New Sunday Times Feature - Diary of a Private Investor

Duke of Marmalade

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If the market was efficient, the price would reflect the risk without a premium.
Just want to make sure we are talking the same language. Let's imagine we have a betting slip which pays €2 if a coin toss comes up Heads and zero otherwise. A fair (efficient?) price for this slip "reflecting the risk" would be €1. However, for investors anyway, they should want compensation i.e. a premium for the risk as well as a reflection of it. They might only give you 80c.

All the evidence shows that over the last 100 years (for successful economies) equities have outperformed "risk free" assets considerably. But it is impossible to tell to what extent that was because there was a risk premium or to what extent it was because things came up Heads. I used the qualification "successful economies" and indeed the Equity Risk Puzzle was based on the US and given the very propitious environment for economic development (technology etc.) over the last century, my own view is that there is no puzzle. The 6% p.a. outperformance of equities could indeed be a 1% p.a. risk premium, which is what the authors claimed was justified, and 5% p.a. because Heads came up (10 times in a row at least for the US IMHO).
 

cremeegg

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???? I don't know whether you're referring to me, my contribution, or Mr and Mrs Bezos. I'll leave it go.
None of the above.

I have explained ( to my own satisfaction if no one else’s) why the idea that “every business faces risk” has no connection with the risk faced by a diversified investor.

I have failed ( to my own frustration if no one else’s ) to progress from there to formulate an explanation of the risk that diversified investors do face.
 

cremeegg

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And how would the price to "reflect the risk" be calculated? Presumably by discounting expected future receipts at the bond yield plus the equity risk premium, so you end up in the same spot.
I like the way you have formulated the question.

But if the market is efficient, why should there be a premium over the discounted value of the expected future receipts.
 

cremeegg

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Just want to make sure we are talking the same language. Let's imagine we have a betting slip which pays €2 if a coin toss comes up Heads and zero otherwise. A fair (efficient?) price for this slip "reflecting the risk" would be €1. However, for investors anyway, they should want compensation i.e. a premium for the risk as well as a reflection of it. They might only give you 80c.
Excellent comparison.

I will happily offer you 85 cent for that betting slip.

And so on until any premium is eliminated, unless of course the market is inefficient.

Indeed if we live in a world which has come up Trumps so often you would expect a reverse equity risk premium. By which I mean equities would become overvalued because investors would see that they continually out perform.

Or to go back to your illustration. If your coin came up heads 10 times in a row as you suggest for the US markets, and I agree. Then I suspect that betting slips would sell for €1.01 if not more.
 

Duke of Marmalade

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I like the way you have formulated the question.

But if the market is efficient, why should there be a premium over the discounted value of the expected future receipts.
Ahh! Now we are getting to the nub. A major focus of the dismal science is to explain pricing in terms of human preferences. A few of the basics are: people prefer more rather than less, people prefer now rather than later, people prefer certainty rather than risk etc. Of course these are generalisations, monks who have taken a vow of poverty prefer less rather than more, gamblers seek out risk even at the expense of an overall expected loss. But stockmarket prices are assumed to be dominated by investors rather than gamblers or monks. It is consistent with these assumptions that the price of a future uncertain cashflow would be less than its discounted expected value.
 

Duke of Marmalade

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Excellent comparison.

I will happily offer you 85 cent for that betting slip.

And so on until any premium is eliminated, unless of course the market is inefficient.

Indeed if we live in a world which has come up Trumps so often you would expect a reverse equity risk premium. By which I mean equities would become overvalued because investors would see that they continually out perform.

Or to go back to your illustration. If your coin came up heads 10 times in a row as you suggest for the US markets, and I agree. Then I suspect that betting slips would sell for €1.01 if not more.
Our posts crossed. We better heed Colm's warning not to engage in a medieval theological debate. Financial theory does not see the EMH and the ERP as contradictions. The fundamental premise of the EMH is that there are no risk free arbitrage profits to be made and this does not logically rule out an ERP.

