Investing Demystified

by Lars Kroijer

  It is of course possible that either the product providers like iShare and Vanguard, or the execution brokers or custodians, are massive fraudsters. Ultimately anything is possible, but in my view extraordinarily unlikely partly because of the simple structures of these companies. These are not the kinds of firms where one star manager will make all the decisions. Many people would have to be in on the fraud and the chance of detection would therefore be much greater than the kind of scam Madoff ran. If you wanted to protect against this extremely unlikely possibility I would suggest that you diversify across different product providers, products, brokers and custodians.

  1 Many companies in the world equity portfolio have large net cash holdings (Apple has over $100 billion in cash at the time of writing) unlike governments which are typically large net debtors. In a really nasty world scenario those cash holdings could prove invaluable and ensure survival longer than many governments. To ensure that you actually own those underlying stocks you would need an ETF to be physical instead of synthetic, where you take credit risk with the issuer.

  2 The emergence of virtual currencies/commodities like Bitcoin may provide financial shelter in the future and a potential alternative to gold. These currencies are still in the nascent stages, but if they end up as a recognised asset that can be stored securely I would not be surprised to see its value go up at times of turmoil and stress in the financial markets.

  chapter 17

  * * *

  A wish list aimed at the financial sector

  Frustratingly, some simple tools that could help the investor make the best investment decisions are not readily available from the index trackers, banks or financial advisers that have the greatest interaction with individual clients. Sometimes these institutions can sell higher-margin products to their clients and are not interested in selling the cheapest, simplest solution, and in other cases the lack of economies of scale of advisers or the thin margins of product providers prevent the provision of a few simple tools I feel investors would be better off having.

  The portfolio described in this book is actually pretty simple. By creating a portfolio that combines a minimal risk asset with a world equity portfolio and potentially other bonds, an investor is already doing very well. Adjusting this portfolio for the optimal risk levels and doing so in a tax optimised way will in my view leave the investor better off than the vast majority of investors.

  So what tools or information do we really need to do this? The short answer is that we can do it pretty well with what is available today, but a couple of things could make the search for the most suitable rational portfolio even easier.

  Enhanced independent comparison sites

  First of all we need a simple place to find out which products are available to us and what the costs of those products are. In Chapter 14 we discussed how there are now a very large number of index-related products available to the end investor. That is a good thing. But with the large increase in choice also comes confusion over what is the best product for any one investor. We should have a simple comparison site that compares the all-in costs and liquidity of the various products, seen in the context of the customer’s currency of assets, eventual currency of liability and tax situation. In particular, investors outside the major currencies are at times confused as their local choices of investment products seem more limited, even if they are not.

  In short, it’s not that simple to compare the all-in costs of owning an index tracker and applying an educated view of your risk tolerances. A large, independent and credible website that did this would be incredibly valuable to the investing community. Of course it would have to have huge scale as its charges would have to be minimal and paid by the investor to maintain its independence. A site that is paid for mainly by product providers is unlikely to advise you that their products are too expensive.1

  Risk expertise

  Perhaps as a supplement or component of the enhanced comparison site, a website on investments would be inadequate without some detailed tools to help the investor think about risk. In the few surveys I have seen over the years, investor risk is almost taken as understood or subject to a few simplistic questions. I remember having to answer, ‘Do you like risk? Please tick yes or no’, and thinking how incredibly inadequate a help this was in figuring out my risk profile.

  What an investor should have is a thorough understanding of the risks in the market. This should involve very generic things such as ‘how likely are you to lose 25% of your investment?’ with thorough explanations of how this likelihood can change. There should be more in-depth sections with more technical or mathematical calculations for those who want it, along with discussions of the Black Swan theory of Taleb’s books (see Chapter 16). I don’t think there is enough of this kind of information available for investors today.

  This risk section could be tailored by incorporating information given by the investor. The more information you as the investor are willing to share, the more detailed analysis you would get back. This could include pension age, other assets, potential liabilities, tax, etc. presented in a fairly generic way, but with the possibility of getting very sophisticated and more detailed. Subject to proper data protection and guarantees of confidentiality, this risk assessment could include data such as your job, education, residence, mortgage, marital status, family wealth, tax returns, Linkedin and Facebook profiles, etc. that are already available subject to a few clicks and permissions. While intrusive sounding, I wouldn’t be surprised to see the advisory world move in that direction with the happy complicity of customers. Done correctly the customer could be better informed and invested.

