In this article, I’m going to compress a lot of study, experience and opinion about personal investing, into a single essay to which I can refer others.
Albert Einstein pointed to compounding rates of return as the strongest force in the universe. It’s the idea of earning interest on past earned interest, and is the basis of the Rule of 72, which states that 72 divided by the rate of return, is the approximate number of years required to double your money.
Two important observations:
- Long term investing can dramatically grow the value of money. For any given period required to double your money, subsequent equivalent periods will result in your money multiplied by four, 16, 32, etc.
- The rate of return is important. At 5%, you will have quadrupled your money in about 29 years. At 10%, you will have quadrupled it in only 14.
Consider this example of the power of compounding returns, and the importance of starting early:
A person investing $250 per month, beginning at age 20, and earning 8% per year, will, having invested a total of $120,000, have accrued nearly $900,000 by age 60. If the same person started saving just five years later, at age 25, the accrued savings would be $573,000. Think about that—the first 35 years contributed $573,000, and the final 5 years almost $325,000! Clearly, for those interested in investing, it’s important to start early.
Where to invest?
There are lots of things in which one can invest: real estate, gold coins, painting, or a bank savings account. (Let’s call such things in which we can invest, asset classes.) Key considerations in asset class selection include costs, convenience, risk and expected rate of return.
Considering rate of return, bank savings accounts wouldn’t seem very attractive over the long run, since they usually don’t offer rates of return exceeding the rate of inflation (which, itself, works compounding magic, but in reverse, eroding the value of your money over time!) One definitely doesn’t want to arrive in the future with less real money than one invested. (The term real money is used, to refer to the notion that one dollar in ten years won’t buy what one dollar will today.)
It turns out there are a number of asset classes in which one can invest, conveniently and with low cost, through a simple brokerage account, and which have traditionally delivered attractive rates of return. These include stocks, bonds and some other classes we’ll introduce a bit later.
Risk versus return
Each asset class in which one can invest can be characterized by its expected return, and its expected risk. Over the 76 year period from 1926 to 2002, bonds returned about 5.5% per year. But from individual year to year, they fluctuated within a range of plus/minus 9%. During the same period of time, stocks returned an average 10% per year, but from individual year to year fluctuated as much as plus/minus 21%.
This punctuates one of the key tenets of investing:
To gain higher returns, one must accept higher risk. There are, however, two concepts which can work to reduce risk:
- Investment period
In general, time dampens the expected volatility of overall investment return. For example, we can look at various windows of time, invested in stocks, during the period from 1950 to 2002.
- 1 year. The worst return over any one year period was -26% while the best return was 52%.
- 5 years. The worst return over any five year period was -2.4% while the best return was 23.9%
- 10 years. The worst return over any 10 year period was 1.2% while the best return was 19.4%
- 20 years. The worst return over any 20 year period was 6.5% while the best return was 17.8%.
(The average return over each of these periods was roughly the same.)
While we know from the math of compounding rates of return, that the difference in the value of a dollar invested over 20 years at 6.5% and 17.8% is huge ($3.5 versus $26.5), it’s comforting to see that, in absolute terms, we wouldn’t lose money over any period 10 years, even having been invested in a relatively risky asset class like stocks.
While I won’t go into the details of how this works, and for that will refer the reader to a couple of books at the end of this article, we can state the following:
Combining uncorrelated asset classes (diversification) can work to both reduce volatility (risk) while increasing overall return. This point is very, very important, and is why asset allocation (the splitting of ones investments among (hopefully) uncorrelated asset classes is likely the most important aspect of investing.
The correlation of any two things (asset classes, or whatever) is a measure of the extent to which they are dependent on each other. One can expect that the stocks of companies in New York are likely to be highly correlated with the stock of companies in California, as they all are similarly dependent on the dynamics and sentiments of the American stock market. The stocks of American companies, however, can be expected to be less correlated with the stocks of European companies, due to their existence in different markets and denomination in different currencies. And one might expect investments in any stocks to be even less correlated with the price of physical gold. (Tables of asset class historical correlations can be founded in the recommended readings at the end of this article.)
