It's hard to know what to do with your savings, and there's a lot of bad advice out there. A couple years ago I decided to spend some time to figure out options for investing my money. I had some basic questions I wanted to answer:
- Should I buy shares in companies myself, or invest in a mutual fund?
- What kinds of funds should I invest in? How can I get a good return without too much risk?
- What kinds of assets should I invest in? How does the stock market compare to bonds, gold, real estate, and other exotic options like penny stocks, cryptocurrencies, angel investing, etc.?
I later realized many people struggle with these questions. This post is my attempt to provide a starting point for those people.
What should you do with your savings? Here's the summary
- Put your money in a mix of stocks and bonds using index funds (80% and 20% respectively is reasonable). Avoid actively managed funds.
- Use funds with low fees. There is a huge difference between a 0.2% and a 1% fee when compounded over decades.
- Investing in individual stocks, industries or countries to get a better return than index funds is very hard. Best left to the professionals.
- Ignore analysts on the news who tell you to buy or sell stock X. They have historically been no better at prediction than the flip of a coin :D
- Investing in Bitcoin, Ethreum, other cryptocurrencies, tulips, penny stocks or whatever the latest craze is a very bad idea.
- Invest for the long term (a minimum of 5-10 years) and ignore day to day fluctuations.
First, what exactly are stocks and bonds? Buying a company's stock gives you ownership of a small part of a company. You then benefit when the company either appreciates in value or gives out a portion of its profits to owners (also called dividends).
A bond is a loan to a company, government or other institution. You benefit by receiving interest on the loan made to the institution.
Generally speaking, buying a bond in a company is safer than buying a share of the same company, because if the company goes under assets will be sold and bondholders are paid out first.
What should I do with my savings?
Put them in a mix of stock market index tracker funds and high-quality bond index funds.
Ok, now what are index tracker funds? Broadly speaking, there are two types of mutual funds. There are index tracker funds, also called passive funds or index funds, that simply track a particular section of the market (an index). If the index goes up, the funds do better, if the index goes down, the funds do worse.
The other type of funds are active funds. Active funds are managed by professional fund managers who try to get better returns than the market by using their knowledge and skill. An active fund manager will usually pick a market index, and try to outperform than that index.
To be successful, the manager must not only outperform the index, but they will also need to do so by a margin that compensates for the costs they charge investors in their fund. And they will need to do this for a long period of time, around 5-10 years at least.
In practice, all these things together make the manager's job very difficult, and the vast majority of managers will fail to beat a passive fund that tracks the same market index after accounting for fees.
My recommendation is to avoid active funds and invest only in index funds.
So how do I start investing in index funds?
- Nutmeg or other automated investing solutions will invest in a portfolio of index funds on your behalf. They are a reasonable option, but a bit expensive. Nutmeg's basic option currently costs 0.45% per year.
- Alternatively, you can just buy the index funds yourself. Vanguard's LifeStrategy or Target Retirement funds would be the simplest choice. They cost 0.22% and 0.24% respectively at the time of writing.
- To manage these funds, you will need to register with an investment platform. Some options:
- Vanguard has their own fund platform for buying Vanguard funds. It's probably the easiest way to get started.
- I personally use Interactive Investor. Their fees are reasonable and they have a large selection of funds.
- I've also used Cavendish Online before. Their fees are reasonable, and their user interface is decent though it looks a little outdated. Their fund selection seems a bit smaller than Interactive Investor's.
One specific portfolio
My current portfolio roughly looks like this:
- 55% in Vanguard FTSE Global All Cap Index
- This gives exposure to large, midsize and small companies in the stock market all around the world.
- 25% in Vanguard FTSE UK All Share Index
- Since I live in the UK I maintain a higher exposure to the UK stock market by investing in a UK index. Not really sure if there's any benefit to doing this though.
- 10% in Legal & General Sterling Corporate Bond Index
- High-quality corporate bonds. i.e. loans to companies that are in strong financial standing and thus likely to pay them back.
- 10% in iShares UK Gilts All Stocks Index
- Another bond fund; this one to invest in UK Government bonds, also called "Gilts".
Honestly though, I plan to just sell all of this at some point and move all my money to Vanguard's LifeStrategy 80/20 (80% stocks and 20% bonds) fund to simplify things.