  Governments and regulatory authorities could also do more here than their current barren and infrequently used websites. They could be the vital provider of sophisticated web-based tools that could help investors understand risk better, and perhaps serve as a valuable double check on what the investor has found in the private sector. Through its social safety net, the government is the ultimate source of help for investors that have lost it all, perhaps because they didn’t properly understand the risks they were taking or products they were sold.

  Tax advice

  Just as there should be a web-based service that would advise us on which products would be the cheapest way to buy an index-type exposure, there should be a good website for simple tax advice. The private banks are always paranoid about this. Whatever investment idea they pitch me, they are always incredibly keen to point out that they don’t give tax advice and that I should get my own counsel. I find this frustrating. The few times I have gone ahead and talked to tax lawyers on a specific idea the whole thing often ends up expensive and at times even less clear. So I stay away.

  I miss a website that would give very simple advice about taxes for investors in the context of index-tracking products like those of the rational portfolio. It could be something as simple as: ‘I am a Danish citizen living in the UK with taxable income of X and expected capital gains of Y. What would be the best way for me to buy index exposure? What other tools are currently available to save me taxes? What may change in the future that could affect my circumstances?’

  I’m perhaps making things too simple, but I think a lot of people are left with tax sub-optimal investments because they were unaware of some fairly basic facts. Also, as tax regimes constantly change, the time spent finding out what is indeed tax optimal would be done better centrally by an investment-related service like the one discussed above.

  In cases where the simple tax advice on investments was inadequate the site could then refer to a network of tax experts in the area who had been vetted and approved by the site’s hosts.

  Customisation

  We have discussed how we should really be looking at our investing lives in almost a holistic way (see Chapter 8). When considering our risk and portfolio we also need to incorporate non-investment assets and liabilities. Since many non-investment assets are often geographically quite concentrated near where we l
ive or work it sometimes make sense for us to have fewer of our investment assets based there.

  It’s partly because of this kind of thinking that there are today several exchange traded fund (ETF) products that offer exposures like ‘The World ex-US’ or similar. And those are good things to consider. But why stop there. Since a world ETF is really just an aggregation of the exposures of the individual underlying countries, there is no reason why you should not be able to customise your exposure quite cheaply. You might for example like to own the world equity markets, except Southern Europe. You should then be able to de-select the countries you didn’t want and end up with your own tailor-made adjusted world equity exposure. With this kind of customised exposure you would be better able to tailor the investment portfolio to that of your overall assets. Other than painstakingly creating this kind of exposure by buying ETFs for each of the underlying countries that you want (so every country in the world, bar a few Southern European ones in the example above), this kind of service is unavailable today. The customisation could also allow you to pick tax-optimised products by geography, if there was an advantage to this, and thus ensure that the overall portfolio is tax optimal.

  Related to the customisation where you exclude countries or regions, the exclusion of industries could be interesting to some. As an investor you may already have great exposure to the IT sector and therefore don’t want this to be a part of your world portfolio. But you still want the rest of the world ex-IT. As above, there is no reason why this kind of customised exposure could not be created cheaply and tax efficiently. The underlying products are there – you are still buying the same underlying stocks in other countries and in the same proportions to one another: you are just excluding certain sectors.

  How it used to be and how it might become!

  My maternal grandfather mainly lived in Southern Spain for the last 25 years of his life, until he passed away in the 1990s. With some time on his hands and a bit of money to invest, my grandfather enjoyed following the stock markets. He would keenly read the Herald Tribune and other publications that came with some regularity. Unfortunately, like everyone else in the area my grandparents lived in, there was no phone in the house. Even into the 1980s we would send a telegram to my grandparent’s local post office that would then dispatch someone to their house with the message.

  My grandfather would trade shares frequently, often after conferring with the adviser at his bank. They would plan certain times that my grandfather would call this adviser and they would go through what had happened in the portfolio since the last conversation, and decide which stocks should be traded. The commission was around 1% in addition to the trading and foreign exchange costs, which was probably a decent rate at the time.

  I remember visiting my grandfather during the 1987 stock market crash. He would plan his day around a few radio programmes that partly covered finance and study the few articles in the Herald Tribune. He would also try to reach his adviser to get perspectives on the crash, but was frustrated as he had been unable to get through (they had a phone by then).

  Today, the story of my grandfather’s investment management seems crazy. He was miles from having an edge and was in all likelihood incurring incredible costs, not only in commissions, but trading, custody, currency, and probably even phone bills. My guess would be that every year my grandfather would spend about 4–5% of his portfolio on all of this, before considering the validity of his stock picks. Even Warren Buffett would have a problem making up this shortfall.