The underlying idea, is that the splitting of investment across a number of uncorrelated asset classes should, in the long run, increase return while reducing risk—the only free lunch one finds in the domain of investing. (That’s worth re-reading about 100 times!)
So what are some asset classes in which one can conveniently invest through a brokerage? It turns out, quite a lot!
- Stocks of companies large and small, from around the world
- Bonds of companies and governments around the world
- Real estate (yes, real estate!)
- Gold, and other precious metals
- Commodities, including oil, wheat, corn, etc.
Investing in the market as a whole
While it may seem surprising, a long history of data clearly demonstrates that almost nobody consistently beats the market itself. While there are a couple of notable exceptions—like Warren Buffet—even these can be (at least) justified through simple statistics. If 1000 people flip a coin 10 times, you’re likely to have one person who gets a streak of 10 heads in a row. With millions of people participating in the market, statistically some will do well.
But here’s the important thing: For an arbitrary investor with a historical record of picking individual stocks, it is statistically unlikely they will continue to do well in the future.
The study of behavioral finance sheds some light on why acceptance of this notion can be so difficult. I myself have clearly struggled with it, often finding myself investing in a particular stock that I’m sure will go up in value. But my own personal experience has been absolutely consistent with the theory, at least insofar as my ability to beat the market.
So how do we invest in the market as a whole? It’s very easy, through ETFs.
Exchange Traded Funds (ETFs)
In the 1990s (and before) people wanting to invest in the market as a whole generally did so through mutual funds that tracked market indexes, like the S&P 500. Towards the end of the 1990s, though, an even more convenient, lower cost tool emerged, the Exchange Traded Fund, or ETF. Today, from what I read, proportionally more investments are made through ETFs, and, indeed, many of the historical leaders in mutual funds (like Vanguard) are today’s leaders in ETFs.
An ETF is a product, the shares of which can be bought and sold through brokerages, in exactly the same way that individual stocks can be bought and sold. However, they are similar to mutual funds in that a single share of an ETF effectively buys a fraction of each underlying company (or bonds, or commodities) in which the ETF invests.
Here are some examples:
- VTI, a Vanguard ETF that invest in all companies within the MSCI US Broad Market Index, including some 1,200 to 1,300 American companies.
- VWO, a Vanguard ETF that invest in companies within the MSCI Emerging Markets index, i.e. companies in countries like India and China.
- BND, a Vanguard ETF that invests in the entire American market of quality bonds.
- VNQ, a Vanguard ETF that invests in the broad American real estate market.
- GLD, a State Street ETF that buys gold bullion.
- DBC, a PowerShares ETF that invests in the Deutsche Bank commodities index.
It’s quite amazing when you think about it, that through a single brokerage account you can create a broad and internationally diversified portfolio of investments!
(Note that there are ETFs that also invest in narrowly defined sections of the market. You can, for example, find an ETF that invests in mining companies, or the defense industry. However, many respected investment authorities consider investment in such ETFs as attempting to beat the overall market.)
It is here—in the definition of which asset classes one should include in one’s portfolio, and the percentages of the overall portfolio assigned to each class—where it seems nearly everyone has a different opinion.
Some people suggest a simple split between stocks and bonds, weighted more towards bonds as one gets older. Others suggest complex allocations to small companies, large companies, US treasury bonds, bonds from the governments of emerging countries, and a little gold thrown in for good measure. If you Google for “asset allocation” you can spend days reading about different suggested asset allocations.
