A botched change of policy at Goldmoney

This is the story of how Goldmoney botched the communication of a fundamental change in policy, that ultimately may lead to me taking my business elsewhere.

Buying gold in the early days

As you know from reading my book, I’m a fan of the Harry Browne “Permanent Portfolio”, which promotes holding a quarter of your wealth in gold, and at least a part of which is held in physical gold.

Back in the day, there were two major online options for purchasing and storing physical gold—BullionVault and the original GoldMoney. Both were located in the United Kingdom, and each controlled over a billion dollars in gold for their respective customers.

While both services offered web-based access to their customers, they both felt old-fashioned and rigid. Neither company’s websites would win any kind of design award, although BullionVault’s was, in my opinion, thoughtfully useful. Both companies restricted incoming and outgoing funds to a single linked bank account. Account changes required phoning in. While GoldMoney allowed you to buy and sell directly with them, BullionVault implemented an “exchange” model, whereby you felt like a participant in a “marketplace”.

Both companies had similar revenue models—BullionVault charged commission on both buying and selling, while GoldMoney charged only on buys (though that commission was considerably higher). And both companies charged an annual fee to store your gold.

Enter BitGold, and free storage

Later, a third player emerged, located in Canada, which caught my attention—BitGold.

BitGold’s stated mission was to build technology that allowed one’s gold savings to be used as a currency. Compared to BullionVault and GoldMoney, BitGold felt innovative and modern. You could buy gold with your credit card, or even Bitcoin. You could link multiple bank accounts. You could transfer gold instantly between members. You could even spend gold in the form of a gold-backed MasterCard.

Having hired the talented and motivated designer, Mike Busby, the BitGold website looked and behaved like the kind of high-quality website my own company strives to build for its customers.

And from a cost point of view, BitGold was uniquely attractive in offering no storage fees:

Now, as you know from my book, long-term investors are particularly sensitive to annual fees, due to their destructive compounding effects over time, and so the absence of storage fees was a highly attractive selling point for BitGold.

In terms of revenue models, given that BitGold themselves would certainly have storage fees, it was speculated that their business model hinged on earning surplus revenue through their technology-driven value-add services.

BitGold jump starts their business through acquisitions

I didn’t initially open an account with BitGold, since they were still a new and unproven participant in the market, but that changed when the news emerged that BitGold had acquired GoldMoney, providing them with an considerable jump-start, and making them one of the world’s largest retail holders customer gold.

It was unclear at the time how existing GoldMoney accounts would be integrated into BitGold, but GoldMoney CEO James Turk’s statement certainly implied that the objective of the acquisition was integration:

We created GoldMoney with the vision of making gold accessible for savings and payments, a vision that BitGold is rapidly expanding in a new era of cloud computing and mobile technology. […] Users can expect a gold debit card, expanded payment options, as well as the many applications and features being developed by this innovative team.

One step towards this integration seemed to occur several months later when the company announced that BitGold was changing its name to “Goldmoney” (dropping the capital, “M”), and introducing three types of accounts.

My own account became a “Personal” Goldmoney account. A “Business” account was introduced for businesses. Finally, a “Wealth” account was introduced, that included storage fees, but benefitting from things like a special phone number to call for support, a dedicated “relationship manager”, the ability to hold money in several different currencies, and a couple of other features that I had no particular interest in.

It seemed the terms of my own, now “Personal”, account fortunately remained unaffected. Which was true for a while, anyway—bringing us to today, and to the point of this story.

A major change of policy at Goldmoney

Something has happened recently at Goldmoney, which has forced them to implement a major change in policy affecting Personal accounts:

  • While Personal accounts are still free of storage-costs, they are now limited to holding 1,000 grams of gold. Once you reach that limit, you are not allowed to purchase more, and are directed to open a separate Wealth account, which does apply storage fees of between 0.18% to 0.12% per year, and increases purchase commissions from 0.5% to 2.5%.
  • Existing Personal accounts with more than 1,000 grams of gold will not be forced to reduce their balance, but will have 0.18% storage charge applied to that portion of balance above 1,000 grams, and no further purchases can be made in the accounts.

This is a very big deal, for the following reasons:

  • Wealth accounts are held with a completely different company, i.e. the corporate entity behind the original GoldMoney service, located in the UK Channel Islands, and not the company behind the Personal accounts, located in Canada.

