A brief history of personal investing?
Employees used to work their entire lives at a single company which provided a defined benefit pension plan, where you got a guaranteed salary once you retire. This changed in the 70s with the introduction of defined contribution plans (401ks), where the employee is responsible for their retirement.
Most plans providers are large asset management firms, which give a limited choice of high fee active mutual funds, even though plan sponsors have a legal duty to provide a competitive selection of funds. Usually the default portfolio is what all employees keep, and this is rarely ideal.
Still they have been immensely popular with $4Tn AUM (Assets Under Management) (plus another $5Tn in IRAs), and because US equities (usually the biggest single component) have done so well over the last 30 years, most participants have enjoyed decent returns despite the suboptimal asset allocation and high fees.
Things are very different now: US and developed markets growth is sluggish, and with more companies delaying IPO (usually the biggest factor in index growth) this won’t simply revert. The emerging markets have emerged, and so the US is a smaller proportion of the total world equity. Hence it’s even more necessary to have broad international diversification. Alternative investments, like commodity funds, Bitcoin and startups provides new options which just didn’t exist before.
See the [PBS FronLine special] [1], for a brief history of 401ks.
[1]: http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/
Isn’t investing just gambling?
Without getting too philosophical, investing for most people is all about risk management - getting enough return to fund their goals with the minimum risk. Generally the difference between a good investor and a bad one isn’t return, but how much risk they ‘spent’ to get that return. Buying a diversified portfolio of diversified funds is just about the safest thing you can do, certainly (in a strong scientifically provable way) better than just holding cash.
What are mutual funds?
[Mutuals] 2 are collective investment vehicles that pool money from many investors to purchase securities. They can be actively and passively managed. You buy/sell units (usually once a day) from your broker. The vast majority of personal investments are in mutuals because most 401k providers (the biggest source of personal investing) only provide a limited set of mutual funds to invest it. The problem is that these are usually high fee active funds that rarely beat the index, but are very profitable to the managers.
What is active management?
Active fund managers try to beat the a target ‘index’ by using their ‘expertise’. They usually charge a significantly higher management fee for this, typical 1-2%, vs 0.07-0.5% for a passive index fund. 1% doesn’t seem like much, but because of compounding these fees can have huge affect on overall [return] 3. These fees would be worth it if the managers actually beat the benchmark, but after fees are subtracted less than 25% of active funds actually beats their [benchmark] 4.
Contrary to popular online advice, optimizing for fees in active funds has little evidence of providing a better return. Usually the higher fee pays for a better manager who is more likely to be in the 25% that do beat the index.
Markets aren’t fully efficient (if they were then according to theory it would be impossible to beat the market) and some active managers do make excess returns (alpha). However due to the way the fund management industry works an average investor is very unlikely to get access to the best managers. Specifically active funds can only get so big (AUM) before the returns get diluted, hence there is limited allocation. The best active managers are effectively rainmakers and won’t want to share their precious alpha. They either work for themselves at hedge funds or operate special funds at major institutional asset managers that are only open to their best clients.
What is passive management (index funds)?
Passive (index) funds try to hold every security in a target benchmark index (eg S&P 500), in exact weights they occur in the index. They don’t try to beat it (alpha), and hence you get market return (beta). Fees are much lower as this strategy can be implemented efficiently at scale without expensive investment research or lots of trading. Unlike active funds, index funds can grow to enormous AUMs ($10Bn+) without effecting their performance.
What are ETFs?
An exchange traded fund (ETF) is like an passive index mutual fund but trades on the stock exchange. They give the benefit of index mutuals like low fees, and tracking diversified indices, and the benefits of stocks, like being able to buy (or short) anytime, transparency of cost & holdings and tax efficiency.
Compared to passive mutual funds, there is intense competition in the ETF industry that has led to even lower fees and broader investment choices (Bitcoin, gold, etc).
Who are the main providers of ETFs?