Why not buy and sell shares myself, instead of investing in a mutual fund?
The stock market is a little different from the typical markets we're used to in daily life. Because of the massive scale and liquidity available in the stock market, there are very big players with vast resources who value prices of stocks and will buy if they think the stock is cheaper than it should be, and sell if they think it's more expensive than it should be.
This leads to prices of stocks being highly efficient; the price of a stock tends to reflect all the available information about the prospects of the underlying business. If an investor believes Coco Cola shares should cost $10 instead of the current price of $9, they will buy all the shares they can under the price of $10.
Big market players have an edge in assessing prices of stock more accurately; they have teams of analysts, large amounts of historical data, and highly sophisticated systems. If they think the price of a Coca Cola share is $9, why do you think you know any better than they do?
All this means is that valuing shares better than the market is incredibly hard, and almost definitely not worth it for your average investor.
This idea is expressed more succinctly in the Efficient Market Hypothesis (EMH): asset prices fully reflect all available information.
Everyone's talking about company/sector X, clearly I should put my money into it!
The key question is not to ask which companies/sectors have a high potential for growth. It's to ask: which companies/sectors have a high potential for growth that no one has realized yet? If everyone's talking about it, the high potential for growth is already being factored into the price you're paying.
You only benefit from insights you've had that the other market participants haven't had yet. If everyone knows company X's future now looks more promising, that optimism is already factored into the price of the company's stock.
Why not invest in funds managed by active investors?
Historically the vast majority of fund managers have failed to beat the market in the long term. It's really, really hard to beat the market for several years.
What makes the problem worse is that active investors spend huge amounts of money maintaining teams of analysts and doing other work to value stocks and bonds, which makes the fund charges high, which eats away at their returns.
In contrast, passive funds only aim to track the stock market, so they can be run mostly in an automated way, which makes them much cheaper. The average active fund usually costs 1% of the invested amount per year, and in addition tends to have entry and exit fees. The average passive fund usually costs ~0.2% or less, and has no entry or exit fees.
Why stocks AND bonds?
It's a good way to diversify your portfolio. Historically the performance of stocks and bonds hasn't been highly correlated. This is a good thing because it means bond prices should behave independently to stock prices.
Bonds are also in general less risky than stocks while having lower returns.
Why not real estate?
Real Estate Investment Trusts (REITs) are a good way to get exposure to real estate in a diversified way.
However, I believe as an asset class stocks have performed better than real estate historically.
Why not gold?
Here's a good article on gold as an investment. Personally, I prefer to invest in productive assets that create value rather than gold, silver, foreign currency, cryptocurrency etc.
Why not bitcoin/ethreum/other crypto?
You want to invest in things that produce value. Stocks produce value because you own a piece of a company that is producing goods and services for the purpose of making a profit. Bonds produce value because you get interest on a loan you have given to a government or a corporation.
Currencies by themselves don't really produce value. While the technology behind Bitcoin, Ethreum and other cryptocurrencies is very interesting and possibly useful, it doesn't really translate into making the cryptocurrencies valuable as an asset.
Of course, it is incredibly difficult to resist the urge to buy something when its value can only seem to go up :) That's just human nature I suppose, but history suggests it's wise to resist the urge to partake in a collective mania:
My company gives me RSUs as part of my compensation package. What do I do with them when they vest?
Sell them at vest time. It's unlikely you can predict whether the stock price will go up or down, and past performance is no indicator of future performance. You are over-invested in the success of your company already, as you will probably always have a large amount of unvested RSUs with them, and you already work for them.
I don't believe you
Scepticism is good :)
Besides, you shouldn't really trust me blindly, I have no formal education in finance or economics, and I'm not authorized to give financial advice.
You should, however, read opinions of the wide range of experts from the finance industry and academia, many of whom have made the suggestions I've outlined in this post. See the section below for some sources more credible than I am :)
Where can I learn more?
The Bogleheads wiki is a good place to learn more about passive investing: https://www.bogleheads.org/wiki/Main_Page
And the Bogleheads forum is a great place to ask questions: https://www.bogleheads.org/forum/index.php
The Monevator blog is also worth following for UK investors: http://monevator.com/
Warren Buffett on index funds: