Being financial independent means you are able to pay all your expenses without a salary, if you are extremely wealthy you might already have money enough to live without working anymore, otherwise, you need to invest your savings to generate a passive income.Paradoxically as it might sound, not investing is more risky than investing, simply because with time inflation will reduce the value of your non-invested cash, this is taken for granted.
If you keep your savings in cash hidden under your mattress because you are convinced is the best place to keep it, then, you are wrong. If you think certificates of deposit with 2% return rate are the way to go, then, you are wrong again. If you think real estate is the safest bet, you are also wrong. If you are paying an annual fee to keep all your savings concentrated in a gold bullion held in a bank safe deposit box, you are very wrong as well.
If you have savings but never invested because you think it's safer to keep it in banknotes just in case something goes wrong, than, keep in mind that in case some apocalyptic event happens, more likely cash will be worthless. In the past this happened in Germany during the Weimar Republic, from 1919 to 1923 inflation rose by 100.000.000%. This means, if one banana could be afforded with 1 mark (German currency at the time) in 1919, the same banana would cost 100.000.000 marks in 1923. Now, if you ask me, instead of keep my savings in cash so I could buy bananas in the future, I would rather prefer have my money invested in a company that produces bananas, so if inflation strikes, not only the price of the banana will rise, but the share prices of the banana producer company as well.
Fear, mistrust and lack of knowledge drive the way we think and manage our money, we have to be able to see the big picture and consider all possible scenarios, in practice, to invest wisely.
Why you shouldn't invest in certificates of deposit:
If the return rate of your investments is lower than inflation then you are losing money. This means that the price of goods and services is raising faster than the value of your investments. If you had 10k in cash hidden under your mattress, assuming a inflation rate of 3%, in 5 years the value of your money would be 8.6k, in 10 years 7.4k, in 20 years 5.4k. Now let's assume you had that same cash invested in certificates of deposit with 2% return rate. Since the inflation rate of 3% is higher than the return rate on the investment, your money will devalue as well. 9.5k - 5 years. 9k - 10 years. 8.2k - 20 years.
Again, let's imagine an apocalyptic event. Are you convinced that it's safer to put your savings in a certificate of deposit held by some financial institution than in the stock market? What if the financial institution goes to bankrupt and the deposit insurance guarantee backed up by the state isn't able to refund you? Very recently this hypothetical scenario could have happened in Greece or Cyprus. In fact, it really happened in Cyprus, however foreign creditors came to uphold the guarantee. It was easy to solve this one since the country is so small, imagine the consequences if same happened in US, Germany, Japan, France etc...
If you ask me, once again, I would rather prefer to have my money invested in companies spread around the world, thus, eliminating the risk of having my whole money in a single company holding the certificate of deposit (a bank for example), which is backed up by a single country deposit insurance guarantee.
Real estate, the safest bet?
Surely this type of investment has more interesting return rates, but I would never put my whole money in an apartment for rental and then be totally dependent on the rent. Let me explain why giving you the example of my colleague: This guy owns two apartments near Barcelona, before the crisis in the Eurozone he could easily pay both mortgages with his salary and rent from one of his apartments. His wife stayed at home taking care of the kids. Things started shaking when the Euribor climbed near to 5%, consequently the monthly payments for both mortgages were now a burden. It got worst when his tenant left the rental apartment and nobody showed up to replace him. His life was not getting easier, so he decided to sell the rental apartment, but once the economical condition in the region was so bad, no one offered to buy it. Nowadays he works in Switzerland where salaries are higher than in Spain, this way he can keep paying the mortgages.
Lesson: Don't put all your eggs in same nest. This guy invested all he had in the same asset class, same continent, same country and same region. Now he's stuck with two apartments worth far less than when purchased, yet he can not get rid of them...
Your net worth should definitely include real state, but diversified. If you can't afford apartments, offices, shops, hotels and industrial complexes for rental in every country, then, for little money you can own shares on a real estate investment trust fund that will do that for you. By diversifying this way you assume less risks than owning a single property, plus, you can trade your shares at any time once dealing with a liquid asset. You have access to this funds through any brokerage firm, however there's an annual fee to keep the fund running, if you go with Vanguard for example, you pay 0,10% annually to get exposure to North American real state. So, if you invested 10k€ the annual fee would be 10€.
It's hard to tell which way of investing in real state achieve better returns since there are many variables, but keep in mind that a fund offers diversification thus less risk, and if you wish it's possible to get rid of it in a second through the stock market.
