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Everything my friends need to know about investing

This article started its life as a note written in response to a friend’s question about how he ought to invest his savings. He, like many people I know, found finance mysterious.

My friend was not persuaded by my argument that finance is a far easier subject than he imagined, and that he is more than capable of investing his savings on his own. He merely wanted some sympathetic and thoughtful guidance, along with some actionable advice, not a ramble through dense thickets of theory. And most importantly, he wanted to be able to ruminate on, and explore, the logic underlying the advice.

Here, I start by setting out my views and beliefs, and end with actionable advice.

I loosely follow the style of John Fowles’ book The Aristos, in which the author sets out his beliefs on a wide range of topics in a series of terse paragraphs separated by spaces, allowing each thought to stand on its own. Fowles merely states his beliefs with no evidence in support of them, and leaves agreement, disagreement, or even disproof, entirely to the reader.

My views, on the other hand, while similarly set out, are backed by a substantial body of theory and evidence that I have deliberately chosen to exclude in order to stay within my self-imposed limit of 1,000 words. They invite spirited discussion and, yes, dissent.

I sent my note to my friend, and to my delight, it satisfied him. It has since satisfied numerous friends and relatives. They have implemented its recommendations without difficulty and are happy with their results. I hope it satisfies you as well.

Theory and beliefs

1. Investing is putting your savings at risk: no risk (e.g. cash under your mattress), no reward; good risk (e.g. stock and bonds), good rewards; bad risk (e.g. gambling), bad rewards. You'll earn about 4% each year with moderate risk over the long term if you buy and hold a globally diversified portfolio of stocks and bonds. That's about 2% better than inflation, which runs about 2% each year.

2. If I knew how to earn 15% each year with no risk, I'd tell you. I don't, and neither do the charlatans who claim that they do.

3. While financial markets offer investors a dizzying array of investments, and while salespeople routinely promise the sun, the moon and the stars, you'll do just fine by ignoring them and investing in a globally diversified portfolio of stocks and bonds through exceptionally low cost mutual funds known as index funds, which simply buy and hold all the stocks or bonds in the market and don't trade them other than to rebalance.

4. But isn’t it better to identify, and invest with, the next Warren Buffett? It absolutely is, if you can identify the next Warren Buffett! But it’s exceptionally hard to prospectively identify great investors, who are a rare breed. What about retaining a consultant who identifies great investors? Great idea if you can reliably identify great identifiers, but they, too, are a rare breed! In short, non-index investing is best left to the few investors who have a proven record of success. Index funds work best for everyone else.

5. The benefits of global diversification are underestimated. You’ll do yourself a huge disservice by investing only in your home country and in a few stocks, as it’s incredibly hard to tell in advance which countries, regions, sectors and companies will do well and which will do poorly.

6. The powers of disciplined saving and compounding are also underestimated. If you save the same amount for retirement in each year that you work, over half your retirement savings will come from contributions you made before you turned 40 (Editor comment: Australia's compulsory super system usually means employees save more in later years as their income increases).

7. With social security as a backup, you need to save approximately one-sixth of your income each year for retirement. Furthermore, you can spend about 3% of your savings each year once you retire.

8. Stocks generally outperform bonds over the long term but stock prices are volatile. Don't get starry eyed when they rise and don’t despair when they fall.

9. You won't go too far wrong by investing half your savings in stocks and half in bonds, half domestically (i.e. in your home country) and half internationally. If you live in a small country, invest less than half (say a quarter) domestically and the rest internationally.

10. Here’s why 50/50 is fine:

  1. If the world fares well, so will stocks, and bonds will do you no harm.
  2. If the world fares poorly, so will stocks, and bonds will preserve half your wealth.
  3. If your home country fares better than the rest of the world, your domestic portfolio will do well even if your international portfolio doesn’t.
  4. If your home country fares poorly relative to the rest of the world, your international portfolio will do well even if your domestic portfolio doesn’t.

11. Avoid esoteric investments in real estate, private equity, hedge funds etc. Recall point three and tune out glamour, noise and fees, all three of which usually go hand in hand.

12. Stocks sometimes get overvalued (e.g. during the internet bubble in 2000), so it then makes sense to keep less than half your savings (say a third) in stocks. At other times (e.g. at the depth of the GFC in early 2009), they get undervalued, so it makes sense to have more than half your savings (say two thirds) in stocks.

13. It's incredibly hard to tell if stocks are going to rise or fall in the short term, and most periods of overvaluation and undervaluation are obvious only in hindsight.

14. Invest at the lowest possible cost. Your earnings belong to you, not to someone else. If you are paying more than 0.3% of your assets in fees each year, you are paying much too much. Ditto for sales charges of any kind. They benefit salespeople, not you.