But I agree a lot with the other thrusts of your post. That there is a theoretical basis for an ERP together with ample evidence of its delivery in the past does not guarantee that current pricing has an embedded ERP. And I am with you that if the one track mantra of financial advice is that you get rewarded for taking risk (end of) then that of itself could well price the ERP away, and indeed I think there is evidence that this is the case from more recent decades compared to the first part of the last century.
 

Colm Fagan

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@cremeegg @Duke of Marmalade I'm wary about re-entering this debate; you two seem to have it completely sussed. But I'm still not sure I've got my point across.
But if the market is efficient, why should there be a premium over the discounted value of the expected future receipts.
No, there shouldn't be a premium. The key issue though is the rate at which future receipts are discounted.

If I were to buy a government bond (most unlikely in my case), I would be discounting future receipts at the bond yield, which is currently 0.84% per annum for an Irish 10-year bond, i.e. I set up a little spreadsheet, insert future coupons each half-year and the redemption amount at the end of ten years into the spreadsheet, discount them all at 0.84% per annum and I arrive at the current market price of the bond.

It's more difficult to do the same calculation for a share, because of the uncertainties surrounding future income, but I try. Take Phoenix Group, which I mentioned at the end of my latest diary entry as offering very good value (IMO). How did I come to that conclusion?

The current annualised dividend is 45.2p a share. I'll assume that the dividend is safe, that it won't increase or reduce in future, and that I'll be able to get my money back in ten years' time. These are all heroic assumptions, but I think they're as reasonable as any other assumptions: the actual result could be better or worse with approximately equal probability (in my opinion). Because of the uncertainties, however, I'll discount expected future receipts, not at 0.84% a year (which is what I'd use for a government bond), but at 7.5% per annum. The share price that will give me that return is 603p, which is almost precisely the current price.

Therefore, on my reckoning, at the current price, I'm expecting to get an equity risk premium of 6.66% a year (7.5% - 0.84%) for my investment in Phoenix Group. There are uncertainties around that estimate, of course, but that's precisely why I'm getting a risk premium.

PS: I'm not recommending Phoenix Group as an investment; I'm simply using it as an example to show how I do my own personal equity risk premium calculations. I hope I've also answered the Duke's question as to why I expect to get 6% a year in future. There's a good safety margin in the 6% estimate!
 
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Duke of Marmalade

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If we discount the PG cashflows at .83% we get a present value of 984 which says that it stands at an almost 40% discount to the equivalent risk free investment. I am not saying that this is wrong.
 
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Colm Fagan

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Duke

I'm sure your arithmetic is right, but the information you've provided is of absolutely no use to me. I've no interest in an asset that will only yield 0.84% over 10 years, so I'm equally uninterested in how the price of another asset compares with such a low-yielding investment.

I take a different approach, focused on achieving an adequate long-term return. Here's how I might do it for the Phoenix Group (while recognising that it is only an example):
My main concern with the Phoenix Group is that, while it may be able to maintain the dividend for the next ten years, the long-term capital value might be at risk (because of the peculiar nature of the company's business; the top concern will be different for a company with a different operating model).

In order to quantify this concern, I've calculated what yield I would get if the dividends were safe for the ten years, but if I were to only get back 75% of my original investment at the end of the period (this is a possibility if Phoenix isn't successful in acquiring new closed books). The answer, per my little spreadsheet, is that I'd still get a total return over the ten years of 6% per annum. I would not be unhappy with that return.
 
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Colm Fagan

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I intended my “like” of cremeegg’s last post as a “Thank you”, not an endorsement of the sentiment expressed in the post!
 

Colm Fagan

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The Virtues of a Small Harem

“Diary of a Private Investor” Update #11 Colm Fagan 9 February 2019

Warren Buffett, arguably the world’s greatest stock-picker, has often extolled the virtues of a concentrated portfolio. One of his funniest analogies, particularly in view of his advanced age, is comparing his portfolio to a harem. If you have a harem of 40 women, he says, you never get to know any of them well.