  • When you login to a Wealth account, you’re transported back in time to the original GoldMoney website, with only a visual update (currently in beta) to provide some consistency with the Goldmoney (nee BitGold) product.
  • Gold purchases are subject to a 2.5% commission, with no commission for sells. For comparison, BullionVault (and Goldmoney Personal accounts) charge 0.5% on buys and sells, and so your Goldmoney Wealth account purchases would need to appreciate by a factor of four before you’d come out better there. Storage fees between the two are nearly identical.
  • Unless your Personal holdings are stored in the Toronto vault, it’s going to cost you a 0.5% vault-to-vault transfer charge to move funds from Personal to Wealth.

This seems to change the basic Goldmoney service proposition to something sort of analogous to “checking” and “savings” accounts with a bank—i.e. you’re to hold your savings in a Wealth account, and any funds you want to use for low-fee transacting should be held in a balance-limited Personal account.

But while all this represents a fundamental, and arguably unfortunate, change, it’s not what I’m here to complain about. What I’m here to complain about is the way in which Goldmoney has communicated this change, which relates to the issue of trust.

Spinning a story

It would not be surprising to learn that BitGold/Goldmoney couldn’t manage to earn enough through their technology offerings to cover their own gold storage costs. Clearly, a company has to be profitable to be sustainable in the long-term and so even though it was good while it lasted, I can understand the need to apply storage costs.

What I dearly wish, though, is that Goldmoney had simply communicated the changes in a straightforward plain-English way, respectful of their customers ability to understand the reality of the situation.

Instead, this is the email I received today, which appears to spin the story as if the whole change is somehow “a great thing!”, and in the process, introduces confusion, and leaves many questions unanswered:

After leading with a positive-trending graphical chart and congratulatory message, the communication of the fundamental change in policy is delivered in this perfect example of corporate-speak:

We’ve worked to expand the capabilities of the Network and want to share the benefits of applying for a Goldmoney Wealth Holding, as storage fees will apply to Network account balances above 1,000 grams at a rate of 0.18% per year as of January 1.

Whatever this mess of a sentence is saying, here’s what it does not communicate:

  • You can NOT continue with your Personal account—If you’re currently a Personal account holder with over 1,000 grams, you must open a Wealth account in order to continue saving. There is no option to continue with your Personal account.
  • The whole Goldmoney experience changes—If you decide to continue saving with a Wealth account, the whole experience will change. The company changes. The website changes. The funding methods will change (no more purchasing with credit cards). The costs will change.
  • The transition may cost you—Depending where your Personal funds are vaulted, it may end up costing you 0.5% to move any excess balance from your Personal account to a new Wealth account, in order to get the storage fees down from 0.18% to 0.12%.
  • Why this all had to happen—Most importantly, the email doesn’t explain why we’re being subjected to this change. Reading it, you’d simply get the impression that, despite things going really, really well at Goldmoney, they’ve just decided to start charging Personal account holders with storage fees, above the arbitrary balance of 1,000 grams.

To understand any of the above (except for the justification), you have to login to your Personal account, and try to make sense of all the error messages and alerts. Overall, this was a botched communication.

Why this matters

Here’s a quote from 37 Signal’s book, “Getting Real”, from the chapter entitled “Publicize your screwups”:

If something goes wrong, tell people. […] Be as open, honest, and transparent as possible. Don’t keep secrets or hide behind spin. An informed customer is your best customer. Plus, you’ll realize that most of your screwups aren’t even that bad in the minds of your customers. Customers are usually happy to give you a little bit of breathing room as long as they know you’re being honest with them.

Although the change at Goldmoney isn’t necessarily the result of a screwup, it’s a major event that completely changes the product experience for savers, involves an inconvenient transition, and potentially involves costs.

Goldmoney’s communication should have clearly addressed these things. When you break your promises to someone, you better explain why. But it didn’t. Instead, it spun the story as a positive event, downplayed how fundamental the change is, and left many questions unanswered. And the result of that approach is twofold:

  • First, it leaves me to figure out all the consequences of the changes myself. It was only when I logged into the website that I realized I could no longer use the Personal account. It was only when I started to create a Wealth account that I realized it’s a completely different company, with a different website that lacks many of the features of the Personal account. And it was only when I started the migration process that I realized costs will be involved.
  • Second, it introduces distrust, and damages my confidence in this company. Is this how I can expect to be treated again in the future if/when they’re required to make major changes that affects me?

The whole situation has left me with such a bad taste in my mouth that I’m quite likely to take my business elsewhere. I hope this story finds its way to those in charge at Goldmoney, and that the folks working in PR there learn the lesson that it’s OK to tell things as they are.


