As investors we’ve become conditioned to believe the solution to every investing problem is a product. Want to earn a market beating return? Try this new, improved ETF which tracks a back-tested, newly created index. Want to achieve your goals? You need a trading platform that removes all the friction from each transaction.

The investment industry won’t stop talking about products – because they are trying to sell you products. On the 100th episode of our podcast Investing Compass, Shani and I explored the pathway to becoming a successful investor. Not one product came up. As investors, you shouldn’t care about products. You should care about outcomes.

This focus on outcomes directly influences how we should evaluate investment opportunities. Each of us is unique. Each of us has unique goals and a unique temperament and set of skills that lend themselves to different competitive advantages as investors. All of these factors come into play when deciding if a particular ETF or share is something that should find its way into your portfolio.

Evaluating investment opportunities includes two steps. Determining if it is the right investment for you and deciding if it is trading at a level where you can reasonably expect to achieve the return you need for your goals.

Is this the right investment strategy for you?

Investment products and ideas are often presented to us with an unnecessary amount of passion. The source of this passion is almost always self-interest. And this constant barrage of passionate advocacy for investment strategies and approaches gives many investors the impression that there is only one way to invest. Many investors internalise the notion that if something isn’t working it is because they have chosen the wrong approach. Therefore, the logical way to invest is to constantly search for new approaches.

This constant search for the ‘right’ investing strategy causes many investors to continually churn their portfolio. Investors hurt their chances of ever achieving their goals by naively chasing performance as they are cheered on by an industry all too happy to introduce new products and gather transaction fees.

The impact of this behaviour is underappreciated. Morningstar’s annual Mind the Gap study quantifies the difference between investment returns and the return investors receive based on the timing of their entry and exit points in the products. Our 2021 study found that investors underperform the return of their investments over a ten-year period by 1.7% a year. For a 25-year-old with $50,000 and investing over a 40-year time period the difference between an 8% return and a 6.3% is having $1.086m instead of $575k.  

The truth is that there are many different investing approaches that are successful. There are successful passive investors and successful active investors. Value investors achieve their goals and growth investors achieve their goals. But not everybody is built to be a value investor or a growth investor or any other investing approach. There are many different investing approaches that work – but there is likely only one that works for you.

The key to successful investing is to find an investment strategy that truly resonates. Aligning your goals, your competitive advantage as an investor and your temperament to a strategy is a recipe for success. This intellectual alignment between you and an investment will lower the impact from poor timing decisions and insulate you from the negative effects of market volatility.

Start with your goals

Investors do themselves no favours by failing to ask the most important questions first: What are my objectives? Why am I investing? Rather than an academic exercise, taking a goals-based approach ensure you have the structure needed to help you achieve your goals. Remember that is the actual point of investing in the first place.

Defining your goals allows you to calculate the required rate of return needed to get from where you are, to where you want to be. Knowing your required rate of return lets you answer two of the fundamental questions that vex all investors; 1) Is my portfolio allocated to the right asset classes to achieve my goal; 2) How am I tracking against my goals and do I need to make adjustments?

For those of you who haven’t defined your goals now is the time to do it. Use that start of the year optimism and energy to take the initiative to define your goals. Unlike your solitary trip to the gym for the year, this exercise will have a lasting impact for years to come. If you haven’t set your goals yet we have some resources to help you out:

Calculate the required rate of return

Setting goals can be intimidating, but don’t worry, they are not set in stone. For those of you who have already set one, or multiple goals, it is a good time to reassess them. Two things are more likely than not to have changed since the last time you reassessed your goals – your portfolio has fluctuated and time has ticked away until you want to achieve your goal.
There might also be changes in your financial situation that may impact the amount you can save and invest. Any change in those variables will mean that your required rate of return will be different than when you originally set your goal or the last time you reassessed it.
Assess the feasibility of your goal

Once you’ve recalculated your required rate of return you can assess if you are on track to meet your goals. If the return needed to achieve your goal is higher than the last time you checked than you might be falling behind. This is where the degree of the change matters. Small fluctuations should be expected and can be chalked up to the volatility inherent in investing. However, if the change is measured in percentage points rather than fractions of a percent you might need to reassess.

Perhaps you need to save more or lower your expectations. Perhaps you need to extend the time horizon until you want to achieve your goal. Go through some different scenarios using a financial calculator or our goal setting feature. The other option is to check the asset allocation of your portfolio and shift some additional funds into riskier assets.

Think about the drivers of returns

There is always a lot going on with the share market. Lots of opinions about what is going to happen. Lots of distracting noise. Investors should strive to strip away all the commentary we hear about markets by focusing on the actual drivers of returns – changes in valuation levels, changes in earnings and dividends. 

A historical example provides some perspective on how to think about the source of returns. If I bought Cisco at the end of 1999 there would be a lot of people that would have said I was a genius. The prevailing wisdom in 1999 was that investing in anything connected to the internet would make you rich. Cisco was selling the plumbing of the internet – what could be better. This was an amazing narrative and it resonated to such a degree that Cisco was the third most valuable company in the world in 1999. If I took a look at the three drivers of share market returns maybe I wouldn’t be so quick to anoint myself a genius.

Cisco didn’t pay a dividend in 1999 so that source of returns wasn’t available. That leaves changes in valuation levels and earnings growth to propel the share price higher. Cisco made $2.25B USD in 1999. We aren’t talking about some crazy internet company that was losing a ton of money. Cisco had a market capitalisation of $337B USD which means it was trading for 140 times earnings. This compared to the S&P 500 that was trading at ~30 times earnings. Cisco’s valuation was 4.6 times more than the index. This extreme valuation makes it very unlikely that the share price would be driven higher from further valuation increases.

Far more likely than maintaining the elevated valuation is that it falls over time. All things being equal the share price would then also fall. If Cisco traded at 100 times the same earnings the share price in 1999 would have fallen close to 30%. This is very plausible scenario as over time sky high valuations tend to revert to the mean even if they remain higher than the overall index. As an investor in a company with an extreme valuation the hope is that earnings grow fast enough to make up for any reductions in valuation levels. Lets explore a scenario where Cisco experienced mean reversion and simply traded at double the index level of 1999 over the subsequent decade. Reverting to a valuation level of 60 times earnings would require earnings to grow 9.87% a year for 10 years just for the share price to stay the same. A tall order.

This extended example is looking at the past where everything that seemed so murky at the time has the clarity that comes from knowing the outcome. Between the last trading day of 1999 and August of 2022 Cisco’s share price was down 16%. Twenty-two and a half years later and the share price is down 16%. Earnings grew 6.7% annually over that period. That impressive run was buried by the valuation hit of having the price to earnings ratio drop from 140 to under 16.

How a plan plays out

I have spent the last three to four years building up cash in my investment accounts. I was ahead of schedule on my goals given a historic market run and I was wary as investors collectively descended into a speculative frenzy. My reaction to the market environment was far from drastic. At no point was I screaming into two telephones so I could unload my positions at precisely the right time. I simply started to accumulate dividends and kept most of my new contributions in cash. This has left me in an enviable position in a down market with a 25% allocation to cash. Now I just need to figure out the right time to put this money to work. 

Investing is ultimately an expression of optimism about the future. And like any bear market, optimism is currently in short supply. The same scepticism that served me well during the bull run may now be my Achilles heel. An underappreciated contributor to investing success is self-awareness. As I reflect on my own investing disposition, I see strengths and weaknesses. A long-term orientation and a focus on cash flow generation instead of my net worth has anesthetized me to volatility in my portfolio. That is a good thing as I am far less likely to panic sell. Conversely, I have a pathological need to get the best deal possible when investing. Oddly, this quality does not apply to any of my day-to-day spending decisions. But from an investment perspective it makes it harder for me to pull the trigger because I keep imagining further falls and better entry points.

Here are some things I’ve been thinking about in the current environment and another plea to put some structure around investing. Structure won’t eliminate emotionally driven investment decision making. But it will reduce the impact of greed and fear on your returns. That reduction may be enough. Investment success over the long-term is often just preventing the big mistakes. Now is the time when many of those mistakes occur.

We need to call a spade a spade. What I am doing is basically market timing. And market timing generally doesn’t work because most investors can’t determine when to sell and when to buy. The major distinction is that I didn’t sell at the top—I just didn’t buy more when I was uncomfortable with valuation levels. And I didn’t buy more because I was still on track to achieve my goals. Many will disagree but I consider that a structured approach to investing. Right now I’m not trying to catch the bottom. I am trying to make sure that each dollar from my cash hoard is invested at a point where there is a strong probability of achieving the long-term return needed to reach my goals.

To achieve my goals I need a 6.9% return over the next 20 years. I know that because I took the time to figure it out. I calculated my required rate of return and regularly track it as the market fluctuates, I contribute additional funds and as time ticks away. Listeners to Investing Compass know that Shani and I go through this exercise at least every six months and review the results on the podcast. This structure matters. Finding investments that earn at least a 6.9% return to achieve a specific goal is very different than a focus on wealth maximisation. The reason the “get as rich as possible” crowd often fail is because there is a constant attempt to do the impossible. In this market environment it is about catching the bottom. In rising markets, it is about constantly switching to an investment that will perform better.

Acknowledging the fact that the market will likely keep falling after I buy anything—and being ok with it—is the right mindset for this trying environment.

For me the answer is not yet—but getting really close. There is an obvious but important caveat to that statement. I am talking about the right situation for me. Your situation is different, and therefore your decision-making process should reflect that reality. I hope expanding on my thinking provides a bit of perspective.

I always keep a list of my “dream” shares. These are companies that I think are great and fit my investing style. I have this list because I’ve taken the time to figure out the investing approach that works for me. A plan and an investing approach makes it easier to establish the criteria that needs to be met to determine if an investment is the right fit for my portfolio. That is a deeply personal set of criteria. Investment opportunities that don’t fit fmy approach aren’t bad. It just means they don’t fit my goals and my investing style.

The greatness of the companies on my list is widely acknowledged. I’m ok with that because I’m realistic about my competitive advantages as an investor. It is not my ability to analyse a company better than everyone else. Some people can do this. I don’t think I’m one of them. I think part of my competitive advantage is discipline around buy and sell decisions—my behavioural edge. I combine this with the self-awareness about which investments are right for me.

My hope is that this formula leads to buying great companies at reasonable prices and holding them for an extremely long period of time. Patience is the final source of my competitive advantage. A long-term orientation eludes most investors despite their best intentions and proclamations to the contrary. A long-term approach is a major contributor to achieving your goals and an underappreciated advantage that individuals have over professionals. It is an advantage that so many people carelessly give up by chasing returns and fads. Figure out a structure that truly allows you to take a long-term approach.

How does this inform my decision making in the current environment? An example may help. One of the companies on my list is American Tower which provides mobile phone towers to wireless companies. I like boring companies with moats that do reasonably well in all market environments. I like companies that operate in relatively stable operating environments and aren’t subjected to investor hype and the fluidity inherent in new industries. I like companies that pay and grow their dividends. I like companies that are conservatively geared. This combination often results in predictable and strong cash flow generation. American Tower fits the bill. It is a company that suits my investing criteria.

American Tower has had an incredible run as they’ve benefited from the explosion of data needs by mobile phone customers in the last decade. The share price has performed well and they’ve grown their dividend by at least 20% a year since 2013.

That track record certainly won’t be replicated going forward. But I don’t need that to happen to achieve my goal. I am looking for a total return of at least 6.9% going forward. To see if this is reasonable, I look to the three drivers of equity returns—dividends, changes in valuation levels and earnings growth.

The current dividend yield is 2.75%. Not earth shattering but it is close to 40% of my total return needs and I expect the dividend to keep growing. This is also the highest yield for American Tower in more than a decade.

On the valuation front the shares are trading at a price to earnings ratio that is 37% below their 5-year average. According to our analyst the shares are fairly valued with a 3-star rating. The last time they traded at a 3-star level was 2018 and they haven’t been undervalued at a 4-star rating since 2016. None of this makes me think that increases in valuation levels will be a driver of returns. But I also don’t see a falling valuation level negatively impacting returns.

The final driver is earnings growth. Our analyst sees revenue growth of mid to high single digits over the next 5 years with expanding margins further boosting earnings. I need earnings to grow 4.15% a year to hit my 6.9% required return if the dividend isn’t raised further and if valuation levels stay at the same level. Seems reasonable and achievable. I would like to see the share price fall a little further to build a bit more of a margin of safety but as I said—things are getting close.

If I make the decision to buy American Tower it will be at a level that is right for me. That likely won’t correspond with the bottom of the market and I’m ok with that. Prolonged and intense market falls impact great companies and terrible companies. Keeping structure around your decision making and having a clear idea what you need to achieve is the key to keeping your cool in this challenging market.