Follow the basic principles of investing for the best result

The new year has started with a bang. The ASX has broken the 7000 barrier, and the Dow Jones is over 29,000.

These are both records, but keep in mind that the ASX almost reached 7000 in 2007 - 13 years ago - so it's hard to say that it's now at stratospheric levels.

However, it's still a good performance, especially when you factor in that most Australian shares also yield 4.5% per annum, fully or partly franked.

SIX OUT OF TEN: The sharemarket historically has six out of ten good years.

SIX OUT OF TEN: The sharemarket historically has six out of ten good years.

As the market rose steadily in 2019, people kept asking if it was overpriced. Should they sell? Should they defer investing even if they had spare money available?

Such questions will be even more relevant as new levels are achieved, so anybody investing in shares should keep some basic principles in mind.

First, nobody can consistently and accurately pick the top or bottom of the market, so beware of anybody who tells you a boom or a crash is about to happen.

Second, in reality, share markets tend to have four bad years and six good years every decade. This is why you should never invest in shares unless you're prepared to leave your portfolio untouched for at least 10 years. This gives you time to ride out the inevitable downturns.

If you are young, you can stay invested or add to your investment, secure in the knowledge that time is on your side. However, if you are nearing retirement, or retired, during the good years you should keep three to four years planned expenditure in cash, to enable you to ride out the inevitable downturns. You never want to get into a position where you are forced to dump quality assets during a normal market downturn.

If you have a self-managed super fund, or a substantial portfolio outside superannuation, remember to factor in the income from those investments when budgeting for the next few years. Remember, if your share portfolio's value falls due to a market downturn, the dividends and franking credits normally keep on coming.

Third, if you are uncertain about investing in shares, be aware of the doctrine of relative attractiveness. This is how attractive one course of action is as opposed to another course of action. For example, if you leave your money in cash you would be lucky to get 1.5% return, but you have the security of knowing will never suffer a 5% fall in value overnight - unattractive returns; attractive security.

If you keep your money in residential real estate, you will probably get a 3% net yield after maintenance and vacancies, and you should never experience your investment becoming worthless. However, you have low liquidity - if you need money quickly you can't sell the back bedroom. So, neutral returns; attractive security; unattractive liquidity.

What about shares? They can be bought and sold in small or large quantities, and if you invest in quality Australian shares you will enjoy the benefit of franked dividends to enhance the yield. But the price you pay for liquidity is the possibility that your portfolio may fall substantially in a short time, and take a long time to recover. You are looking at attractive liquidity and returns; but unattractive volatility. This should not be a worry for long-term holders with quality assets.

Fourth, if you are just starting out investing, another consideration is how large a sum you need to get started. For real estate, you need a relatively big chunk of money to start investing, whereas a small sum will get you into a modest share investment, and you can build it up as you go.

Having been an investor for more than 50 years, it is my firm belief that shares are the most user-friendly investment one can have. And the outlook is positive. Thanks to compulsory superannuation, 9.5% of the nation's payroll is invested into superannuation every month. This money has to find a home, and a big chunk of it is sure to end up in Australian shares.

  • Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance.
This story Follow the basic principles of investing for the best result first appeared on The Young Witness.