Sadly, I don’t have Warren’s colourful turn of phrase. Neither do I have a harem, but we’re in full agreement on the virtues of a concentrated portfolio. Over 90% of my portfolio is in eight stocks; more than 50% in just two, Renishaw and Phoenix Group. I know I’m breaking all the rules of investing by having so many eggs in so few baskets, but like Buffett’s harem, I’ve got to know most of them well over the years. That knowledge has proved invaluable at times, including over the last few weeks.

At the end of 2018, my portfolio was on the ropes, down almost 30% in the year. Yet despite the prevailing gloom, I was feeling good as we headed into 2019. I believed that most of my stocks were worth considerably more than their market values, thereby breaking another golden rule of investing, that the market is always right. I was confident that Mr Market would eventually see the error of his ways and agree with me – if I could only avoid having to sell at the depressed prices prevailing at year end.

Phoenix Group, I felt, was particularly undervalued. I was already heavily exposed to the stock, but I decided to back my judgement and increased my exposure still further, buying in early January at £5.72 a share. This caused Phoenix to overtake Renishaw as my single biggest holding: I was putting even more eggs in this one basket.

My confidence wasn’t misplaced. Phoenix’s share price rose more than 13% in January, to £6.35 by month end. To add to the good news, sterling strengthened against the Euro, adding another 3% to the return.

My other top holdings also rose in value during January: Renishaw by more than 10% (although it has since surrendered some of the gains), Apple by 5% and even bombed-out Ryanair, by 2%.

The icing on the cake was a 7.8% fall in the share price of Tesla, in which I have a short position, so the price fall was good news. Tesla’s price fell despite results for 2018 better than I had expected. I thought it could run out of cash this year, but that now seems less likely. The jury is out however on whether the good cash outcome was a consequence of good underlying performance or resulted from cutting back on research and development, from eating the seed-corn as it were. The Chief Financial Officer jumped ship immediately after the results announcement, hardly a good omen. I’m holding on to my short position for now.

I dodged a bullet with SoftBank, the Japanese telecoms/ internet investment company, in which I also had a short position. I cashed the SoftBank short in late December at ¥7,120 a share. The current price is ¥10,015, up over 40%. I dread to think what I would have lost if I had waited.

The overall result for January was a gain of 11.6% on the portfolio. I’m still a long way from clawing back the losses in 2018, but it’s a good start.

It wasn’t all good news in January. I sold a portion of my Renishaw holding near the start of the month at an average £39.77 a share, compared with the current £43.06. I didn’t sell because I’d lost faith in the company. Far from it. Renishaw is still my second biggest holding. I was concerned however by its exposure to China, which is going through a rough patch just now. A desire to address the imbalance in my portfolio also played a part. Renishaw’s results for the half-year to 31 December, announced at the end of January, came as a pleasant surprise. The company’s performance in China wasn’t as bad as I’d feared.

Sterling strengthened against the Euro in the month, causing me to lose money on my sterling hedge, but the loss on the hedge was more than offset by currency gains on my sterling denominated stocks.

My most painful loss was caused by an 8% drop in the share price of AMP, an Australian financial services company that I bought first in May 2018, then topped up in July following a severe price fall, in the mistaken belief that it was now a bargain. In the process, I discovered the dangers of trying to catch a falling knife.

AMP has been a disaster from the start. I’m sorry I didn’t opt for a long courtship before committing serious money to the share. The AMP experience has strengthened my resolve to start with a small stake in any potential addition to my core portfolio and give it time to see how the relationship develops before making a long-term commitment to love, honour and protect. In other words, I’ll stick with a small harem.
 
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Sarenco

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Warren Buffett has consistently argued the virtues of index funds –

“Investors, on average and over time, will do better with a low-cost index fund…"

But if you think you can compete with Buffett's stock picking skills, then, sure, a highly concentrated portfolio makes sense.
 

