INVESTING 101

You have squirreled away a little nest egg and are ready to hit the road. Or you even got lucky and ended up with a lump sum. Or you are a vagabond looking to build a more permanent financial safety net. 

You could just park that money in the bank until you need it. But put your savings to work, and instead you could be slowly growing your assets or generating true passive income. This could be the key to financial independence and never-ending adventures. Investing your hard earned cash in the modern financial markets offers a flexible but at times daunting solution.

Get Out of Debt

This might seem a bit off-topic, but it is worth repeating, there is little room for debt if you are seeking financial freedom. High-interest credit card debt and loans need to be repaid first. You will be fighting an uphill battle until then.

Yes, there might be some exceptions if you crunch the numbers on some low interest debt such as mortgages. But did you really consider the whole picture?  Your life, economic conditions, everything is in constant flux and can change in the blink of an eye.  Financial liabilities can rapidly turn into shackles. Get your house in order. Get out of debt. Ideally before even considering long-term travel.

Determine Your
Investment Horizon:
Volatility

The next question you need to ask yourself is what exactly are your savings intended for. If, like many young travelers, you saved enough to cover your upcoming trip and not much more, earning a return on your investments is not a priority. You want your money to be predictably and reliably available throughout your journey. No problem, a regular bank or savings account is just fine. Financial independence can wait. Or come from other income sources.

If you are not planning on touching much of that sum, you can tolerate a much higher volatility over several years or decades. Volatility refers to the size of change associated with the value of a financial asset. It is also a measure of risk.  In other words, a volatile asset will fluctuate more in price. 

investing investments volatility
Low (short-term bonds) vs high (stocks S&P500) volatility. Source: Google Finance

Higher expected returns are generally associated with higher volatility. For example, stocks typically yield double digit returns. On average, over many many years. But I’m sure you already know it comes with dramatic ups and owns. Above, stocks (S&P500) returned 33% since 2007, but went down more than 50% during the 2008 financial crisis. Ouch.

Short-term bonds in contrast barely moved since 2007. But the returns are much lower. This is somewhat over simplified, but you get the picture. If your investment horizon is measured in decades you can comfortably sit out the bumpy ride. If it’s limited to a year, you can’t.

Know Thyself:
Humans Suck At Investing

Traditionally, prospective investors are quizzed to determine their risk profile. If you spend all day looking at the roller-coaster ride of your investments and can’t sleep if it goes down more than 2 or 3%, you would certainly be ill-advised to pick a high volatility portfolio. Unfortunately, even the more relaxed investors are similarly prone to making bad decisions.

Daniel Kahneman’s investor psychology classic Thinking Fast and Slow is a sobering read. Our brain has evolved to make lightning fast flight-or-fight decisions in the jungle. It is however systematically overwhelmed when it comes down to understanding a complex system such as the financial markets.

We all suffer from an uncomfortably long list of cognitive biases and chronic overconfidence. Investors tend to buy and sell at the worst possible times, chase bubble after bubble, and can be highly delusional. It is essential to understand and accept this before starting your investing journey. Basically, we humans suck at this. Know thy enemy.

Know Thyself:
Coping With Our Biases

Beginning gradually and keeping your good old savings account in the mean time is perhaps not such a bad idea after all. Consider investing as a long-term project. You will need to acquire some specific knowledge on the way, don’t rush!

The best way to cope with our biases is to have a plan, and religiously stick to it. Fidelity once did a fascinating study. They found out that the best performing portfolios belonged to clients who forgot about their account! In other words, the more active an investor, the lower the returns.

Or have you considered a financial advisor? We generally strongly advice against them because of the ridiculous fees they tend to charge. Nevertheless, even an overpriced one could paradoxically be the best decision of your financial career. But only if she or he can enforce some discipline in times of panic and turmoil.

So a simple investment plan that requires as little attention as possible once set up is best. In other words, an hour a month or even once a year should be sufficient to manage your investment strategy.  And lower volatility investments will make it more likely that you stick to it.

Passive vs Active Investing

The results of extensive academic research are clear. The large majority of active investors, both individual and institutional, underperform their benchmark. And statistically at least it is nearly impossible to prove that the few who outperform are not outliers due to sheer luck.

