Investing Demystified

by Lars Kroijer

  Summary

  Cash deposits are not entirely without risk. Don’t hold cash in excess of that which is guaranteed by the government at one bank, and do worry about which government has issued the deposit insurance on your cash.

  By holding investment securities like government bonds (or products like ETFs for government) instead of cash with a financial institution, you are often in a far better situation to recover these securities in the event of a bank failure.

  Buying the minimal risk asset

  Because of costs in trading bonds most investors in short-term bonds have to accept that the bonds in their portfolios will not be super short term,3 and that you will be taking a little bit of interest rate risk as a result. The most liquid short-term bond implementation products like ETFs or index funds that represent the underlying bonds have average maturities of 1–3 years. The slight interest rate risk that comes from holding bonds with 1–3 year maturities is a reasonable compromise between the theoretical minimal risk product and one we can actually buy in the real world. For most investors with longer-term investment horizons other implementation products typically have different ranges of maturities like 5–7 years, 7–10 years, etc. to suit your preferences.

  How much of the minimal risk asset you should have in your portfolio and what maturities it should have depends on your circumstances and attitudes towards risk. If you are extremely risk averse you could have your entire portfolio in short-term minimal risk assets, but you could not expect much in terms of returns with that. I will revert to what sample portfolios look like when you start introducing more risk, but the availability of the minimal risk asset is of critical importance to all investment decisions:

  You can use the minimal risk asset as part of your portfolio to adjust the risk profile. In the simple scenario where you can only choose between the minimal risk asset and a broad equity portfolio, you could weigh the balance of those two according to the desired risk. The minimal risk bonds would have very little risk, whereas the equities would have the market risk. How much risk you want in your portfolio would be an allocation choice between the two (we will later add other government and corporate bonds).4

  For some investors, the minimal risk asset is their optimal portfolio. If you are unwilling to take any risk whatsoever with your investments and willing to accept that this means low expected returns, this is it.

  Summary

  If your base currency has government bonds of the highest credit quality (£, $, €, etc.) then those should be your choice as the minimal risk asset.

  If your base currency does not offer minimal risk alternatives you have the choice of lower-rated domestic bonds where you take a credit risk, or higher-rated foreign ones where you take a currency risk. Keep in mind that a domestic default will probably happen at the same time as other problems in your portfolio, and the domestic currency would probably devalue, rendering the foreign currency denominated bonds worth more in local currency terms.

  If you want no risk at all you should buy short-term bonds. If you have a longer investment horizon, then match the investment horizon with the maturity of your minimal risk bond portfolio. You will have to accept interest rate risk even if you avoid inflation risk by buying inflation-adjusted bonds.

  1 For those who don’t think government bonds can default I would encourage you to read This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff (Princeton University Press, 2011). The authors make a mockery of the belief that governments rarely default and that we are somehow now protected from the catastrophic financial events of the past.

  2 There are cases where the yield curve is reversed and shorter-term bonds yield more than longer-term ones, but these cases are less frequent.

  3 Imagine the scenario where you want to hold one-month government bonds. Tomorrow the bonds are no longer one-month to maturity, but 29 days. Is this ok? How about 2 days hence? How much you are willing for the maturity to deviate from exactly 30 days is up to you, but in reality there is a trading and administrative cost associated with trading bonds. It would simply not be feasible to stay at exactly 30 days to maturity at all times.

  4 Certain corporate bonds trade with lower risk premiums than many governments. The view is that these corporates are lower credit risk than many governments – not hard to believe – and although they do not have the ability to print money, nor do governments in the eurozone. The reason I believe that you should not consider these bonds as the minimal risk asset is more practical. Compared to government bonds, the amount of corporate bonds outstanding for any one company is minuscule and you would probably not be able to trade them as cheaply and liquidly as government bonds.

  chapter 5

  * * *

  World equities – increased risk and return

  Buy equities from around the world

  In order to move the portfolio towards the promise of higher returns you need to increase your risk/return profile by buying publicly listed equities (referred here simply as equities). I am not recommending you buying equities because I have some insight that equities are set to have an outstanding performance relative to other assets. It is because I consider equities to be the highest expected return asset class (at the highest risk) and the most easily bought, in a diversified fashion, of the three groupings of investments that I think someone without an edge should invest in. The three are: the minimal risk asset, equities and other government and corporate bonds. Later we look at why other asset classes are excluded from the portfolio. But here the question is: which equities?

  Figure 5.1 is a chart of the Dow Jones, the world’s oldest stock market index that was created to track the US stock market since its inception in 1896. From a start of around 40 in 1896 that index is trading at around 13,000 today.