Update 1 of 2: A week after posting this article, I posted some follow-up thoughts including a Twitter conversation I had with Goldmoney’s founders.


Update 2 of 2: To clarify what I would have liked to have received, I’ve drafted an alternative version of the Goldmoney email.


When marketing trumps logic — Betterment on the Apple Watch

I received an email today from the Betterment brokerage announcing their new Apple Watch app as, “A smarter way to invest on the go.”

Of course, Betterment’s after the PR value of being among first to the platform, but the underlying idea is silly for a number of reason:

  1. “Impulse saving” isn’t a thing. Investing, particularly according to the Betterment approach, is a long-term systematic activity of regular savings. Generally it’s done automatically, but even if done manually, nobody—nobody—will be in such a rush to “invest” that they couldn’t wait to do it from the comfort of a desktop or tablet environment.

  2. Betterment knows the psychology behind the general recommendation not to monitor one’s investments frequently. Why? Because on a day-to-day basis the market will be up as often as it’s down, and we know that it’s far more painful to see a loss than it is pleasureful to see a gain. And so even though the value of our portfolios may climb over time, frequent checking usually has a cumulative negative effect over time. So the last thing we want, as smart investors is to have portfolio monitoring on our watches!

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p>I know it’s hard for a marketing department to pass over the idea that, “Wouldn’t it be great to ride the PR around the Apple Watch?” But I find myself a bit disappointed that an organization I’d like to believe to be among the more serious of modern investment firms to go for gimmicks like this.

Investment returns of the average investor — What happens when you don’t stay the course.

In my book, Money for Something we discuss how important it is to “stay the course.” Most people, however, don’t stay the course, and this chart from the J.P. Morgan Guide to the Markets illustrates the astounding consequences.

Continue reading Investment returns of the average investor — What happens when you don’t stay the course.

Lifecycle Investing

We live in an age in which the responsibility for providing for one’s financial needs during retirement mostly lies on the individual. A historically successful approach involves persistent saving and investing according to the fundamentals introduced in my book, Money for Something. This article looks specifically at asset allocation over one’s lifetime.

Continue reading Lifecycle Investing

The opportunity cost of spending today

The power of compounding interest can be understood through the “rule of 72”—i.e. the number of years it takes to double your money is approximately equal to 72 divided by your rate of return. For example, assuming your invested savings compound at a rate of 7%, you would double your money every 10 years.

Especially important for young people, this same rule highlights the opportunity cost associated with spending, rather than saving. That means one dollar spent today would be worth $2 in 10 years, $4 in 20 years, $8 in 30 years, etc.

So if you’re twenty years old, just remember that when you spend $40,000 on that new car, instead of $20,000 on a used one, you’re potentially giving up $160,000 in retirement savings!

To learn more about investing, be sure to check out my book, Money for Something. It can be read in less than an hour.

Recent performance of the Permanent Portfolio

A friend contacted me recently with concerns about the fact that his Permanent Portfolio is down about 2% since he started investing about eight months ago.

Let’s start by looking at why the portfolio is down. Here’s a chart of the performance of the portfolio’s four asset classes during the past six months:

Continue reading Recent performance of the Permanent Portfolio

People just want to want to know what to do

My new book, Money for Something teaches the fundamentals of investing, and hopefully motivates the reader that they should be investing.

The actual act of investing, though, requires making a personal and very important decision — the choice of the particular “asset allocation” in which to invest. The book, and its companion website, provides a handful of popular allocations that should work well for most people.

When wrapping up that particular chapter, though, it occurred to me that when I’ve read such books in the past, I’ve always ended up thinking, “I sure wish that in addition to giving me the information necessary to make a decision, the author had also described the decision they took!”. And so I decided to go one step further, and conclude the chapter with a short note about “what I do”, in which I describe my own asset allocation, known as the Permanent Portfolio.

As it turns out, the great majority of emails I’ve received from readers getting started with their own investment program have chosen to invest in the Permanent Portfolio, and I think that’s worth of a bit of reflection.

Whether we are product designers, lawyers, tax advisors, or writers, it’s easy to assume that the job-to-be-done is providing the information or tools necessary for our users to make decisions. In reality, though, the job-to-be-done in the mind of our users is to make the right decision, and we can support that objective by taking our services one step further, with a suggestion, recommendation, perhaps thoughtful defaults settings, or in the case of my book, a section called, “What I do.”

How often should you check your investment portfolio balance?

I’ve been receiving lots of emails from people who have read my new book and are excited to report that their new personal investment programs are underway. To these folks I say, “Congratulations! You’re on your way!”

