How to Invest Intelligently Steps 4 – 6
Welcome to How to Invest Intelligently part 2! Let’s get into it….
4. Understand Inflation
We hear the word “inflation” bandied about but do we really understand it?
Inflating a balloon or an air mattress means pumping air into it to blow it up big.
When it comes to money, inflation is the blowing up big of prices.
My grandfather was forever complaining about how much the price of everything (from milk, to petrol, to houses) had blown up – “daylight robbery”! He thought that the price he paid for a gallon of petrol when he began buying petrol as a young adult, was the correct price.
The pace of the blowing up of prices is called the inflation rate. When the inflation rate is 4.76% it means that the average price increase of something over a specified period of time was 4.76%. For example, if something was $100 at the beginning of that period, and was $105 at the end of that period, there has been a price increase of 4.76% ((5/105)*100).
Inflation is calculated from the changes in the CPI (Consumer Price Index) over periods of time (typically 3 month periods). Here is how the ABS measures the CPI.
What causes inflation? More demand than supply. If you are selling your car and have 20 people wanting to come and look at it, you put the price up – right?
Why do we need to understand inflation? Because the purchasing power of our money does not stay the same as time goes by. If we make the assumption that it does, we’ll get more and more stressed with the passage of time, like my grandfather was.
When we’re considering how to invest, there are two main things we need to understand about inflation:
- Plans for future portfolio income MUST take inflation into account.
Simply put – we are going to need more dollars in the future than we need now, to buy the same stuff (assuming that inflation will generally happen over time in the future, as it has in the recent past).
- Defend against the potential value loss that goes with inflation.
We can achieve this if we own assets that hold their value when the big price blow up happens. These are called “inflation hedged” assets.
5. Know the features and benefits of various asset classes
What assets should you own and why? And how much of each? How to invest? Will it be property, shares, bonds, cash, venture capital? How do you answer these questions?
You need to have the big picture – your end goal – in mind. What exactly ARE you aiming for? As well as knowing what you want, you have to also have an idea of what you DON’T want.
Some important asset features when considering how to invest are:
Capital preservation – how safe is your money(capital)? What is the likelihood of getting it back?
Liquidity – how quickly and easily can you sell and get your money back?
Value Volatility – how changeable is the value/price of your asset? What causes the value to change?
Growth Potential – is it going to grow in value over time? What are the growth drivers?
Inflation Sensitivity – is the value going to be preserved in a high inflation economy?
Income Generation – how and when is income generated, how often is it paid, and is it fixed or variable amounts?
6. Know when to buy and sell various asset classes
A behaviour that distinguishes novice investors from savvy investors is the timing of when to buy and sell.
Savvy Investors understand economics. They understand that there are boom and bust cycles, and they have at least some idea of the indicators and causes of these. (They don’t have economics degrees by the way, but a basic understanding is essential.) Most importantly, they aim to buy low and sell high. Sounds simple enough but it’s not what novices do.
When we are novices we follow the herd, (because we don’t have any other way of deciding how to move). We see others jumping into purchasing properties, or particular shares, and we figure that if they’re doing it, we should too. Typically novices buy high and sell low, which of course loses money.
Most importantly, buying and selling assets must be based on rational thinking – NOT emotions! The classic emotional drivers of fear and greed must be recognised when they are present, and not be allowed to influence purchase or sale decisions.
All your friends are buying shares in the next big thing, and expounding the belief that it’s going to take off like a rocket and you’ve got to get in fast or you’ll miss the big price jump….. They are excited about what they believe is a sure thing, and generating FOMO for you (fear of missing out). You must see this for what it is.
Investing should not be exciting! That’s a bit sad isn’t it. But I believe it’s true!
If we are going to be Savvy Investors, we need to learn and apply the fine art of emotional management alongside the practice of making fine (rational) distinctions about what we’re getting into or out of. We need to look for excitement in other departments of life, and have our thinking hats firmly pulled on when it comes to investing smartly.
Until next time,