15. Finally, never, ever, burn with envy because someone you know claims to have effortlessly made a fortune. Virtually all such stories are the product of an active imagination aided by a selective memory.


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Actionable advice

Diversified Exchange Traded Funds (ETFs) are a particularly useful starting point for investors as they package a mixture of stock and bond index funds into a single strategy.

(Editor's Note: Tom and I met by Zoom to discuss an Australian equivalent to his original US examples, and the following is an adaptation for an Australian audience).

single fund with a 50% growth/50% income will work well for the rest of your life regardless of your age. A low-cost, all-in-one investment portfolio provides exposure to diversified assets in a single ASX trade.

Here are two Australian examples:

Vanguard Balanced Index ETF (ASX code: VDBA)

VDBA can be purchased in the same way as any shares via a broker account. More details on the fund are available here

For investors with less risk appetite who prefer a single fund with 30% growth and 70% income, the code of the Conservative version is VDCO. Investors wanting a more aggressive version with greater exposure to equities, 70% growth and 30% income, can choose the Growth version, VDGR. The management fee on all these funds is 0.27%.

BetaShares Diversified Balanced ETF (ASX code: DBBF)  

This is also a 50/50 fund, with more information here. The other BetaShares versions are Growth DGGF and Conservative DZZF and all have a 0.26% fee. Choose the relevant fund based on your risk appetite.

This single fund diversified solution is especially useful if you find finance intimidating and want to keep costs down. You can't beat it for simplicity and over time, you will be happy with the results.

 

Thomas Philips teaches Quantitative Portfolio Management and Valuation Theory in the Department of Finance and Risk Engineering at New York University’s Tandon School of Engineering.

In 2000, he received the first Bernstein/Fabozzi/Jacobs-Levy award for his paper “Why Do Valuation Ratios Forecast Long Run Equity Returns” which appeared in the Journal of Portfolio Management, and in 2008, he received the Graham and Dodd Scroll Award for his paper “Saving Social Security: A Better Approach”, which appeared in the Financial Analysts Journal.

He received his Ph.D. in Electrical and Computer Engineering from the University of Massachusetts at Amherst. This article is general information and does not consider the circumstances of any investor.

 

20 Comments
Adam
September 08, 2020

Hmmm, some risk is ok. I bought TLS recently at $3.06. Sold it 40 days later for $3.37. But I am not that clever, it went to over $ 3.50. I have bought it again at $ 3.06. I got the dividend last Feb and will get it again soon. So far its about a 12.5% return on investment including the fully franked dividend . Telstra is a solid blue chip company. The big tech companies , Facebook, Google, Netflix etc , all need Data. The Risk is not buying low enough and neglecting to spend at least 20 minutes a week following your company of choice. To make your time worth while you need to buy big. I don't do investment properties anymore. Just this. I buy big . So identify a good company, follow it . Watch all the indicators. Don't get caught in all the Hype and invest, sell , buy again and so on. But have fun with it.

James
September 07, 2020

Index funds are good in theory, but when people realise that they are investing substantial amounts into tobacco, gambling, alcohol, weapons, coal and other controversial areas, they are often horrified. A key point that has been overlooked here is that everyone has their own ethical criteria, and that these criteria can be taken into account when investing - often without higher cost, and often with above benchmark performance...whether in active or passive funds. Point 16!

SMSF Trustee
September 07, 2020

There are lots of funds that explicitly exclude those types of shares, running against an ''ethical benchmark''. So don't turn this into an argument against index funds - that's not the point.

James
September 08, 2020

The point is that not once in the article or the example ETF’s are ethics mentioned...a missed opportunity.

Geoff F
September 04, 2020

Thanks, an excellent article.

CC
September 03, 2020

with interest rates at never seen before lows near zero, you'd have to be CRAZY to put 50% of your portfolio in bonds. do the maths on bonds capital losses when interest rates eventually rise from 0.25% to 1.5% or 2% .....

John Edwards
September 03, 2020

Very good advice. I’d also add that retirees could also consider the large listed investment companies such as AFI, ARG, BKI etc. Many LICs have the ability to retain earnings and maintain dividends for people who rely on regular income. They also tend to hold a higher percentage of franked shares than the index, which will juice up the after tax returns for retirees.