Some have even setup auto-updating Google Spreadsheets, allowing them to track their investment balance with up-to-the-minute accuracy!

To those folks I say, “That might not be such a great idea.”

Although a well-structured investment portfolio should, over the long-run, increase in value, it will, on a day-by-day basis, likely go up or down with about the same probability—with “up” being slightly more likely.

The new field of behavioral pyschology tells us that we humans tend to feel more pain when we experience a loss, than pleasure when we experience a gain. The consequence is that if you check your portfolio on a daily basis you will, cumulatively over the course of a year, likely feel more pain than pleasure. And that certainly doesn’t help in achieving the real objective — sticking with your investment plan over the long-run.

So, what’s a good frequency to check your portfolio? Personally, I’d love to have the discipline to check mine only once per quarter. But that’s hard to do, and so I’m pretty happy if I can limit myself to once per month.

How much should you learn about investing?

Many years ago, I learned the fundamentals of investing, and over two decades of consistently following them, confirmed that (at least for me) they worked exactly as advertised. Over the years, though, a questions I’ve asked myself many times is how much investing knowledge should the average person have? Have I learned more than necessary? Have I not learned enough?

Continue reading How much should you learn about investing?

The Harry Browne Permanent Portfolio

Each person who makes the decision to save, must decide where to store his savings. This article introduces the “Permanent Portfolio,” in which the late Harry Brown recommended to store that portion of one’s savings that is considered precious.

Cash in a bank will lose value over time due to inflation. Value in a real estate isn’t very liquid. Money invested in a company’s stocks can be lost in a bankruptcy. In general, modern investment theory speaks with a uniform voice—we should allocate our savings across a diversified mix of (ideally uncorrelated) assets. But which assets?

Conventional wisdom—stocks and bonds.

Almost all of the leading investment experts (Malkiel, Bernstein, Bogle, etc.) recommend that we allocate our savings primarily across stocks and bonds. Within this camp, a few peripheral voices recommend mixing in small quantities of alternative investments such as commodities or real estate investment trusts, for their diversification benefits.

In addition, the particular proportion of stocks and bonds is important, as it defines one’s expected “risk” level. A portfolio of 80% stocks and 20% bonds will provide far greater opportunities for gain than a portfolio of 20% stocks and 80% bonds. At the same time, however, it also provides opportunity for far greater loss.

The experts insist that each individual must assess his own level of acceptable risk when choosing a particular allocation, and that we must monitor and adjust accordingly over time, as we get older or as our circumstances change.

Will the future look like the past?

While I am undoubtedly certain of the importance of diversification, I’ve always had two fundamental problems with asset selection conventional wisdom:

  • First, the particular assets of stocks and bonds have been chosen because of their historical relationship. For as long as we’ve had data available (more than 100+ years), a mix of stocks and bonds would have outperformed other passive investment vehicles available to us. But, what if the future doesn’t look like the past (at least within my lifetime)?

  • Second, it is well known that humans have a terrible track record in the assessment of risk. It’s a much, much more complicated issue than answering a few cookie-cutter questions about what you’d do if the market tanked. Furthermore, investment experts such as William Bernstein point out that there’s actually three components of risk that investors need to evaluate—tolerance for risk, capacity for risk and need for risk.

An alternative—the Harry Browne “Permanent Portfolio”.

In part due to these doubts, I became attracted to the investment philosophy of Harry Browne—a successful investor, writer, and Libertarian politician from the mid-1970s through late 1990s—as introduced in his book, “Fail Safe Investing.”

Harry Browne’s approach begins with the question: What are our objectives for the wealth we consider precious? On that, he had two answers:

  • Protection. We don’t want to lose our savings, under any circumstances.
  • Growth. If possible, we should try to grow our savings, at least enough to compensate the erosive effects of inflation.

Then—and this is key—rather than selecting assets by looking backwards, he selected them looking forward. He asked, “What are the possible states of our economy?” And for each of those states, he asked, “Which is the asset that responds most dramatically during this state?”

He identified the following four states of the economy, and corresponding optimal investment assets:

  • Prosperity—In times of prosperity, stocks perform well. According to the principle of diversification, he recommended (as do most experts) investment in low-cost, passively managed mutual funds or ETFs that track broad market indicies.
  • Inflation—In times of strong inflation, when the purchasing power of our paper currency is being eroded (and in times of political or currency crisis), gold does well. He recommended owning physical gold, although owning it in a more convenient alternative (such as an ETF) is also acceptable.
  • Deflation—In times of deflation, when interest rates and prices are dropping, the value of bonds increase. The sensitivity of bond prices to such conditions is a function of the bond duration—the longer, the better. Furthermore, we need to be holding bonds that can’t be called. In such times, we therefore need to be holding long-term government bonds—e.g. 20-year US treasury bonds.
  • Recession—In times of recession, almost all investments decline. During such times, we need a cash cushion to sustain ourselves, and with which to buy up those other assets that are temporarily dropping in value.