But before one gets too bogged down in the concern of asset allocation, it’s important (though easier said than done!) to always keep in mind the words of respected investment authority, William Bernstein:
It’s far more important to have consistently stuck to your allocation through periodic rebalancing, than to have picked the perfect allocation in the first place. And that brings us to rebalancing…
Rebalancing is another key concept in investing. Imagine your portfolio value is $100, and your chosen asset allocation looks like this:
- Stocks, $40, 40%
- Bonds, $40, 40%
- Gold, $20, 20%
And imagine this year stocks go up 30%, bonds go down 8%, and gold drops 5%. Your portfolio at the end of the year will have a value of $107.80 (an overall gain of 7.8%), but its allocation will look like this:
- Stocks, $52, 48%
- Bonds, $36.8, 34%
- Gold, $19, 18%
The notion of rebalancing mandates that you sell enough stocks to bring its allocation back down to 40%, and buy enough bonds and gold to bring theirs back to 40% and 20%, respectively. The idea is that all assets move up and down over time, and so you are continually selling what has gone up, and buying what has gone down, such that in the long-run. You are buying more of what is cheap, and less of what is expensive, with the ultimate objective of increasing return while preserving the risk/return characteristics of the overall portfolio.
As noted by many authorities on investing, rebalancing, while being one of the most necessary aspects of long-term investing, is unfortunately one of the most difficult to stock to in practice, because it requires that you commit to an allocation over time, and that you are continually investing in what is presently against the market sentiment.
(In fact, it is this act of rebalancing that allows investors to realize gains on asset classes that have no nominal expected return, such as gold.)
In terms of how often you should rebalance, many recommend rebalancing once per year. I recently read an interesting article by the manager of the Yale Endowment fund, however, in which he reports that given their tax-free status, they can rebalance daily, and attribute this to an additional return of 1.6% last year!
I hope to have covered the basics in this article. There are many additional topics which are important, and are addressed in the books recommended at the end of this article, including:
- Costs. The costs of your investments, when considered in the context of compounding over a long period of time, have considerable impact, i.e. it makes a big difference if the annual cost of your portfolio (through custodial fees, ETF/mutual-fund fees, etc.) is 1.7% versus, say, 0.4%.
- Taxes. Your tax structure and available vehicles for holding investments are important considerations. For many Americans, it may make sense, for example, to hold income-generating assets (like bonds) in tax-deferred accounts such as IRAs.
In summary, what I’ve learned through study and experience include:
- Especially young people should educate themselves on the potential long term benefits of consistent investment.
- A number of asset classes (like stocks, bonds, and real estate) have historically delivered attractive rates of return.
- Diversification of one’s investments across loosely correlated asset classes both reduces risk while increasing return.
- Asset allocation, maintained through rebalancing, is the primary driver of long term portfolio returns.
- Historically, very few people (professional or otherwise) have been able to consistently forecast and beat the market. For this reason, most investment authorities recommend investing in asset classes that track broad markets as a whole.
- One can build and maintain a considerably diverse investment portfolio through ETFs, purchased, conveniently and for low cost, through a brokerage account.
(Again, I believe that legally it many necessary for me to repeat, that nothing in this article should be construed as advice.)
Recommended Reading & Additional Resource
For anyone reading this article wishing to learn more, I would recommend the following introductory list of books and articles.
- Matt Henderson, Money for Something. This is a book that I authored, that can be purchased online, and takes about one hour to read.
- Burton Malkiel, Elements of Investing
- William Bernstein, The Investor’s Manifesto
And for anyone wanting to go into more depth, I’d recommend:
- Burton Malkiel, The Random Walk Guide to Investing
- William Bernstein, The Four Pillars of Investing
- William Bernstein, The Intelligent Asset Allocator
I found the following article quite interesting, which demonstrates the historical behavior of a seven-asset, equally distributed portfolio of weakly correlated assets:
Community. The following forum is the best I’ve found for general discussion of investing:
- The Bogleheads. (FYI, John Bogle is the founder of Vanguard, the industry leading low-cost passive management mutual fund, and now ETF, company. He’s considered the “father” of index investing, and has quite a following; hence the name of the forum.)