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Investing 101 (2/2)

This entry builds on the first part of investing 101. If you haven’t already, make sure you check out that one first!

Choosing your asset classes

How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.

Robert G. Allen

An asset class is a grouping of investments with similar characteristics [1]. Common asset classes are cash, stocks, bonds, real estate and commodities. Cryptocurrencies recently broke in the pool as well. Which asset class should you invest in? Let’s start by discarding some.

Cash

You reading this implies you’re probably holding too much cash. You should always keep an emergency cash fund of 6 months to one year worth of expenses. But that’s it. Remember that cash gets eaten away by inflation.

Commodities and crypto

Commodities (e.g. gold, silver, oil) and cryptocurrencies are purely speculative investments. They have no associated cash flows. Lack of cash flows makes it difficult to get an objective view on their value. For example, a typical valuation method called discounted cash flow can’t be used. Their value is still determined by supply and demand. But having no cash flows make them a risky long-term bet. There’s no intrinsic reason why they should provide long term returns. You better stay away from commodities and crypto.

Real estate

Real estate can be an interesting choice depending on your unique circumstances. The main problem with real estate is that, for most, it concentrates too much wealth in a single asset. It’s not a diversified investment. Not unless you’re either rich or invest through REITs. I’ll exclude real estate for now and touch on it in the next section.

We’re left with stocks and bonds. The choice depends on your investment horizon and your risk tolerance.

Stocks (or equities)

Stocks and equities are the same thing. When you buy stocks, you acquire ownership in a company (equity). The value of your investment is linked to the financial performance of such company. Stocks are a risky bet. Read risky volatile. But have historically been very lucrative in the long run. Stocks have had nominal yearly returns in the range 6-10%.

You should only invest in stocks if your investment horizon is long enough to dampen the volatility. Say at least 15 years. Better if 20. You also have to be psychologically prepared for a bumpy ride. Pullbacks of 10% or more have occurred in 11 of the past 20 years [2].

Bonds

When you buy bonds, you lend money to a company. The risk of bonds depends on the issuer. Government bonds are issued by governments and are safer. Corporate bonds are issued by companies and pose an additional credit risk.

All bonds – but especially government bonds – are a rather safe bet. Read safe not-so-volatile. Historically, they have provided nominal yearly returns in the range 3-5%. Although in the last 10 years it’s been more like 1-3%. Because of their lower volatility, bonds are more adequate for shorter investment horizons.

You can check the entry how bonds work for additional info.

Stocks vs bonds

Should you buy stocks or bonds? Both is a good answer. A popular rule of thumb is to hold a portfolio with your age in % in bonds and the rest in stocks. For example, if you’re 25, you hols 25% bonds and 75% stocks. If you assume that your investment horizon is retirement, this is a very consistent approach. In addition, it helps diversify your portfolio. But more on diversification later.

That said, both Swiss and European bonds provide no yield at the moment. Or even a negative yield. If your investment horizon is over 15 years, I’d argue it’s better to go 100% stocks. At least currently.

On real estate

Investing in real estate is very popular. In fact, many people never consider any other options. They’re too narrowly focused on real estate investments. Probably because real estate is tangible. Many avoid stocks and bonds due to an inherent fear to financial markets. They see financial products as something difficult to grasp. A black box. Something out of their control. A house, in contrast, is just a house, right? Easy.

I don’t mean to categorically assert that investing in real estate is a mistake. But there’s still too many people who naturally pivot towards it without even considering other alternatives. Because of that, I’ll offer some arguments why real estate is not always right:

  • Diversification: With stocks, you can diversify. You can buy into the whole economy. From utilities (e.g. water company) to tech (e.g. CPU manufacturer). Buying a house often means putting all your eggs in one basket. Including those you don’t have
  • Leverage: These are the eggs you don’t have. Leveraged investments are investments partially funded with debt. Real estate investments fall in this category most of the time (think of mortgages). Leverage can amplify your returns, but also your losses
  • Maintenance: Owning a house implies spending hundreds of hours per year fixing stuff. Securities such as stocks and bonds won’t take up any of your time
  • Liquidity: You can buy and sell stocks and bonds pretty much at any time. It takes seconds to trade, and bid-ask spreads are ridiculously smalls. In contrast, it takes months to sell a house, and bid-ask spreads can easily be in the dozens of thousands

Diversify

Diversification is the companion of margin of safety.