Colm Fagan

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A Guy in the Attic

“Diary of a Private Investor” Update #12 Colm Fagan 9 March 2019

An anonymous reader, writing on the website askaboutmoney.com under the pseudonym @Gordon Gekko [1], questioned my DIY approach to investing, asking: “How can a guy on his own, working from his attic, beat the professionals?”

“Gordon” went on to tell of his friend, “a stellar stock-picker with a global investment bank (as in $10m+ bonus a year)”, who had left his job and had assembled a team of specialists, aiming to beat the market. According to Gordon, lots of people lampooned his friend’s efforts. Gordon then posed the question: if someone with his friend’s ability and back-up team had doubters, how could I, “one man and his dog”, possibly hope to do well over the long-term?

To answer Gordon’s question, let’s do a thought experiment. Imagine two sophisticated investors, Abigail and Beatrice. Both employ experts to help them: CFA’s (Chartered Financial Analysts), quants (Quantitative Analysts), accountants, maybe even a few actuaries.

After surveying the market, Abigail and her team decide they’d like to buy shares in company X. They assemble lots of information on the company, its products and markets, the quality of its management team, etc. and eventually decide how much they’re prepared to pay for the share.

Beatrice already holds shares in X and would like to reduce her holding. Maybe, like me, she’s getting on in years and needs the money. She and her team get out their spreadsheets and eventually decide a price at which they’ll be prepared to sell.

Abigail and Beatrice start haggling – virtually of course, through the stock exchange - and eventually arrive at a price “P” that’s acceptable to both.

Meanwhile, the guy in the attic decides that he’d like to buy a few shares in X. He toddles along to his stockbroker and puts in his order. He ends up buying at “P”, which happens to be the going price as decided by Abigail and Beatrice and their respective teams of experts. The guy in the attic knows nothing about Abigail’s and Beatrice’s haggling but by buying at P he has unwittingly tapped into their collective expertise –at no cost.

Twenty-three years ago, thoughts on these lines prompted me to decide to manage my own pension investments rather than entrust them to professionals to manage on my behalf. I had no experience of investing, but I trusted the market to get prices right most of the time. I reckoned that, by buying stocks at random, I wouldn’t match the professionals’ gross returns (i.e. I accepted that there was still some room for skill), but that the net returns from my random portfolio would be comparable to those earned by the professionals, after deducting their charges.

About eight years ago, fifteen years into my DIY investment voyage, I concluded that the market was far from efficient, that it had significant inefficiencies, but that the nature of pooled investment products (mutual funds, unit trusts, unit-linked funds) forced the managers of those funds into straitjackets that hindered their ability to exploit the inefficiencies. DIY investors could escape the straitjackets and therefore could aim higher.

A lightbulb moment came while I was attending an investment conference hosted by a major financial institution. In the course of a presentation on the institution’s European Equity Fund, the Fund’s manager said that 20% of the Fund’s investments were in companies that he and his team had classified as winners. In the subsequent Q&A, I asked the obvious question: why wasn’t the “winners” proportion 100% rather than 20%?

His – somewhat embarrassed - reply was that investors expected returns from the Fund broadly to match the relevant index (European equities in this case). This prevented the manager from straying far from the index when deciding which stocks to hold and what weightings to give them, thereby limiting the manager’s ability to exploit any insights they might have on the relative merits of different stocks. DIY investors are not subject to the same constraints.

My recent experience with Phoenix Group Holdings illustrates the point. At end 2018, Phoenix represented 25% of my long portfolio. This was already a very high exposure to a single share. I believed the company was significantly undervalued so, despite my already high exposure to the stock and the fact that I was making regular withdrawals from the portfolio to meet my income needs, I still managed to increase my exposure to Phoenix. Now, just over two months later, Phoenix accounts for over 33% of my portfolio. Its share price has risen more than 23% since the start of 2019 and sterling has strengthened against the Euro (although my currency gains were limited by a decision to hedge a portion of my sterling exposure). The net result is that, in the last few months, Phoenix has made a significant positive contribution to the portfolio’s performance.

Many professional fund managers would also have concluded that Phoenix Group was significantly undervalued at the end of 2018, but they would not have been able to use that insight to make a meaningful difference to the performance of their portfolios. Phoenix, with a market capitalisation of £5 billion, is a relative minnow in stock market terms, accounting for less than 0.2% of the UK market. A fund manager would be sticking their neck out – possibly to the point of putting their job at risk - by allocating even 1% of their portfolio to Phoenix Group. A weighting that low would do virtually nothing for a pooled fund’s performance.

This is just one of the ways in which the DIY investor can match or even beat the professionals. There are many others, which I hope to explore in future updates. Meanwhile, I plan to continue working from my attic.



[1] Post #95 on https://www.askaboutmoney.com/threads/new-sunday-times-feature-diary-of-a-private-investor.195710/page-5
 
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Duke of Marmalade

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Colm,

I remember that thinly veiled "tip" for Phoenix and am kicking myself for not grabbing it:oops:
But did you outsmart the market or just get lucky? If there has been no significant new info on P then by definition you have been ahead of the market. If there has been more info which you couldn't have anticipated then you have been lucky. I take it that it is the former.

You imply that Abigail and Beatrice would have been equally if not more convinced than yourself that P was undervalued, except benchmark constraints held them back. Perhaps that is just modesty on your part but somehow that doesn't stack up. I agree with the earlier part of your update that the price is essentially set by highly researched professionals. So if Abigail and Beatrice were filling their boots as much as they dare, Alf and Bob must have been dumping their holdings. The price is the price set between knowing professionals.

Note to Moderators: I know this looks like a handball inside the penalty area in so much as it discusses an individual share. However, I hope that if you consult the VAR you will conclude that since I am discussing Colm's assertion that the gal in the attic can beat the gals on the trading floor that the handball was accidental.
 

Colm Fagan

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Duke

I assume you have the advantage of youth over me. Most people have. With youth comes innocence. When I was young and innocent, I too believed in the Efficient Market Hypothesis, for much the same reasons as you’ve articulated.

My loss of faith in the EMH probably dates from my experience with an Irish Life corporate bond (i.e. one issued by Irish Life plc on the stock market, not the type that Irish Life Assurance offers to policyholders) around 2010/11. This bond had a coupon of 5.25% and a 2049 redemption date. At the height of the crisis, it traded at close to 50c in the Euro, providing a running yield of more than 10%, with the prospect of a massive pick-up at maturity. The market wrongly linked its prospects to those of Irish Life & Permanent. They were wrong of course. Irish Life Assurance was always completely sound. I filled my boots with the bond and was duly rewarded when Irish Life was taken over by Canada Life. The bond's price increased to more than 100c in the Euro. Belief in the EMH went out the window after that experience.

How could “the market” have been so stupid to ignore such phenomenal value? My personal belief is that research is not one of the “sexy” areas of finance, therefore the quality is generally poor and that it's mainly done by youngsters who have no real understanding or experience of business. There is also a lot of groupthink.

But I’ve never worked in an investment department, so I may be completely off the wall in my opinions. One of our contributors who works in the industry may be able to enlighten us. I’m not hopeful, to be honest, as the quality of contributions on investment topics on AAM has declined recently (with some notable exceptions – like yourself).
 
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Colm Fagan

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This month's diary update tells a cautionary tale of placing too much faith in Cristiano Ronaldo to rescue the situation – not on the football pitch but on the stock market.

I couldn't post the article normally: I was told that it contained banned words!!! Sorry to disappoint , but the banned words were the name of a leading luxury brand!
In order to get round the ban, I've attached it as a pdf file.
 

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Brendan Burgess

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Moderator's note: Some brand names are banned as they are so often an indicator of spam. I have shortened the name of a well known brand to LV.
The Naughty Step
Diary of a Private Investor Colm Fagan Update 13 9 April 2019


When children misbehave, their parents put them on the naughty step. I tried the same with a misbehaving investment, but to no avail.