Gold, precious metal?
Gold can be seen as an insurance against an apocalyptic event. In theory if the whole system blows, gold will keep it's intrinsic value while currencies and companies won't have any without a solid system behind able to inspire trust. The whole system is based on trust, our governments are necessary to establish propriety rights, implement and enforce the law, and punish those who violate the rules. Otherwise we would live an anarchy.
For this reason, gold tend to valuate when panic strikes the economy and the whole system shakes. In the following image you can see opposite trends of gold and two major stock indexes during September/August 2011. In one month Gold rose by 30% while the EuroStoxx 50 sank 30%. During this time news channels and newspapers were spreading apocalyptic news about a possible Greek default and hypothetical scenarios of chaos and misery after the end of Euro as a currency. Financial markets crashed abruptly and investors sought refuge on gold, if the Euro really ended, at least investors would have a precious metal instead of worthless paper bills in their hands.
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| For those less familiarized with the investment world: The EuroStoxx 50 is constituted by the 50 leading Eurozone stocks. The SP500 includes the 500 largest North American companies based on their market capitalization. Gold and SP500 are quoted in US dollars, in this graph both are adjusted to Euro for an accurate comparison. |
Gold can be used to diversify a portfolio, since there's low correlation with stock indexes it can be useful to smooth extreme market trends, however I wouldn't allocate more than 5% in my portfolio.
Why? Because it's a non productive asset, zero sum. While in the long term companies will distribute dividends and invest the remaining earnings to create more value for investors, gold is simply a useless metal with it's value dependent on unpredictable macroeconomic and geopolitics events. In turn, is a highly volatile and risky asset class, not recommend for the majority of small personal investors. In later posts I will explain how uncorrelated assets can create profit opportunities.
In the meanwhile I would like to raise a question. Gold plays an important role in the International Monetary System, since nearly all countries fixed the value of their currencies in terms of a specified amount of gold. Who can guarantee that gold won't be replaced as the standard by other even rarest metal or mineral in the future?
Stock market, the way to go.
Much have been said about the stock market, millions of articles and books have been written, some of them mandatory to read before investing a single cent in the stock market. Knowing the nature of the stock market is the key to being able to invest large sums of your money over time with the absolute confidence that you are doing the right thing.
It’s worth gaining this confidence, because investing knowledgeably in stocks has always been the single best thing to do with your money in terms of getting lifetime income with no effort on your part.
"The Little Book of Common Sense Investing" by John Bogle is the only book I beg you to read. Assimilate the ideas on the book and have the total confidence you need to take the first step. I will quote some paragraphs from his book, I'm not an expert on the subject, but he is, so don't take my word for it.
When I try to encourage my friends to start investing in the stock market, their reasons to not do it are based on mistrust and irrational fear. Some of them know about my crazy goal of being financial independent at 25, they often ask me how's going the stock market "game", they think about stocks as a gambling game, where one puts his money and then luck dictates the result as a tremendous loss or a get rich hand.
They don't understand the following:
I can't tell you the perfect percentage allocation to each index, for sure, I wouldn't put all my money in the S&P500, I would rather prefer to distribute it through regions around the world with different economic outlooks, demographics, political systems, natural resources, currencies and other factors that can influence stock markets in the long-term. For example, MSCI All Country World Index covers around 9000 stocks across large, mid and small capitalization size segments and across style and sector segments over 46 different countries. There are 23 countries classified as developed markets and 23 countries considered emerging markets, US weights 47,36%, United Kingdom 7,97%, Japan 7,78% (...) China 1,89%, South Korea 1,72% etc... Still, better returns might be achieved if all chips are invested in the S&P500. No one can tell, there are too many unpredictable factors to tell exactly which approach is better.
Personally I prefer to have my investments spread geographically, in my view, is less risky. My stock portfolio is roughly distributed like this: US 30%, Emerging Markets 30%, Europe 25%, Pacific 15%.
My stocks allocation might not be perfect, but can't be "wrong" either. If I was older and less keen on experiencing volatility in my portfolio I would reduce my exposure to emerging markets, but by doing so, in theory I would also reduce the chances of higher returns in the long-term.
Anyway, this post is supposed to be an introduction on investing, for now I won't go in much more detail about allocation. The basic idea is that if you put your money in an index fund that offers exposure to a large number of stocks covering different capitalization size segments, economic sectors, styles (value/growth) and regions around the world, automatically, you will be ahead of the great majority of personal investors.
