How to Invest Step 2: What should I buy?

This blog post is part 2 of a bigger series called “How to Invest”. The first post was about “How much should I invest?

So you decided that you’re going to invest and you ask yourself “what should I buy?”. In the following I’ll attempt to answer this question. You could skip right to the end of this post to find the answer. However, in the following you will see how I derived it.

Assumption

The underlying assumption for the following to be valid is an investing duration of at least 10 years. Even though the odds will be in your favour with any time horizon, below a period of 10 years the randomness factor is too strong and you might be better off putting your money in a fixed-income instrument, such as a government or corporate bond. However, in the current age of low interest rates this isn’t an option for many investors.

Active vs. Passive

Maybe your friend is bragging about all the 10-baggers in his portfolio and you want to do the same. He promises you quick returns in just a couple of days if you just pick the hottest growth stock, the newest cryptocurrency, the fanciest old timer, the most underrated art piece, or if you put all your money in Gold.

Do you think you can pick individual stocks better than the rest? Do you think you can identify winners and losers? Well, chances are you can’t and neither can your friend – or even a professional fund manager for that matter. In fact, studies show that 95% of active money managers underperform their benchmark. This benchmark is usually a stock index that reflects the overall sector or the national stock market that the fund manager aims to outperform.

Why is it virtually impossible to outperform the market? Well firstly, by definition no more than 50% of fund managers can outperform the average – and the market reflects that average. Secondly, when you throw management fees into the mix (which are higher for active managers), this number decreases significantly. In fact, it decreases so much that over a long enough time frame only 5% are left.

If you’re not yet convinced that you can’t outperform the market, you can go further down the rabbit hole and take a look at cognitive biases. Studies show that we see chart patterns where there are none, that we buy in a boom and sell in a crisis at precisely the worst moments, that the more often you trade the worse you perform, and so on.

Index Funds

Hopefully we have established that over the long run passive beats active investing and that you cannot outperform the market – and neither can your bragging friend with his magic stock picks.

So how can you take advantage of this as an investor? This is where index funds come in. An index fund has one main goal, which is to replicate the performance of a specific index as close as possible. Since this replication can be achieved by following certain predefined rules, index funds have minimal cost (compared to actively managed funds) and therefore they can offer much lower fees. In fact, by lending out their assets, some index funds are able to offer investors zero management fees. The most popular index funds are available as ETFs, which means that they can be traded on an exchange (such as the NYSE, the NADSDAQ, or the SIX stock exchange).

Choosing the right Index

Ok, at this point we have established two things. Firstly, passive beats active and as an investor you take advantage of this by buying an index fund. The next step is to pick an index that you want to follow. Unfortunately, there are now more indices than stocks, which illustrates that choosing the right index fund might not be as trivial as you hoped for.

If you want to go down the rabbit hole you can start with this podcast and follow its sources. But for your convenience, here are the main arguments:

  • For the long-term, choose an equity index: “The 119 years from 1900 to 2018 were not especially kind to investors in government bonds. Across the 21 countries, the average annualized real return was 0.9%. In the same 119 years equity returns in Europe, Japan, the UK, and the US were all above 4%” (see table 1, page 21). Especially after considering dividends, stocks also outperform Corporate Bonds, Gold and Real Estate.
  • Diversify across industries: “Of the US firms listed in 1900, over 80% of their value was in industries that are today small or extinct. In the UK the figure is 65%.” (see page 18)
  • Diversify across countries: “There are plenty of instances in which geographic diversification has been a lifesaver, preventing wealth from being wiped out. […] There are plenty of instances where a given country’s equity market was decimated, and it often takes decades to recover from the losses. […] This decade, the US has been the best performer so far, but it was one of the weaker performers in the previous decade following the dot-com bust; it was one of the best performers in the 1990s, but before that you have to look back to the 1920s to find a decade in which US equity performance was better than middling. […] The equally weighted [globally diversified] stock portfolio took material losses at times, but experienced drawdowns that were shorter and shallower, and it tended to recover faster than most individual country equity markets. […] While we focused on the stock market above, investors can of course suffer material losses being concentrated in other assets as well. One particularly egregious example is German bonds from WWI, which lost 95% of their value relative to cash in the year or so after Germany surrendered. Despite earning more than a 900% excess return since then, investors concentrated in German bonds in this period have never recovered their wealth.” (see source)

So in summary, you should choose an equity index that is well diversified across industries and countries.

Choosing the right ETF

As elaborated above, no matter where you are from, you should probably replicate the returns of an equity index that is well diversified across industries and countries. You can do this by buying an ETF (exchange traded fund) that replicates the index of your choice and that has low fees. Let’s look at the things you have to watch out for when choosing an ETF.