Benjamin Graham

Real estate might not be the first thing you want to invest in in part because of lack of diversification. But what does that mean? Why is diversification so important?

What does it mean to ‘diversify’

Diversification is a risk management strategy in which you pool multiple investments together. It’s the opposite of putting all eggs in one basket. Why is it so powerful? Let’s look at an example.

A simple example of diversification

Imagine two stocks, s1 and s2. The chart below shoes their historic prices over the last five years. For simplicity, both start at 100. Had you bought either of them, you’d have signed for a bumpy ride. s1 skyrockets 40% within 20 months. Only to abruptly correct later. s2 loses as much as 13% in the first year and a half. But then it recovers.

As an investor, you don’t like this kind of volatility. This is psychologically difficult to deal with. Imagine you invested 50k in s2 only to find you had 43k after almost two years. How would you feel?

Luckily, we can diversify and simply buy both. Say in equal amounts. In that case, you’d be riding the green line in the chart below. The bumpy rides of each stock somehow cancel each other out, so your portfolio experiences less volatility. In technical terms, s1 and s2 are not perfectly correlated. They offer a diversification opportunity. As an investor you like this.

What if instead of two you bought ten stocks? Well, then things average out even more:

Shouldn’t we feel bad that we didn’t fully harvest the returns of the blue stock that goes over 250? No. You had no way to know which stock would outperform. Had you chosen only one, you’d be putting all your eggs in one basket. You’d be less of an investor. And more of a gambler.

Diversify to the Moon?

How far can we take diversification? Research suggests that you should hold at least 30 stocks for your portfolio to be diversified [3]. But there’s no reason why you should stop there. Nowadays, it’s extremely cheap to buy funds that contain thousands of stocks. ETFs are an example of such funds. We’ll get to them in a second. For now, the important thing is to understand how both a long investment horizon and diversification help mitigate volatility.

This example focused solely on stocks. You can also diversify across asset classes. In general, it’s actually even more efficient. This is one of the benefits of holding both stocks and bonds, as discussed earlier.

Active vs passive investing

One way to classify investment strategies is to split them in active and passive. Active investors try to outperform a benchmark. Passive investors try to mimic a benchmark. What is benchmark? A benchmark is normally an index. And what is an index? An index can be anything.

A practical example

Let’s look at a practical example. In our in the diversification example above, the portfolio of 10 stocks could be the benchmark index. A passive investor would be happy buying them all and mimicking the green line. An active investor would try to do better than the green line. How? By timing the market and attempting to buy stocks at the right moment. Or by selecting securities according to their performance expectations.

The problem with active investing

Active investing sounds exciting, doesn’t it? I mean, who doesn’t want to do better? Market timing and superior security selection seem to be nice tools to have under your belt, right? No. In fact, I advise you to distrust both. There’s whole professional teams trying to outperform benchmarks. And they fail. Big time. Over a 15-year horizon, 95% of active funds fail to outperform the markets [4]. And these are professionals. They have time, resources and knowledge. You don’t. Not as much at least. Evidence suggests that you’re better off not trying to do better than the thick green line. If you do, chances are you’ll end below it.

The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.

Benjamin Graham

The benefits of passive investing

Alright. No active investing, you say? What should I do then? You should follow a passive investing strategy. You buy diversified funds for the long haul. And limit the amount of purchases and sales. In fact, you never sell. Not unless you’re rebalancing your portfolio according to rules defined in advance. You have a buy-and-hold mentality. What will you get in return?

  • Higher long term returns than active investors
  • Almost zero time consumption
  • A well diversified portfolio that reduces volatility
  • Less stress, you don’t have to constantly make decisions
  • Ultra-low investment fees
  • Transparency
  • Tax efficiency, e.g. in capital gains taxes

Passive investing through ETFs

ETFs are the most common way to invest passively. An ETF (Exchange Traded Fund) is a basket of stocks or bonds that trades exactly like a single stock. They normally track an index. Differentiating ETF and index can be tricky. So let’s deep dive into each.

What is an index?

An index is simply an indication of something. In finance, indices measure changes in financial markets. You’re probably already familiar with some indices. If you’re Swiss, you’ve probably heard of the Swiss Market Index (SMI). If you’re German, the DAX 30 probably rings a bell. IBEX 35 if you’re Spanish. CAC 40 if French. FTSE MIB if Italian. FTSE 100 if British. S&P 500 if American (or even if not). Each of these indices is calculated as the weighted average of the prices of a bunch of domestic companies. The weights are the company size. That’s it. An index is an average. A mathematical construction. You can’t buy an index.

