A Better Way to Invest

For anyone who thinks investing is all about predicting what the market or interest rates is going to do over the next 12 months, you’re getting a real-time look at why this type of thinking can be dangerous for your wealth.

According to The Economist, Towers Watson, an actuary, asked a group of fund managers at the start of the year on what they thought about government bonds. 81% of them were bearish on the financial asset – in other words, the majority predicted that interest rates would rise (when bond prices fall, interest rates rise).

The narrative – for United States government bonds at least – seemed logical and believable: Since 2012, the U.S. Federal Reserve had been buying up massive quantities (up to US$85 billion a month) of Treasury bonds on a regular basis through its Quantitative Easing programme. Near the end of 2013, the U.S. Fed finally announced that it would be cutting back on its bond buying. With the huge buying presence of the Fed starting to be weaned off the bond markets, prices of bonds would fall since a large part of the demand was no longer there – or so says the common wisdom.

But, reality just isn’t so. With the yield on 10-year Treasury bonds starting at 3.02% on 1 January 2014, the figure has since declined, dipping past 2% on 15 October 2014. This has happened even as the U.S. Fed had steadily scaled down its QE programme, culminating in a likely termination of it by this month.

This is a great example of the folly of trying to make forecasts (especially short-term ones) in the realm of investing and finance. And it really shouldn’t be surprising – the evidence has shown that we are really bad at the activity.

This hasn’t stopped the demand for forecasts from investors. But, investing need not be about trying to make forecasts. Instead, investing can – and should – be about incorporating a margin of safety. Put simply, the margin of safety is the gap between what you think will happen and what you would need to happen in order to get a good outcome. The larger the gap there is, the more room for error you have.

If we go back to March 2009, when the Straits Times Index (SGX: ^STI) hit a bottom of around 1,500 points, the index very likely had carried a single-digit price-earnings ratio (the index’s PE was 6 at the start of 2009). When measured against its long-term average PE of 17, the index was dirt-cheap. Many things could go wrong and Singapore’s market barometer could still produce a decent investment return – in other words, it had a margin of safety.

As it turns out, investors who invested in the index through the SPDR STI ETF (SGX: ES3), an exchange-traded fund which mimics the STI, would have more than doubled their money as the ETF grew from a low of S$1.54 in March 2009 to S$3.21 today.

Shares like Noble Group Limited (SGX: N21) and CapitaLand Limited (SGX: C31) also showed how the margin of safety could work. At the start of March 2009, they were valued at 6 times and 4.4 times trailing earnings respectively. With such low valuations as a starting point, both shares managed to grow respectably in price (77% for Noble and 48% for CapitaLand as of today) despite both their per-share earnings figure falling by more than half.

Back then, even if you had forecasted Noble and CapitaLand to have had higher earnings today as compared to March 2009, it didn’t matter that you turned out dead wrong. That’s because both shares had a huge margin of safety with their low valuations.

As the great investor Benjamin Graham once said, “The purpose of the margin of safety is to render the forecast unnecessary.” Take forecasting out from your investing and give yourself wide room for error – that’s when you can reach a better way to invest.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.