Ok, fine, how can I own those funds? You can own an index fund through a mutual fund or an exchange-traded fund (ETF). The first work great for Americans, in Europe not so great since there isn't so much offer. In both continents Vanguard Group is often one of the best solution in terms of costs and products. Nowadays the Vanguard Group is expanding its offer in Europe, for the future let's keep an eye in this possibility.
In the meanwhile, Europeans can go with ETFs, which track exactly the same indexes as mutual funds, sometimes with the same total expense ratio (TER). These ETFs are investment funds traded on stock exchanges, much like stocks, through almost any brokerage firms you can buy and sell shares of these funds over the course of the trading day. This might sound like an advantage, but in fact it isn't since for each trade you do your broker will charge a commission.
Successful investing is achieved through reduced expenses, this means you should chose funds with the lowest TER and open a brokerage account that charge low commissions and no account management fees. You are supposed to be an investor, someone who invests money in profitable businesses and keep them for ever. This said, the number of trades should be minimal, just buy and hold your shares.
If you are completely new to this some homework have to be done. First, read one or two good books about investing. Second, study different asset allocations and chose one that suits your investment philosophy. Third, chose the fund provider. Forth, don't procrastinate one more second, open an account and start investing, urgently!
First step:
Read "The Little Book of Common Sense Investing by John C. Bogle", then, if you feel curious and want to get some more academic knowledge about the subject I recommend "A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing" by Burton G. Malkiel.
The basic principles described in these books can guide any folk to successful investing and help to avoid the common fallacies of investing like overtrading and picking expensive exotic funds or "winning" stocks.
Disclaimer: I could tell you a lot of bullshit to cover my real intention, instead, I will tell you the truth. I posted those links to hopefully receive some tiny insignificant commission from Amazon, probably won't be enough to pay one month of hosting this blog, still, better than nothing. Those links are associated with this blog, which means if you decide to make a purchase the Amazon store will know the customer came from my blog. Either you decide to buy the books or not, I truly recommend their reading.
Second step:
To understand how different allocations can influence the returns of your investments I suggest to do some research first. There are many available tools for that purpose on the web, in the following video I explain how to use one of my favorites: http://www.msci.com/
Find other useful tool here, it allows back-testing of "buy and hold" type portfolios that are re-balanced annually to a fixed asset allocation. The application can also perform portfolio optimization to find a portfolio with small historical risk for a given return.
For back-testing I set a portfolio constituted by: 30% Emerging Markets, 20% SP500, 20% Europe. 10% US small cap value, 10% Pacific, 5% US Real Estate and 5% Gold. The average annual return would have been 13,84% and the worst drop 40,72% in 2008.
This tools shows the past performance, you shouldn't completely rely on that to set expectations of future returns.
Third step:
Do your own research and find the funds that best suits your portfolio. You can't go wrong with one of these fund providers:
https://global.vanguard.com
http://www.lyxoretf.com/
http://www.amundietf.com/
http://www.etf.db.com/
"SUCCESSFUL INVESTING IS ALL about common sense. As the Oracle has said, it is simple, but it is not easy. Simple arithmetic suggests, and history confirms, that the winning strategy is to own all of the nation’s publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return that they generate in the form of dividends and earnings growth."
When I try to encourage my friends to start investing in the stock market, their reasons to not do it are based on mistrust and irrational fear. Some of them know about my crazy goal of being financial independent at 25, they often ask me how's going the stock market "game", they think about stocks as a gambling game, where one puts his money and then luck dictates the result as a tremendous loss or a get rich hand.
They don't understand the following:
"Simply put, thanks to the growth, productivity, resourcefulness, and innovation of our corporations, capitalism creates wealth, a positive-sum game for its owners. Investing in equities is a winner’s game.
The returns earned by business are ultimately translated into the returns earned by the stock market."
It's true that speculation, macroeconomic new data, geopolitics events, natural catastrophes and so on can originate huge variations in the stock market, however, for the long-term investor like you were supposed to be, it doesn't matter at all, you are not supposed to guess the right moment to get in or out of the market, unless you have a crystal ball. In the long-term all those crazy variations will cancel out to zero, the value of stocks will go up as the earnings of the underlying companies goes up, as a shareholder you get your part. Simple as that.
Right, what should I do then?