  • Does it track your desired index? That is the most important question. After you’ve chose and index in the previous step, you’ll want to find an ETF that replicates that index and lets you invest in it.
  • Avoid leverage. Make sure your ETF is “plain vanilla” and does not use leverage. Leveraged ETFs usually contain words like “Bull 3X” or “Ultra”. They have very high fees due to borrowing and trading derivatives for index replication. Therefore, they are not suited for longer time horizons. Their goal is to track the index on any given day – however, in between days they might behave very differently – usually much worse.
  • The next important thing is fees. Luckily you can focus on one number, the TER (total expense ratio). It indicates ratio that will be deducted from the fund’s assets in order to cover the expenses. When it comes to fees there are huge differences between ETFs. Some charge as much as 2% annually for just tracking the S&P 500, probably the most widely tracked index. For such “passive” ETFs that simply track an index, you should look for a TER below 0.25% annually.
  • Avoid Currency Hedging. Some ETFs replicate an index while hedging it in your local currency. The hedge is a bet that your local currency will perform better than the rest. The entire point of global diversification is to reduce risks by reducing dependencies on your geography. By adding a currency hedge you’ll do the exact opposite. Additionally, the hedge always costs money (increasing the funds fees) and might as well work against you (if your currency performs worse than foreign currencies).
  • Liquidity: Now we’re really getting into the details, but some investors might need an ETF that is frequently traded and that they can buy and sell in big volumes. Also, if your ETF only trades a couple of shares a day and has an empty order book, your limit orders might take a long time to get filled.
  • Finally, I recommend choosing an ETF that is traded in your local currency in order to avoid currency-conversion cost. For example if you’re located in Switzerland (like me) and have your cash in CHF (Swiss Francs), I recommend buying an ETF that is traded in CHF, rather than USD. This will save you approximately 1% for each conversion.

Putting it all together

There you go. As explained in the paragraphs above, it is prudent to go with an ETF, with low fees, that tracks a globally diversified equity index.

So here are some ETFs that fulfil these criteria:

ETF NameBenchmark / IndexTERTicker:Exchange (Currency)
Vanguard Total World Stock ETFFTSE Global All Cap Index0.08%VT:NYSE (USD)
Vanguard FTSE All-World ETFFTSE All-World Index0.22%VWRL:EURONEXT Amsterdam (EUR)

VWRL:LSE (GBP)

VWRD:LSE (USD)

VWRL:SIX (CHF)

Here’s a good source that I found for additional ETFs. If you want to add a tilt on ESG (Environmental, Social, and Corporate Governance) or emerging markets, you’ll find good options there.

Closing thoughts & limitations

As taught at university, this blog post briefly addresses its limitations. So here they are to the best of my knowledge:

  • Firstly, this blog post could well be perceived as a rant against active investing. For the average investor active investing and speculation should only be done as part of your “fun” budget (see my previous post on “How much should I invest?”). However, I do acknowledge that there are certain investors that consistently manage to outperform the market. If you belong to those elite 5% it is rational for you to pursue your own strategy. For the rest of us, we should probably stick to the approach and principles explained above.
  • In recent years the concept of “Risk Parity” has been popularized by Ray Dalio and his hedge fund Bridgewater. It describes a different portfolio mix that aims to balance the volatility of different asset classes. Interestingly, the portfolio only consists of 30% stocks and still managed to outperform the S&P 500 over extended periods of time – especially during market drawdowns. However, the portfolio actually performed badly during the Covid crisis when certain correlations between asset classes broke down.
  • Some experts (including Meb Faber who’s podcast provided the basis for this blog post) mention the benefit of adding a value tilt to your portfolio. Rather than choosing a market-cap weighted diversification between countries&stocks, you might prefer the equal-weight approach. The main critique for market-cap weighting is that it over-weights large/expensive stocks and it under-weights small/cheap stocks. However, in recent years this hypothesis has not held true and market-cap has been outperforming equal-weight.
  • Finally, there have been warnings about “too much indexing”. Even John Bogle, the founder of Vanguard which popularized passive index funds, acknowledged that a market with 100% passive investors is not desirable. In this podcast, Michael Green examines the “passive risks to the market” and the unintended effects that this trend brings along – among other things it includes increased volatility.

That’s it. Before you go ahead and follow the steps above, you might want to wait for the following blog posts. Among other topics, these posts will cover “when to buy”, “what to look for in a broker”, and “Roboadvisors”.


Favorite sources discovered while researching for this post:

Disclaimer:

I am no financial advisor and this is no financial advice. So don’t sue me when your portfolio blows up. Do your own due diligence.

Before making any investment decision, you should seek financial, legal, tax and accounting advice, taking into account your individual financial needs and circumstances and carefully considering the risks associated with such investment decisions.

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