  As I will discuss further in the next chapter, far from all equity markets have been as successful as the Dow and we can’t extrapolate the Dow performance to the wider world. When estimating the returns we can expect from investing in equities it is important to incorporate the returns of all equity markets.

  From the perspective of the rational investor, each dollar invested in the markets around the world is presumed equally smart. This means that we should own the shares in the market according to their fraction of the market’s overall value. So if we assume that the market refers only to the US stock market and that Apple shares represented 3% of the overall value, then 3% of our equity holdings should be Apple shares. If we do anything other than this, we are somehow saying that we are more clever, more informed – that we have an edge on the market.

  Figure 5.1 Dow Jones index since 1896 (‘normal’ and adjusted for inflation and dividend reinvested)

  But why stop at the US market? If there is $15 trillion invested in the US stock market and $2 trillion in the UK market there is no reason to think that the UK market is any less informed or efficient than the US one. And likewise with any other market in the world that investors have access to. We should invest with them all, in the proportions of their share of the world equity markets within the bounds of practicality.

  Many investors overweigh ‘home’ equities. The UK represents less than 3% of the world equity markets, but the proportion of UK equities in a UK portfolio is often 35–40%. Investors feel they know and understand their home market. Perhaps they think they are able to spot opportunities before the wider market, although in fairness the concentration is often because of investment restrictions or because investors are matching liabilities connected to the local market. Various studies suggest that this ‘home field advantage’ is perceived rather than real, but we continue to have our portfolios dominated by our home market.

  If you over- or underweight one country compared to its fraction of the world equity markets you would effectively be saying that a dollar invested in an underweight country is less clever/informed than a dollar invested in the country that you allocate more to. You would essentially claim to see an advan
tage from allocating differently from how the multi-trillion dollar international financial markets have allocated which you are not in a position to do unless you have an edge. So besides it being much simpler and cheaper, since investors have already moved capital between various international markets efficiently, the international equity portfolio is the best one.

  Take my situation as an example. As a Danish citizen who has lived in the US and UK for over 20 years I might instinctively be over-allocating to Europe and the US because I’m familiar with those markets. But in doing that I would implicitly be claiming that Europe and the US would have a better risk/return profile than the rest of the world. This might or might not turn out that way, but the point is that we don’t know ahead of time. Or you could find yourself making statements like, ‘I believe the BRIC (Brazil, Russia, India and China) countries are set to dominate growth over the next decades and are cheap.’ Perhaps you’d be right, but you would also be saying that you know something that the rest of the world has not yet discovered. This does not make sense unless you have an edge.

  The advantage of diversification

  The world equity portfolio is the most diversified equity portfolio we can find. To give an idea of the benefits of diversification in the home market consider Figure 5.2, which suggests the benefits decline as we add securities in the home market. This makes sense. Stocks trading in the same market will tend to correlate greatly (they are exposed to the same economy, legal system, etc.), and after picking a relatively small number of them you have diversified away a great deal of the market risk of any individual stock. So you could actually gain a lot of the advantages from the US index funds by picking 15–20 large capitalisation stocks and sticking with them, assuming they did not all act like one. (If you only added stocks from one sector that all moved in the same way the diversification benefits would be far lower.) It is not the rational US portfolio that you have achieved (you claimed an edge by selecting a sub-set of 15–20 stocks and deselecting the rest of the market), but from a diversification perspective you have accomplished a lot.

  Figure 5.2 Portfolio risk and diversification

  By expanding the portfolio beyond the home market we achieve much greater diversification in our investments. This is because we spread our investments over a larger number of stocks but, more importantly, because those stocks are based in different geographical areas and local economies. Decades ago we didn’t really have the opportunity to invest easily across the world, and while it’s still not seamless for investors in many places, investing abroad in a geographically diversified way is a lot easier than it used to be.

  So, in summary, the key benefits of a broad market-weighted portfolio are as follows:

  The portfolio is as diversified as possible and each dollar invested in the market is presumed equally clever, consistent with what a rational investor believes. (I bet a lot of Japanese investors wished they had diversified geographically after their domestic market declined 75% from its peak over the past 20 years.)

  Since we are simply buying ‘the market’ as broadly as we can it’s a very simple portfolio to construct and thus very cheap. We don’t have to pay anyone to be smart about beating the market. Over time the cost benefit can make a huge difference. Don’t ignore that.

