumes were up, the slide in the US economy appeared to be slowing, banks were returning to profitability, commodity prices had bounced and many retail investors had capitulated and gone to cash.

But there also was a case for more pain. Toxic assets still weighed on banks’ balance sheets, economic signals were patchy, short-covering was driving rallies, the Madoff scandal had knocked confidence and fear was still widespread.

Of course, with the benefit of hindsight, that month did mark the bottom of the bear market. In the intervening period of just over five years, major equity indices have rebounded to all-time or multi-year highs.

This table below shows the cumulative performance of major indices in the 18 months or so of the bear market from November, 2007 and then the cumulative performance in the subsequent five-year recovery period.

You can see there have been substantial gains across the board since the market bottom. And while annualised performance over the six-and-half years from November 2007 is not impressive, the pain has been a lot less for those who did not bail out in March, 2009.

In 2011, Europe was gripped by a sovereign debt crisis. Across the Atlantic, Washington was hit by periodic brinksmanship over the US debt ceiling. In Asia, China grappled with the transition from export-led to domestic-driven growth.

Around any of these events, there were a broad range of views about likely outcomes and how these possible scenarios might impact on financial markets. The big question for the rest of us is what to do with all this commentary.

The fact is even the professionals struggle to consistently add value using analysis of macro-economic events, as we see repeatedly in surveys of fund-versus-index returns. And history suggests that those looking for “certainty” around such events before investing could set themselves up for a long wait.

There is always something to fret about. Recently, the focus has been on low volatility, particularly when compared to the days of 2008-09. Sage articles muse over whether risk is being appropriately priced and whether volatility is being unnaturally suppressed by central banks’ explicit forward guidance about policy.²

Just as in March 2009, one does not have to look far to find well-reasoned discussion in support of why the market has topped out, alongside equally compelling reasons of why the rally might continue for some time.

What is the average investor supposed to make of all this conjecture? One way is to debate the market implications of news and to try to anticipate what might happen next. But whom do you believe? We’ve seen there are always cogent-sounding arguments for multiple scenarios.

An alternative approach is much simpler. It begins by accepting the market price as a fair reflection of the collective opinions of millions of market participants. So rather than betting against the market, you work with the market.

That means building a diversified portfolio around the known dimensions of expected return according to your own needs and risk appetite, not according to the opinions of media and market pundits about what happens next month or next week.

It also means staying disciplined within that chosen asset allocation and regularly rebalancing your portfolio. Under this approach, you sell shares after a solid run-up in the market. But the trigger for this rebalancing is not media speculation, but the need to retain your desired asset allocation.

Say you have chosen an allocation of 60% of your portfolio in equities and 40% in fixed income. A year goes by and your equity allocation has rallied strongly so that the balance between the two has shifted to 70-30. In this case, it makes absolute sense to take some money out of shares and move it to bonds or cash.

It works the other way, too, so that if shares have fallen in relation to bonds, you can take some money out of fixed income cash and buy shares. Essentially this means buying low and selling high. But you are doing so based on your own needs rather than on what the armies of pundits say will happen in the market next.

Of course, this doesn’t mean you can’t take an interest in global events. But it does spare you from basing your long-term investment strategy on the illusion that somewhere, at some time, “certainty” will return.

1. ‘Five Signs the Stock Market Has Bottomed Out and Five Signs It Hasn’t’, Associated Press, March 15, 2009

2. ‘When Moderation is No Virtue’, The Economist, May 22, 2009

In investment, risk and return are related. In other words, the price of earning a return is accepting some level of risk. But not every risk is worth taking. And one of those is the risk associated with individual stocks or sectors.

Economists call this idiosyncratic risk. It relates to the peculiar, individual influences on a particular stock or industry. And the general rule is the less diversified your portfolio, the more you are exposed to these granular risks.

Treasury Wine Estates (TWE) is the second-largest publicly traded wine maker in the world. This Melbourne-based company, created in 2011, is home to such brands as Penfolds in Australia and Beringer in the US Napa Valley.

One of TWE’s fastest growing markets has been China, which is now the biggest market for red wine in the world. In fact, China’s drinkers last year consumed 1.86 billion bottles of red wine, an increase of 136% on five years before.¹

However, that pattern started to change recently as China’s president Xi Jinping announced an austerity drive and a crackdown on corruption. (Wine is frequently used to grease the wheels of business deals in China.)