Browne recommended that we divide our savings equally among those four assets, and periodically sell those that are doing well, and buy those that are doing poorly—a critical process known as “rebalancing”—in order to maintain that equal 25% distribution of savings across each.

This portfolio, known as the Permanent Portfolio offers a lot to like. It is simple. It is permanent. It doesn’t require self-assessment of risk or time-frame. It contains at least one asset that should be doing well at all times, and which historically has carried the portfolio as a whole. Finally, through modern ETFs, it’s very easy to own this portfolio, at extremely low costs.

But how does the Permanent Portfolio perform?

How has the PP performed historically? Very well, in fact! Since 1964, the PP has returned an average of 8.5% per year; quite respectable compared to the 8.8% return of the common 60/40 stocks/bonds portfolio. But whereas the common stocks/bond portfolio lost 30% of its value in the crash of 2008, the PP lost only 1.3%. You might want to pause, to contemplate that last point.

In fact, the Permanent Portfolio has prospered during both bull and bear markets, in a manner that has been very stable. In short, the PP has performed nearly as well as standard 60/40 portfolios, but with far less volatility.

So what’s the catch?

One might wonder, as I often have, why more experts don’t recommend the PP, and why more people don’t invest in it?

As to the first question, why experts don’t recommend the PP, nearly every objection I’ve heard relates to an analysis of one of the PP’s components in isolation. Cash loses value due to inflation. Gold offers no long-term return. Long-term bonds will get crushed when the government finally increases interest rates.

Such analysis is fundamentally flawed in that it’s the portfolio that matters, not the individual components. The magic of the PP is the relationship these four asset classes to each other—i.e. three of them are both highly uncorrelated and volatile; essential ingredients in a winning portfolio. Gains are captured through rebalancing, and stability is achieved through dis-correlation.

And the proof is in the pudding—the PP has a 50 year track record of offering near-equivalent performance to a 60/40 portfolio, but with far lower volatility. And it has never suffered a black-swan event like the 60/40 did in 2008, losing almost 30% of its value. (And remember, you need a 42% gain to recover from a 30% loss!)

Regarding the second question, why more people don’t invest in it, the PP has a big issue working against it—tracking error. It’s ups and downs will not mirror those of the general stock market, and so when stock-heavy investors are boasting of their big returns in a given year, the PP holder will more likely than not be looking at more meager growth. For this reason, investing for the long-term in the PP requires determination and fortitude.

That I have no problem with; I know I can stick with a plan.

Interestingly, famed investor William Bernstein recently weighed in, publishing an article about the Permanent Portfolio, in which he refers to it as, “a thing of beauty.” In fact, the only problem he has with the PP is precisely what I mentioned above: It’s hard for most people to stick with it, over the long run. Reading that article made my day.

There’s a lot more to the permanent portfolio—and investing in general—than I’ve covered here. For general investing, I’d recommend my own book, Money for Something, and for a deep-dive into the permanent portfolio specifically, the best starting point is the Crawling Road blog. (The Crawling Road forums are great.)

Reconciling A Random Walk and The Great Wall.

Dr. Burton Malkiel, professor at Princeton university, is one of my favorite authors on the subject of investing. His book, A Random Walk Down Wall Street, is considered one of the cornerstones of personal investing literature.  In 2008, Dr. Malkiel published another book, From Wall Street to the Great Wall, in which he makes the case for investing in China. Having read both books, I was puzzled by the apparent conflicts between the two.

Continue reading Reconciling A Random Walk and The Great Wall.

An overview of personal investing.

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. It covers the power of compound returns, definition of asset classes, importance of diversification, role of asset allocation in the setting of risk, and introduces the Exchange Traded Fund (ETF). Continue reading →

An overview of personal investment

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.

Why invest?

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:

  1. 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.
  2. 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.

Start early

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:

  1. Investment period
  2. Diversification

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.

Diversification

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!)

Asset Classes

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:

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.)

Asset Allocation

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

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!

Other topics

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.

Conclusions

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.

And for anyone wanting to go into more depth, I’d recommend:

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.)