  This kind of broad-based portfolio is now available to most investors whereas only a couple of decades ago it was not. Most people then thought ‘the market’ meant only their domestic market, or at best a regional market. Take advantage of this development to buy broader-based products.

  If for whatever reason you are unable to buy a broad geographic portfolio like the one described above, then buy as broad a geographic portfolio as you can and get as large a fraction of the market as you can. So if you can only buy US stocks, buy the whole market – like a Wilshire 5000 tracker instead of an S&P 500 tracker – if the costs are the same. If you can only buy European stocks, buy that whole market, etc.

  Do alternative weightings do better?

  Many works on investing suggest that value investments (shares with low price/book or price/earnings ratios) and smaller companies both outperform the general market over time. Various indices and products have been created to cater to this argument.

  In short, I don’t think rational investors should buy alternative weighted investments as proxies for their market exposure. By actively de-selecting a portion of the market (the higher growth or larger companies) investors are claiming that others who have invested in those companies are somehow less informed than themselves, which is a grand statement and inconsistent with rational investing. It is probably fair to assume that all those investors in the growth or larger companies are highly experienced and informed, have read all the relevant books on investing and are well aware of all the aspects of historical outperformance of various sectors of the markets. They are not stupid; in fact they are as much a part of the market as the value or smaller company investors are. Do you really think that the trillions of dollars that follow companies like Google and Apple are somehow from ill-informed investors and that you know more about the markets than they do to the extent that you can de-select those stocks?

  Anyone who suggests an alternative weighting to that of the overall market looks more like an active investor than a passive one. Likewise, the implicit cost of the part of the portfolio that diverges from the general index can easily approach the fee levels of an actively managed fund. Suppose an alternative weighted index has an overlap of 66% with the wider market, but costs 0.3% more a year to implement. In that case you are paying 1% a year on the part of your investment that is different from the general market, or fees akin to those demanded by some active managers.

  I also think that many of these alternative weighted indices are created to match what has had the best historical performance and thus be easier to sell. If stocks with high price/earnings (P/E) and growth rates had been the best performers over the past decades many alternative weighted indices would consist of that market segment, complete with charts outlining the great reasons why that trend could be expected to continue. We would be guilty of fitting the product to past returns and essentially saying that we had the insight that the future would be like the past.

  On top of the active de-selection of some parts of the market that it implies, my main issue with small company investing has to do with implementation. Actively implementing a portfolio of smaller companies is very expensive as the execution trade is subject to large bid/offer spreads and price movements if you trade in any size. But even if you could pass the hurdle of costs, you are still left with the same question: do you really know enough about the markets to claim an edge to the extent that you over-weigh these stocks at the expense of other stocks in the market? What is it you know that the wider market doesn’t?

  Whether you are picking a North American Biotech index, the Belgian index, an index of commodities stocks, etc. you are essentially claiming an edge and advantage in the market as if you were picking Microsoft shares to outperform.

  To ensure that this book is not without a ‘get rich quick’ scheme here is one. Buy whatever index you think is sure to outperform and sell short the broader index against it with as much money as you can borrow. Now wait for the world to prove you right, ensure you riches and the financial media to turn up and write articles about your investing brilliance.

  In summary: stick with the broadest and cheapest market.

  What are world equities?

  Today, the total value of the equity markets in the world is $40–50 trillion. As you would expect, this value has grown dramatically over the past decades, rendering what seemed like massive drawdowns in 2008–09 appear as minor blips on what looks like a certain upward trajectory.

  The increase in the size of the world market capitalisation is not only because share prices went up. Many new shares were listed on the stock exchanges and particularly outside the US and Europe new markets took off in spectacular fashion. There was also an increase
in population, an increase in GDP and savings, privatisations of state-owned enterprises, and more countries moving from planned to market economies, all which contributed to the large rise.1

  The US is, by some distance, the largest equity market in the world. The market value of the shares listed in the US is approximately $15 trillion, with Apple and Exxon as the two most valuable companies at the time of writing. Although the US stocks represent the largest country fraction of world equities this share is smaller than it was even a decade ago as rising emerging markets have come to represent an ever-greater share of world equities.

  Market capitalisation data changes continuously, so in looking at the split of current market values for the various countries in the world (see Figure 5.3) bear in mind this could have changed since publication.

  While different world indices include country exposures in slightly different ways Figure 5.3 shows roughly the exposure you would have if you buy a product that tracks world equities. Since some ‘world’ indices do not include all the countries with functioning equity markets, the weightings of those that are included are slightly higher. The list of markets and weightings should be available on the website of any product provider you are considering.