Episode Details

In my book, Investopoly, I outlined 8 investing rules that if followed, will help you build wealth and avoid making costly mistakes. These 8 rules are evidenced-based which I have refined over the past 20+ years.

Rule number one is; play the long game. Arguably, it’s the most important rule because I’ve observed that this is the most common mistakes investors make i.e., they don’t play the long game. Whilst this rule is simple to understand, its often very challenging to follow.

Short term profit does not create long term value

Which investment option would you prefer (you can only pick one)? Invest in an index (share) fund which will accumulate $500,000 of additional wealth over the next 10 years or follow a “stock tip” which will generate a $50,000 profit within 9 months?

Unfortunately, many investors would pick the stock tip option. They might justify their decision by planning to invest in the long-term option after they have banked a quick profit, but they rarely do. Instead, they search for the next short-term hit. To many, making a quick profit feels less risky than waiting 10+ years for a much larger gain.

Three reasons short-term opportunities are inferior

I recently came across an investment opportunity to complete a 4-townhouse development which was projected to generate between $460k to $550k in pre-tax profit (which equated to a return of between 15% and 18%). It may take 2 to 3 years to complete this development.

Of course, an alternative to this investment is to purchase a high-quality, investment-grade property and hold it for the long term. This is a better option for 3 reasons (which is why I didn’t pursue the property development).

Risk refers to the chance that your actual returns will vary from your expected returns i.e. that the investment doesn’t achieve what you expect. Low risk investments produce very predictable returns, such as term deposits – as the return is virtually guaranteed. An investment’s volatility rate is a good measure of its risk.

You cannot compare two investing options without also comparing their inherent risk. This is called a risk-adjusted return.

Over long periods of time, a high-quality investment property (house) should produce an average capital growth rate of at least 7% p.a. to 8% p.a. plus a net (after all expenses) rental yield of at least 1% p.a. I have previously calculated that Australian property has a historical volatility rate of circa 10%.

Property developments can present several risks including cost blowouts, failure to achieve your desired sales price due to changes in the market, adverse changes in planning rules and so on. For the sake of this example, lets apply a volatility rate of 30% (for comparison, the share market’s volatility rate is circa 20%).

The Sharpe ratio is a commonly used methodology for calculating risk-adjusted returns. A higher Sharpe ratio is better as it means you receive a high return per unit of risk.

§ Development option: Return of 15% to 18% p.a., risk of 30% = Sharpe ratio of 0.48 (range is 0.43 to 0.53)

§ Long-term hold: Total return of 8% to 9% p.a., risk of 10% = Sharpe ratio of 0.65 (range is 0.60 to 0.70)

This shows that the long-term hold option provides the investor with a higher return relative to its risk.