Easy. First, be humble:
Mean: If you try to beat the stock market by picking individual stocks and trading them actively in order to get higher returns than the average, then, you are arrogant by thinking you can outsmart other investors.
What you have to do is simply buy and hold all stocks available in the stock market forever. Expect nothing else than the average return.
"Most investors in stocks think that they can avoid the pitfalls of investing by due diligence and knowledge, trading stocks with alacrity to stay one step ahead of the game. But while the investors who trade the least have a fighting chance of capturing the market’s return, those who trade the most are doomed to failure."
Right, what should I do then?
Easy. First, be humble:
"As investors, all of us as a group earn the stock market’s return. As a group—I hope you’re sitting down for this astonishing revelation—we are average. Each extra return that one of us earns means that another of our fellow investors suffers a return shortfall of precisely the same dimension."
Mean: If you try to beat the stock market by picking individual stocks and trading them actively in order to get higher returns than the average, then, you are arrogant by thinking you can outsmart other investors.
What you have to do is simply buy and hold all stocks available in the stock market forever. Expect nothing else than the average return.
"Over the past century, our corporations have earned a return on their capital of 9.5 percent per year. Compounded at that rate over a decade, each $1 initially invested grows to $2.48; over two decades, $6.14; over three decades, $15.22; over four decades, $37.72, and over five decades, $93.48.*
*These accumulations are measured in nominal dollars, with no adjustment for the long-term decline in their buying power, averaging about 3 percent a year since the twentieth century began. If we use real (inflation-adjusted) dollars, the return drops from 9.5 percent to 6.5 percent. As a result, the accumulations of an initial investment of $1 would be $1.88, $3.52, $6.61, $12.42, and $23.31 for the respective periods."
Independently of the economical growth rate, the stock market is always the best place to have money invested to get some of that growth. As long as companies make profit from their operations, investors earn their part through dividends distribution and capital growth reflected in stock prices.
To achieve this, what you have to do is to buy and hold all stocks available in stock market. How? Through an index fund. An index fund tracks a specific index by holding all of the securities in the same proportions as the index. For example, the S&P500 index tracks the largest 500 companies in US, each company has a specific weight in the index based on its market capitalization, Apple as the largest company in the world takes the first place representing 2,99% of the index (...) Coca-Cola 0,96% (...) Harley Davidson 0,09% an so on. As share prices of each company change everyday, so it does its market capitalization, thus, the weight in the index.
It's hard to tell which index is more suitable for you. S&P500 is the standard for Americans, but there are many more indexes tracking stock markets in Europe, Pacific, Emerging Markets and even in Bangladesh if you wish.
The US is traditionally the most business-friendly country in the world, so its stock market has tended to have the highest performance, however there is no evidence it will be always like that, thus, throwing all your chips there might not be the smartest thing. Also, if you don't live in US consider currency risk, changes in the exchange rate between two currencies can influence the returns over your investments. Some academic research have been done on the subject and it's acceptable to say that in the long-term currency risk cancels out to zero, in theory it won't have impact on the investment returns, however be aware one new factor is being taken into the equation.
To achieve this, what you have to do is to buy and hold all stocks available in stock market. How? Through an index fund. An index fund tracks a specific index by holding all of the securities in the same proportions as the index. For example, the S&P500 index tracks the largest 500 companies in US, each company has a specific weight in the index based on its market capitalization, Apple as the largest company in the world takes the first place representing 2,99% of the index (...) Coca-Cola 0,96% (...) Harley Davidson 0,09% an so on. As share prices of each company change everyday, so it does its market capitalization, thus, the weight in the index.
It's hard to tell which index is more suitable for you. S&P500 is the standard for Americans, but there are many more indexes tracking stock markets in Europe, Pacific, Emerging Markets and even in Bangladesh if you wish.
The US is traditionally the most business-friendly country in the world, so its stock market has tended to have the highest performance, however there is no evidence it will be always like that, thus, throwing all your chips there might not be the smartest thing. Also, if you don't live in US consider currency risk, changes in the exchange rate between two currencies can influence the returns over your investments. Some academic research have been done on the subject and it's acceptable to say that in the long-term currency risk cancels out to zero, in theory it won't have impact on the investment returns, however be aware one new factor is being taken into the equation.
Personally I prefer to have my investments spread geographically, in my view, is less risky. My stock portfolio is roughly distributed like this: US 30%, Emerging Markets 30%, Europe 25%, Pacific 15%.