In January this year, TWE downgraded its earnings guidance, saying the crackdown on official gift giving in China was hurting sales volumes. The market response was dramatic, with the company’s shares dropping 20% in a single session.

This wasn’t just felt in Australia. In Europe, French drinks giant Rémy Cointreau announced in April, 2014 that sales of its cognac had slumped by more than 30% due to the crackdown on corruption in China.²

So how do investors protect themselves against these idiosyncratic risks like these? The most obvious way is to diversify. That means holding a large number of stocks and being exposed to a broad number of sectors.

In a portfolio of just one stock or even five, TWE’s sudden fall from favour has an outsized impact. But in a portfolio of several hundred or even several thousand stocks, the idiosyncratic fortunes of a single company mean less.

Think of it in terms of the apocryphal single green bottle sitting on the wall. When it falls, the game is over. But with 10 or 100 green bottles, it’s going to hurt less.

In publicly traded and competitive markets, prices move on news. Any professional journalist will tell you that news is defined as the unexpected or unusual. ‘Dog Bites Man’ does not clear the hurdle of compelling news. ‘Man Bites Dog’ does.

To use our wine example, the statistics on China’s changing drinking habits were well known. Western wine makers like TWE and Rémy Cointreau moved to exploit them. And markets discounted the higher expected cash flows from those efforts.

The ‘news’ in this case was the Chinese government’s move to reduce the level of corruption by outlawing gifts of expensive wine or spirits. Markets responded to the news because this changed their expectations for future cash flows.

Unless you have found a way of predicting news, it is unlikely you will work out what will happen to stock prices. But you can protect yourself against these idiosyncratic risks by diversifying across stocks, sectors countries and asset classes.

Drinking in moderation is fine. But when it comes to investing, one green bottle is never enough.

1. ‘China Becomes Biggest Market for Red Wine’, The Guardian, Jan 30, 2014

2. ‘Rémy Cointreau Sees China Crackdown Hurt Profits’, WSJ, April 17, 2014

Sometimes we read an investment homily or saying from the likes of Warren Buffett that provides a valuable yet disarmingly simple investment lesson. Typically, these lessons are made more palatable with a little humour.

At times, these sayings may seem like throwaway quips yet much thought has probably gone into the creation of the best of them.

Often the sayings are about investor behaviour, the fallacies of trying to time markets, the irrationality of the share market and why a long-term approach to investing makes much sense.

Consider this offering from Buffett: “I will tell you how to become rich… Be fearful when others are greedy. Be greedy when others are fearful.” You have probably heard it.

Buffett is warning investors about the dangers of following the investment herd. The herd tends to get caught up in the mood of the market – the euphoria when prices are rising and the pessimism when prices are falling. The bottom-line is that such crowd-following investors typically buy when prices are high and sell when prices are low.

Economist and commentator Shane Oliver appears to have taken a brief break from the pre-Budget speculation to gather 21 of these investment sayings, including the one above.

“Investing can be scary and confusing at times,” Oliver writes in his newsletter. “But the basic principles of successful investing are timeless and quotes from some of the experts help illuminate these.”

Here is just a small sample of the sayings that Oliver finds “most insightful”:

• “Investing should be like watching paint dry or watching grass grow. If you want excitement…go to Las Vegas.” Paul Samuelson, late American economist and Nobel Prize winner, was emphasising that investment should be viewed as a long-term exercise, not a short-term flutter.
• “The investor’s chief problem and even his worst enemy is likely to be himself.” Benjamin Graham, the late professional investor and investment theorist, was warning that investors who get caught up in the prevailing emotions of the markets – rather than taking a disciplined approach – potentially destroy their own wealth.
• “Much success can be attributed to inactivity. Most investors cannot resist the temptation to buy and sell.” This is another from Buffett. By adopting a disciplined approach to investing and adhering to an appropriate long-term asset allocation for their portfolios, investors are less vulnerable to being swayed by market emotions.

If you are in the mood for a few more of these sayings, get hold of a copy of The Little Book of Commonsense Investing by founder and former chief executive of Vanguard John Bogle. In this updated 2007 book, Bogle focuses on the attributes of index funds, giving particular emphasis to their low-cost advantage.

As Bogle writes: “The more the managers and brokers take, the less investors make.” This can easily be overlooked when markets are performing strongly.

The best and most accurate investment sayings reinforce some of the most basic principles of sound investment practice. They are worth hearing time and time again.