The biggest provider are BlackRock’s [iShares] 5 and [Vanguard] 6 that provide the ‘Core ETFs’ that usually fill the majority of your portfolio. Many of these can be brought commission free! There are also many [smaller players] 7 who provide more esoteric exposure.
What are the basics of portfolio management?
Portfolio management is primary about the interplay between risk and return. Every asset has a individual risk and return, and in general riskier assets will have more return. The goal is to create a portfolio of assets that has a lower risk than any individual asset. This is possible because of diversification (not exposed to any one failure), and because assets classes can be inversely correlated (eg stocks go up, when bond fall).
There is a huge amount of literature behind, as well as many Nobel prizes. See [Modern Portfolio Theory] 8 for more details.
A large part of advancement in finance over the last 30 years have been in risk management, and a lot of this was due to being able to use computers to model risk in a scientific way.
What is asset-allocation?
Asset-allocation is the process of figuring out the exact mix of securities to hold.
What is rebalancing?
Rebalancing is periodically buying/selling securities so that the target asset allocation is maintained. For example say at the beginning of the year your target allocation is 60% stocks and 40% bonds, and the stock market is particular bullish. This means by year end your stocks component has performed well and now your allocation in 80% and 20% bonds. You will now have to rebalance by selling some stocks and buying bonds to correct the allocation. This may seem unintuitive, selling the high performing assets to buy the under performing ones, but this is good risk management. Stocks could fall next year, and you will be overexposed.
What is a better portfolio, surely it’s subjective?
Better portfolios strictly have a better return for equivalent risk, or less risk or equivalent return. The [Sharpe ratio] 9 is a measure of excess return over a risk free asset (US Treasury Bonds) per unit risk. Assets or portfolios with better Sharpe ratios are better investments.
The Sharpe ratio is very useful because you can tell if a fund is getting better returns because of taking extra risk. If portfolio A has a 8% return and a risk of 5%, but portfolio B has a 7% return, but a risk of 2% then portfolio B is a better investment as it’s Sharpe ratio is higher.
Why should I worry about a few %?
If there is one thing to burn in your brain, it’s that ‘COMPOUNDING IS A B**CH’.
Have a play with this [calculator] 10 or read this [PBS report] 11. A quick example: a 2% fee on $10,000 initial investment, after 10 years would have a 18% ($3,275) reduction in value because of fees, after 25 years it’s 40% ($8,687)!
This would be fine if these high fees actually provided excess return, but time and time again it’s been proved they haven’t. US equity (usually the main component in 401ks) used to have high returns (8% y/y), so these fees were easily absorbed. Nowadays this isn’t assured (partly due to the US economy maturing, and in part due to delayed IPOs), so these fees have become really noticeable.
The utility of [money] 12 ($10k is more useful to someone on a $100k salary, than $100k is to someone earning $1M even though both are 10%), means that the absolute value of lost return due to fees is felt the hardest by the people who can afford it the least - the middle class.
Should I trade individual stocks?
If you have to ask, then probably not. Picking stocks by definition has 0 diversification and even 75% of the professionals (active fund managers) can’t do it. However if it’s a small amount relative to your net worth, and it’s in a company/industry you’re an expert in then carefully consider it.
Generally it’s safer to buy sector/country ETFs, that allow you to long/short a particular sector/ country while still getting diversification.
Why should I pay directly for financial advice?
Like anyone, financial advisors need to make a living and if they don’t charge you directly then you’re charged indirectly, usually on commission from high fee mutuals. This is the reason many financial advisors don’t recommend ETFs, as they are exchange traded so they can’t get kickbacks. Paying for advice may ensure you get unbiased information. Beware that many ‘financial advisors’ are effectively sales people, and you may be able to get just as good advice by yourself as the majority of peoples financial planning needs aren’t complex. Generally the more complex your financial needs, the more likely a financial advisor will give value.
I want to learn more?
Here’s some interesting links
Any Books to read?
I really want to learn it like the pros
Look up [Modern Portfolio Theory] 13, or the the bible on [Active Fund Managementt] 14 written by Dharmesh’s former employers.