Basic principles of investment

Posted by Gavin Chau

I thought I’d take a break from studying the global economy and return to basics this week. While I find global developments and technical stuff fascinating, it’s useful to revisit and remind ourselves of the basics occasionally. After all, the advanced level is just mastery of the basics.

The first part is asking yourself why you want to have money. This sounds weird, but most people want money without really understanding why. It’s extremely hard to keep going without getting sidetracked by life if you don’t have some kind of bigger mission to pull your focus back. Some people are motivated to show that they have more wealth than others or to prevent themselves from running out of money at retirement, and some might be inspired to give their kids a better life.

Motivation is probably the lowest form of impetus for action, and inspiration is the highest, but regardless of what it is, you must have some kind of driver. I’ve lost count of the number of people who give up for this reason. Personally, I want control of my time back. We’re all given a finite amount of time on earth, and it would be good to spend more time with the kids while they’re young, and I can still teach them stuff.

Once you have that, compare the returns of different asset classes to find the best place to deploy your capital. The total return between shares, gold, and property are all remarkably similar. The difference is that you can borrow much more money to buy property than in other assets. In other words, leverage. When you assess the internal rate of return (IRR) between asset classes, property is an easy winner. The IRR is the return you get for the cash you have to front up to buy or hold the asset.

Cryptocurrencies are the only asset class that gives you a higher potential return, but the volatility is hard for many to stomach. The key here is position sizing; it is never a bad idea to allocate a small amount of your total investment portfolio (say 1- 5% or whatever you’re prepared to lose) to a risky asset with a huge potential upside. If you lose it, then a 1-5% loss isn’t catastrophic to your end goal, but if you win, you could double your portfolio size over a couple of cycles.

Ok back to property.

Assuming you’ve seen the mortgage broker and have the deposit and the borrowing capacity, the next thing to do is start shopping. Generally, it’s hard to go too far wrong with any property in a capital city, even if you were oblivious to the property market cycle. Understanding the market cycle is far more technical, and I have covered it in previous blog posts and will continue to cover it as required. For what it’s worth, we’re currently around the midpoint of the cycle in most markets in Australia. But even if you were to buy at the very top of the cycle (as I did when I purchased my first property), you will find that it is a very forgiving asset, and by the time the next cycle rolls around, your mistake will be fixed.

The next thing to do is wait.

Surprisingly, it’s much harder than it sounds, but a huge part of successful investment is simply doing nothing for long periods of time. As time passes, your property will increase in price, and your rental income will rise. Eventually, you’ll have enough equity built into your property, and the rent will cover your holding costs. This could take three years, or it could take 10, but eventually, it will happen. The higher your rental yield (total rent for the year divided by property price), the faster it tends to happen. There is a market that I’m currently looking into that is both cashflow positive from the get-go while still having a great growth potential.

At this point, the rent (and tax returns) cover the mortgage repayments, and you can add another property to your portfolio, and the process begins again. The good news is that you tend to be able to add your third property to your portfolio in a much shorter period than your first or second since the income you get from the first property continues to increase and begins to cover some of the costs of the second property.

You simply stay focused and add to your portfolio when you can until you’re ready to retire. At that point, you could choose to deleverage by selling one of the earlier investments to pay off the debt of the others and live off the rental income. Alternatively, you could liquidate the portfolio for one focused on cash flow.

That’s really all there is to it. It’s not an overly glamorous way to invest, but for average Aussies who don’t have ridiculous amounts of disposable income, it is simple and tends to beat the returns of all but the greatest hedge fund managers.

Posted by Gavin Chau, on 19th Nov 2024