What is an ETF?

An ETF is a fund that seeks to track the performance of an index. A fund is a basket of securities. Performance tracking is achieved by pooling investors’ money and buying the actual constituents of an index. For example, an ETF might buy the 500 companies of the S&P 500. You can buy an ETF. ETFs trade exactly like stocks. You can buy/sell them anytime markets are open using a financial broker.

ETFs will always underperform an index. Why? Because of fund fees. The Total Expense Ratio (TER) of an ETF is the single best measure for those fees. In simply terms, a TER of 0.1% will result in you losing 0.1% of your yearly average balance to fund fees. For example, if you hold 20k and the TER is 0.1%, you’ll be paying 20 bucks per year to the ETF provider.

ETFs exist not only for baskets of stocks, but also for basket of bonds. This entry describes how bond ETFs work. REIT ETFs are the real estate alternative. But they’re still less established than stock ETFs. In any case, ETFs are the most simple, transparent and cost efficient way to hold a diversified portfolio. You can find more info on ETFs here [567].

Your investment strategy

Broadly speaking, an investment strategy is a set of rules and procedures that guide one’s investment portfolio [8]. The good news is that, if you’ve made it here and like what you’ve read so far, your investment strategy is pretty much defined. At least if you have a long investment horizon, a relatively high risk tolerance, and believe in the power of diversification and passive investing.

Your investment strategy might read like this:

I am a long term investor. My investment horizon is X* years. I invest passively into ETF index funds. I follow a buy and hold strategy, which means that, generally speaking, I never sell. The only reason I would sell is to rebalance my portfolio according to rules defined well in advance. I don’t try to time the market. Instead, I make periodic purchases (e.g. monthly). The amount I invest is relatively constant month over month. At the same time, I try to minimize investing fees.

*Hopefully X > 15

The psychology of investing

The investor’s chief problem – and his worst enemy – is likely to be himself. In the end, how your investments behave is much less important than how you behave.

Benjamin Graham

So far investing sounds like a piece of cake, right? Save money. Keep a long investment horizon. Invest on a recurrent basis. Buy passive instruments (ETFs). Diversify. It’s all in the investment strategy above. On paper it is that easy. There’s nothing else you have to do.

The issue is that reality is different. Investing will trigger a bunch of psychological responses. And most of these responses will prompt you to deviate from most of what we’ve discussed so far. They’ll prompt you to change your investment horizon. You’ll feel like not investing on a recurrent basis, but when you feel the time is right. You may believe that there’s more you can do than being passive. You’ll think that you could have made more money by putting all your eggs in the same winning basket.

Your psychological response is linked to your risk tolerance. We already saw that it’ll take time for you to get used to taking financial risks. In here, I’ll go through some common psychological traps you might encounter along the way. Be sure not to fall prey of any of them.

Psychological trap 1: hindsight bias

Arguably the most common psychological pitfall. Also known as the i-knew-it-all-along effect. Hindsight bias is the tendency of people to overestimate their ability to have predicted something. In reality, though, it was impossible to predict. If you think that the 2008 crisis, the crypto boom in 2017 or the COVID-19 outbreak could have been anticipated, then you’re suffering from hindsight bias already. Stay rational about what you know. Nobody can’t predict the future. You can’t either.

Psychological trap 2: abandoning your strategy

This is arguably the most dangerous one. Partially because of hindsight bias, at times you’ll think that you could have done better than simply investing passively. You’ll think that next time you’ll be prepared, that you’ll do things differently. For example, to avoid losing money during a market correction.

You might feel prompted to abandon your long-term investment strategy and try to time the market. Avoid it. You can’t. Since you cannot predict the behavior of the markets, you must learn how to predict and control your own behavior. And to stick to your plan.

Psychological trap 3: optimizing too much

It’s difficult for us to understand that we won’t achieve better outcomes by doing more. Not when investing. It’s a classic beginners mistake to think that, the more time you spend doing research or building a complex portfolio, the better outcomes you’ll get. Beginners try to optimize by splitting their portfolio into 20 different funds. Or by rebalancing weekly. Don’t. You’ll just be making your life hard. Wasting time. And paying more transaction fees. Your long returns will be lower. Going with as little as one fund is enough.

Further reading

If you’ve made it here, you already know the basics of long term investing. Congrats! You probably have tons of questions, though. The following material may be useful:

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