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:
- If the world fares well, so will stocks, and bonds will do you no harm.
- If the world fares poorly, so will stocks, and bonds will preserve half your wealth.
- 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.
- 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.
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).
A 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.