Yes there are exceptions out there, but do you honestly think you have an edge? Can you beat an army of analysts and specialists? Do you feel lucky?

A much easier and less time-consuming option is simply to buy an index fund tracking a whole market, which can be done through a mutual fund or a so-called exchange traded fund (ETF). Or alternatively a mutual fund doing exactly the same. Depending on the chosen index, you end up instantly diversified over hundred or even thousands of companies, different sectors, different countries. No quarterly reports to read, no endless discussions about the latest hot pick. Done.

Choose an Asset Allocation

Passive investing still requires a series of initial decisions. You will have to determine an asset allocation, a mix of stocks, bonds and other financial assets reflecting your investment horizon, risk tolerance and expected returns. The goal is to reduce volatility while maintaining acceptable returns. This is the subject of endless and passionate debates.

investing asset allocation 60 40
The classic 60% stocks 40% bonds asset allocation (in red) vs stocks alone (S&P500, in blue). Source: google Finance

A good place to start is Meb Faber’s excellent little book Global Asset Allocations. It’s a short and relatively simple read. Meb looks at the historical returns of a handful of highly popular diversified asset allocations over the last decades. The surprising conclusion is that there is not much of a difference between the different allocations on a long enough investment horizon. Much more important is keeping a lid on fees and taxes. This can be done without taking on extra risk.

Long story short, go for a simple asset allocation and forget about it. Usually it will be a broad mix of stocks and bonds, often also commodities and real estate. And remember, changing every few months between the best strategies still has the potential to ruin you. For a practical example, check out this blog post on building a DIY portfolio.

Reduce Fees With Low-Cost ETFs
And Mutual Funds

There ain’t no such thing as a free lunch”. Except when it comes to fees.  Advisors charge on average around 1% annually, some funds slap another 1 to 4% on top. And then there are transaction fees, redemption fees, and the list goes on. This can easily cost you more than half of your returns. On top of that you still have to pay taxes.

But things are changing fast. Many ETFs and mutual funds now charge less than 0.1%, with some as low as 0.05% or even free. Discount brokers such as Interactive Brokers provide cheap access to the markets. This means that a simple, low-cost passive DIY investing approach is possible.

You will have to learn how to buy and sell securities. But most brokers offer good supporting documentation and tutorials. So-called paper trading accounts, or if you prefer mock trading accounts, help you getting some hands-on experience. Armed with that knowledge you can reduce your fees to almost 0% annually. For more practical details have a look at this post on implementing a DIY portfolio.

Robo-Advisors

If choosing and executing your own investment strategy is still too overwhelming and complicated,  there is a low cost alternative to the traditional advisor. A new class of fully automated so-called robo-advisors has emerged over the last decade. These algorithms manage your portfolio following a pre-determined asset allocation. Some can also tackle tax-related optimisations. The annual fee typically ranges from 0 to 0.5%.

Vanguard, Swab, Betterment and Wealthfront are the current industry leaders from over a hundred competitors. This selection is somewhat US-centric, but more and more options are available in other countries too.

Ethical Investing

You might be rightfully concerned about what exactly your money is invested in. Tobacco, big oil and weapons manufacturers are rarely seen as desirable in one’s portfolio. Although the exact definition of what is ethical is highly subjective and personal.

Fortunately, several funds take a more sustainable, environmentally and socially responsible approach. Some still seek to make a return, while at the other end of the spectrum others prioritize impact over profit. There are now even low cost ethical ETFs. These might be far from providing an ideal solution, but are, like carbon offsets, a step in the right direction.

Quantitative Strategies For Nerds

Investing can be pushed even further. Learn about finance, programming and trading and you could start researching and testing more advanced strategies. You might be able to squeeze out higher returns. It can also be a lot of fun. No need to be working in a hedge fund or to develop excessively complicated algorithms. And no need for a PhD.

Paul Novell from Investing For a Living retired in his early forties and has been traveling all over the US in an RV. His website is a great source of inspiration for a DIY quant approach to investing. This is certainly not for the majority of aspiring investors, but more accessible than many would believe.