I bought my first shares in Samsonite, the luggage company, in May 2017. For a time, it was my blue-eyed boy. It was quoted on the Hong Kong stock exchange, the touch of the orient adding to its allure.

The main attraction was the price. I reckoned that Samsonite was cheap for a luxury brand. Someone close to me, who knows far more about luxury brands than I do, scoffed at my suggestion that it qualified as a luxury brand. It didn’t have any of the cachet of top names like Cartier, LV, Prada, Rolex, Hermès, I was told.

I conceded that it wasn’t in the same league as those top brands, but neither was the price, I argued. The difference between Samsonite’s share price and those of the owners of top brands was more than the difference in quality, I said, adding that Cristiano Ronaldo was global ambassador for one of the Samsonite brands. Surely that had to be a positive?

They say that the worst thing that can happen to a gambler is to win their early bets. That was my experience with Samsonite. The price increased from the HK$29.60 at which I made my first purchase in May 2017, to HK$30.83 in August, when I more than doubled my holding. The price had increased again, to HK$33.98, by the time I bought my third tranche in November 2017. At this point, Samsonite had risen to #5 in my list of top holdings. I bought again in January 2018, at HK$34.70 a share, causing it to edge ahead of Apple as my fourth biggest holding. At this point, Samsonite accounted for 8.5% of my total pension and other investments. From this lofty vantage point, I could admire a substantial unrealised gain on my investment, “unrealised” being the operative word.

Then disaster struck, on the very day I was heading off to the US on holidays, planning to spend some of my still-unrealised gains. That morning, a short-seller issued a report accusing the company of various shady dealings. The report claimed that Samsonite was only worth half its current market value. The shares were suspended on the stock market as the company struggled to draft a response. When the dust finally settled, on the day I was returning to Ireland, the share price had fallen to HK$26.50. My beautiful unrealised profit had turned into an ugly unrealised loss.

The main fallout from the affair, other than a substantially reduced share price, was the sudden departure of the Chief Executive who, it was alleged, had been falsely claimed to have a doctorate from a US university. He wasn’t the first, and won’t be the last, senior executive to be accused of embellishing their CV.

I decided to put Samsonite on the naughty step and to leave it there until after the results for 2018 were announced, at which time I would decide its fate.

The results for 2018 were announced on 13 March last. At first glance, they looked good: sales up 9%; profit margins up, operating profit up 10%. But published profits were down over 25%. The new Chief Executive, who had been promoted from CFO after the departure of his un-doctored predecessor, stressed that published profits included lots of negative once-off factors. When these were excluded, adjusted net income was up 13% on 2017.

I’m always suspicious of the term “adjusted net income”. Adjustments, like beauty, can be in the eye of the beholder. To some extent, management can decide what to include and what to exclude from the calculation. For Samsonite, my suspicions were heightened by the cash flow statement, which didn’t show the higher sales and profit margins translating into hard cash. I decided to sell my entire holding, proving that some naughty children really are sold to the gypsies (grandchildren, please note). The average sale price of HK$24.63 meant I was incurring a significant loss, not just in percentage terms, but also in hard cash, because of the high proportion of my overall wealth represented by Samsonite. Sore.

The final humiliation was the discovery of an Instagram photo of an impeccably suited Ronaldo, Samsonite’s brand ambassador. By his side was a beautiful, petite, and most importantly, expensive …… suitcase from LV

upload_2019-4-9_13-12-24.png

Humiliation has its consolations. My willingness to suffer the occasional humiliation is one of the reasons why I can expect to earn significantly more – on average – than could be earned from risk-free assets. Yes, I could avoid humiliation by taking less risk, but at a cost. I reckon that a “safe” investment strategy would reduce my expected investment return by 4% a year or more, on average. For that, I’m prepared to look foolish every now and then.
 
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Colm Fagan

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Thanks Brendan. Can you add the Ronaldo Instagram post? I'm useless with technology and wasn't able to include it.
 
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