Tony Reardon
September 03, 2020

I support Thomas's views and have written very similar pieces for my relatives and friends. I would add a few other issues to be aware of:
1) Taxation. You need to be conscious of how the tax system in your country works and adjust investments accordingly. Here in Australia, if appropriate and you qualify by age, an SMSF in pension mode is a fantastic, zero tax environment. Given our franking credit arrangement, we also advantage dividends somewhat over capital gains.
2) Currencies. I would rather remove variables from my investing decisions and the AUD can move substantially. In the last decade we have seen the AUD/USD at a high of about 1.1 in 2011 and down to .62 in March this year. This movement can destroy any investment returns or, alternatively, magnify them and I would rather not take the chance so consider looking to hedged versions of funds under consideration for investing overseas.
3) Quoted fund management costs. The top line quoted percentage is not necessarily the total cost. Many funds have layers of management with funds investing in other funds and those lower level fees are not explicit – you only see then through the lower investment returns. If you are investing in index funds, check on how they historically match the index.
4) Cash. In this era of historically low interest rates, you cannot really afford to pay people to manage cash. If you are paying an active manager, then of course they can take a view that they should hold cash temporarily, but index funds shouldn't do this.

sandgroper
September 03, 2020

Unhedged AUD exposure to overseas shares significantly lower risk than hedged exposure (and same expected return) because the AUD generally rises and falls with equity markets. Give me unhedged any day of the week.

PeterJS
September 03, 2020

For what it's worth - Over longer term hedged vs unhedged performance is nearly identical across multiple studies - a 50/50 split just reduces the volatility along the journey
e.g. end July 2020 Vanguard Int Shares Hedged vs UnHedged Returns
1 year 6.83% vs 12.23%, 3 year 12.68% vs 9.06% 5 year 9.67% vs 10.34%, 10 year 13.06% vs 12.84%.

John E
September 07, 2020

Thomas's views represent very sensible advice!
I also support Tony's comment here about currencies to which Thomas seemed not to refer when advocating diversification. An offshore investment has an extra highly significant variable which is of course currency fluctuations. My recollection is that currency traders love the AUD because it is so volatile, and I think that we can be forgiven for leaning towards AUD investments to eliminate having to think about currency risk. On the other hand some funds offer hedged overseas investments (eg Vanguard) - but as pointed out in another comment here, Vanguard's stats show little difference over a 5-10 year period between hedged and unhedged. The other comment re the AUD rising and falling with the ASX is interesting. I will keep an eye out for a graph about that. As hedging comes at a cost (fees) and if you have a 5-10 year outlook, it would barely have been worth it in the past - although as Peter says, splitting 50/50 (I assumed hedged/unhedged) would have reduced the volatility in the past. Decisions, decisions ...

Sandgroper
September 03, 2020

Excellent article. Points 3, 4, and 14 all closely related. Finding active managers that consistently outperform after fees is difficult BUT the reward is significant if you do find them (do 2% p.a. over 10 years and look how the number looks - and this extra return should be at no incremental risk over the passive exposure). The size of the reward always seems to be lost in the debate. It's hard, so don't do it, seems to be the story that groups like Vanguard & Dimensional pontificate in selling their wares.

I would re-phrase: It's hard, but try find a way to do it (or a person/group to do it for you as mentioned above) because the rewards are significant. Only, if you find that it is too hard or time consuming should you seek to find the cheapest option possible.

Jack
September 03, 2020

Other than the higher costs, this is effectively the solution that most Australians already have in their industry funds or retail superannuation fund.

Aussie HIFIRE
September 03, 2020

Another key difference is that most "Balanced" industry funds have anywhere from 70% to 95% of their investments in growth assets like shares and property, with 30% to 5% in defensive assets like bonds and cash. This may turn out to be good for the investor, but it's certainly not the same as having a 50/50 split.

Brendan Ryan from Later Life Advice
September 03, 2020

I couldn't agree more with the content of this article.

An excellent companion to this would be to look at the impact of choice on investor behaviour. Seemingly endless investment choice is the gateway to many financial service providers as a reason to get on board. Yet in being faced with the choice, many investors enter into a kind of paralysis that creates a very valuable inertia to the product provider.

As an example I see clients who have had investment with the normal large financial institutions being presented with page upon page of investment menu choices in their reports - completely bewildering and often resulting in the kind of anxiety inducing choice overload. This leads to them doing nothing. Having confused clients is great business. They stay put.

Having said all of this - while the Vanguard Conservative Index Fund may look simple, we all know that under the bonnet literally thousands of securities are being held, and decisions are made around how to allocate funds amongst asset classes in a considered and sophisticated way.

These are not simple funds - just simple choices. I hope people feel empowered to make the effort and simplify.

Paul
September 03, 2020

Nice article. 2 x "rules" which are akin to #2 and #15 = (i) if it's too good to be true, it usually is and (ii) if you don't really understand it, don't invest in it.

Gary M
September 03, 2020

Returns from bonds are not like the past, and future equity returns are doubtful. You have to invest somewhere, but as this quote warns: "A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years… We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company Analysts (January 2017)

Mart
September 03, 2020

Fabulously put and wonderfully succinct. I plan to print these article and attach it to the inside of my eyelids

Michael
September 03, 2020

why not properly commit and get a neck tatt?

Mart
September 03, 2020

I would do but Victoria's restrictions have nixed that possibility !

 

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