Tuesday, 14 August 2012

Simplify your investment process: Make relative investment​s not absolute ones

Investing in the share market is all about opportunity costs (actually when it comes down to it - everything in life is about opportunity costs).  Because we only have a finite amount of money we have to make a decision about which stocks to invest in if we want to obtain a superior return or whether to invest in index funds which mean that we will never outperform or under perform.
 
This decision becomes much more complex once we start assessing whether or not to invest in the share market after all.  The range of possibilities and the things you need to think about once you start considering whether your money would be better in the bank, in fixed interest securities, in non conventional investments (such as precious metals, collectible items etc) or whether you should just spend it on consumer items.
 
I think that once you broaden your decision making to this level the decision becomes impossible
 
Given the inherent uncertainties associated with almost all investment decisions when we get overloaded with choice we tend not to make any choice at all.  This is most definitely not the best outcome for our financial well being.
 
...So what is the solution?
 
The solution is not something new or innovative.  It is something that people have been doing for hundreds of years. 
  1. Set a specific amount of money that you will save every month (I do this with my savings goals - sometimes this is called 'paying yourself first')
  2. Split that amount of money between the investments YOU want to invest in (for example $xxx to shares, $xxx to the bank etc)
Once you have done this you no longer have the problem of deciding what class of assets you should invest in!  The decision is already made by your plan.  That is the beauty of this system.
 
Note that this does not make the decision process 'easy'...just easier than it was...
 
You should keep in mind that you still need to decide what shares to invest in which is often a complex enough decision - but it is much easier than the one mentioned before.  It is possible to make this easier by
  1. Investing only in index funds 
    • You set up a savings plan every month and every month this amount gets invested in index funds
  2. Invest a certain amount each month into certain categories of shares. 
    • This takes the splitting the investment money to next level.  You allocate a certain amount that will be invested in defensive stocks, growth stocks, dividend stocks etc and then the decision becomes in this category what stocks do you want to invest in?
I do not go to the level that point 2 suggests because I do not have the cash required to make cost effective purchases (in terms of trading costs - even with my cheap brokerage) on a monthly basis if I split the amount I am investing too far.  I allocate a certain amount to shares and try and invest this regularly every month in a share which I think is showing good value.
 
...the moral of the story is to make relative decisions - not absolute ones
 
What I mean by this is that you should be deciding between shares or between bank accounts or between alternative investments not deciding which of these classes of investments you should be putting your money into each month.  The relative decision is complex enough without adding an absolute decision which I think would paralyse most of us because of the number of choices and inherent uncertainty

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