  The world has clearly moved on massively in the past decades since my grandfather’s investing. I find it fascinating that just over a decade after seeing his reaction to the 1987 stock market crash I was working at a New York based hedge fund, using the internet for my information and getting real-time news and stock quotes. Ten years after that virtually anyone around the world who looked seriously at investments would have access to the internet, webinars, Twitter, message boards, blogs, instant news alerts, etc. and be able to trade easily across borders.

  Ten years from now my grandfather’s story will seem crazier still. By then I imagine there will be even fewer barriers to international capital flows and even more investors will consider ‘the markets’ not as their home equity market but the global ones. As a result world markets will be even more efficient and accessible for investors. Hopefully index-tracking products will meet this demand and respond with better-suited products and increasingly low prices that are easy to compare. There will be far more detailed and informed risk assessments of the individual investors, and good tax advice will be more seamless and incorporated in product reviews. This will all be done online and each investor will probably have a ‘Facebook’ page equivalent of his or her investing life that is unique and secure, and incorporates all aspects, including portfolio customisation, or notices of any relevant information. How this comes about I don’t know, but investors will hopefully be far better off as a result and I for one would sign up.

  Do you need a financial adviser?

  I’m cautious about this book sounding as if we could do away with the entire finance industry and do everything by ourselves. There is no doubt that in my perfect world the aggregate fees paid to the finance industry should only be a small fraction of the fees paid today. There are far too many people getting paid far too much for adding too little value. But this does not mean that we should not use financial advice at all. There are a few of places where we need it: tax advice, advice on pensions, help with finding the best products when thinking about our specific circumstances regarding our rational portfolios. With very few exceptions, the financial advisers I have met have been honest, hard-working people with their clients’ interests at heart, and I fully understand the advantage of having someone like that in your corner. It’s nice to have someone to talk to when you are unsure of something or things have not gone to plan, in addition to the specific expertise mentioned above.

  Getting a financial adviser may help you answer some of the questions posed above. Finding the right adviser is certainly not easy and obviously involves costs. Many advisers charge a fee of 1% of assets every year, which at least alleviates the concern that they are somehow making more out of you than the fixed fee and try to profit by selling you products you don’t need. Of course, if we are generally discussing investing methods that in aggregate should cost around 0.2–0.3% a year, the adviser fee seems disproportionally large, but depending on the size of your portfolio may not imply a high hourly rate. Also if you are not after the kind of standardised advice you might find online there is probably a limit to how cheap you want to go. Bad advice will cost you a lot more than the fees. As a client of an adviser what you are asking for is a lot simpler than many clients who want a tailor-made portfolio built from scratch. You are not asking the adviser to find you the best portfolio to put together. You now know all that: you are a rational investor.

  1 I’m sure some people will say, ‘Oh, that exists. Just go to XYZ website.’ Perhaps so, but I maintain that when someone as involved in the financial world for the past decades as I have been is not familiar with the offerings there is room for improvement. That said, I would love to hear about the sites, perhaps for a later edition of this book.

  chapter 18

  * * *

  Conclusion

  This has been a book about demystifying investing and making it simple. Simple because once you embrace that you do not have an edge to beat the markets, the best way to invest money becomes a lot more obvious. At this stage I hope you agree.

  You are potentially now at a critical junction. Now is when you have to take the next step, move ahead and do what the book suggests. It is a critical junction because inertia leads many of us to put the book away and promptly forget about it, or perhaps store a few memorable points or anecdotes at the back of our minds. It’s a bit like when I read about sensible diets. I tend to think, ‘That makes sense. Must go do that. Starting tomorrow.’ And then have myself another coff
ee and piece of chocolate, and promptly forget about it all.

  Please don’t be like me. Do something – you will be far better off in the long run. Here is a simple checklist of things you can do now.

  A checklist of things to do now

  Consider if you have an edge. For most people, in most sectors, it is highly unlikely that you do. If you stop here and embrace this conclusion, that alone will probably lead to better investment decisions in future. But please do plough ahead and implement the rational portfolio.

  Consider the building blocks of the rational portfolio: the minimal risk asset, world equities and potentially other government and corporate bonds, and why they make sense. Those building blocks will be the same for all rational portfolio investors and combining them in the right proportion for you gets you a very long way towards your best possible portfolio.

  Consider your circumstances and risk profile. What stage of life are you at and what is your time horizon? Are you generally a risk taker or risk averse? Depending on your risk profile you should invest in different combinations of the building blocks. If you have zero tolerance for risk, put all your assets in the minimal risk asset; if you want a lot of risk, you can buy all equities.