Wednesday, 11 January 2012

Investment decision: Part 2 (Shares cont'd)

Yesterday I posted on my proposed share allocation split on a month to month basis. Today I decided to go into more detail on the issues associated with both direct share and index fund investing.

Direct shares
One of the biggest dilemmas I find when debating which shares to invest directly into is whether to add to share positions that I already own, thereby getting the benefits of dollar cost averaging or whether to look at new opportunities which may have the potential for greater reward.

With dollar cost averaging you should know more about the company than a brand new company that you are looking at - this gives you an inherent advantage straight away. Further it allows / forces you to invest right through the cycle of share prices. The disadvantage however is that you may have a thesis about the company that is not playing out in the market (yet). Further investing in these companies feels like throwing good money after bad if the stock has been going down or buying in at a much higher price than your original thesis contained.

New opportunities are often the ones an investor gets most excited about. There is a new thesis associated with them and the returns often look better - however this is often just hubris. You get the benefits of diversification however you have the added disadvantage of having to keep track of even more stocks and you end up with a small amount in a great many stocks which is the purpose of the index funds (in my case) whereas the direct share investments are meant to provide the alpha return which typically comes from a concentrated portfolio of good investments.

Index funds
Index funds seem like the typically set and forget type investment so you may find it curious that I'm writing about allocations in it. The fact is that there is no perfect index funds. Although they remove stock specific risk they are still subject to country risk, market risk, currency risk, political risk. Some of these can be used to your advantage.

In my case the Australian dollar is currently very high against the USD, GBP and EUR so I have been looking at index funds in these countries. You then need to weigh it against the other types of risks and how you view those markets. Again the dilemma arises about re-investing in index funds that you already have or seeking new funds which may have different benefits. For example at different points in time a GBP FTSE fund may offer a better currency play vs a USD S&P500 fund. The best thing about index funds is that you can concentrate your efforts on what is going to happen to the currency as there is no alpha benefit from these funds.

There is no real solution to the above investor problems. Everyone faces them and each investor needs to decide how they will deal with them on a case by case basis.

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