My stocks allocation might not be perfect, but can't be "wrong" either. If I was older and less keen on experiencing volatility in my portfolio I would reduce my exposure to emerging markets, but by doing so, in theory I would also reduce the chances of higher returns in the long-term.
Anyway, this post is supposed to be an introduction on investing, for now I won't go in much more detail about allocation. The basic idea is that if you put your money in an index fund that offers exposure to a large number of stocks covering different capitalization size segments, economic sectors, styles (value/growth) and regions around the world, automatically, you will be ahead of the great majority of personal investors.
Ok, fine, how can I own those funds? You can own an index fund through a mutual fund or an exchange-traded fund (ETF). The first work great for Americans, in Europe not so great since there isn't so much offer. In both continents Vanguard Group is often one of the best solution in terms of costs and products. Nowadays the Vanguard Group is expanding its offer in Europe, for the future let's keep an eye in this possibility.
In the meanwhile, Europeans can go with ETFs, which track exactly the same indexes as mutual funds, sometimes with the same total expense ratio (TER). These ETFs are investment funds traded on stock exchanges, much like stocks, through almost any brokerage firms you can buy and sell shares of these funds over the course of the trading day. This might sound like an advantage, but in fact it isn't since for each trade you do your broker will charge a commission.
Successful investing is achieved through reduced expenses, this means you should chose funds with the lowest TER and open a brokerage account that charge low commissions and no account management fees. You are supposed to be an investor, someone who invests money in profitable businesses and keep them for ever. This said, the number of trades should be minimal, just buy and hold your shares.
If you are completely new to this some homework have to be done. First, read one or two good books about investing. Second, study different asset allocations and chose one that suits your investment philosophy. Third, chose the fund provider. Forth, don't procrastinate one more second, open an account and start investing, urgently!
First step:
Read "The Little Book of Common Sense Investing by John C. Bogle", then, if you feel curious and want to get some more academic knowledge about the subject I recommend "A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing" by Burton G. Malkiel.
The basic principles described in these books can guide any folk to successful investing and help to avoid the common fallacies of investing like overtrading and picking expensive exotic funds or "winning" stocks.
Disclaimer: I could tell you a lot of bullshit to cover my real intention, instead, I will tell you the truth. I posted those links to hopefully receive some tiny insignificant commission from Amazon, probably won't be enough to pay one month of hosting this blog, still, better than nothing. Those links are associated with this blog, which means if you decide to make a purchase the Amazon store will know the customer came from my blog. Either you decide to buy the books or not, I truly recommend their reading.
Second step:
This tools shows the past performance, you shouldn't completely rely on that to set expectations of future returns.
Third step:
Do your own research and find the funds that best suits your portfolio. You can't go wrong with one of these fund providers:
https://global.vanguard.com
http://www.lyxoretf.com/
http://www.amundietf.com/
http://www.etf.db.com/
http://www.ishares.com/global/
http://www2.comstage.commerzbank.com
http://www.globalspdrs.com/
There are many more, but I'm more familiar with these.
Forth step:
Open a brokerage account. Nowadays there are many online brokerage firms offering access to worldwide markets and commissions as low as 1$ per transaction. I opened an account with Interactive Brokers, since I'm younger than 26 there's a minimum monthly activity of 3$, even if I don't do any trade that amount will be debited from my account, however I add more funds every month or rebalance my portfolio if necessary, so those 3$ are often spent in transactions. For individuals older than 26 the minimum monthly activity is 10$. Put it this way: Assuming you trade in American and European markets, each transaction will cost you in average 2$. For 120$ per year you can do 5 transactions per month. Other brokerage firms don't require a minimum monthly activity but will charge you 10$ for a single transaction. If you plan to add funds or rebalance your portfolio only once per year you might be better with one of those, otherwise consider my suggestion.
Can one justify why is a 7 tones elephant afraid of a 100 grams mice?
Human beings are driven by fear, all our actions and decisions or lack of both are based on that. As all feelings, fear is irrational and hard to justify, being aware and above of it translates in a state of freedom, personal growth, a frame of mind able to explore and take more risks that often produce positive outcomes and in last instance, happiness. An enlightened guy can see further, thus, rational and intelligent decisions are made based on knowledge and good thinking.
If you live deeply rooted in fear, don't think about investing. Instead, build a bunker, get your own water supply, grow vegetables inside under artificial lights, get some gas masks and above of all, pray a lot.
http://www2.comstage.commerzbank.com
http://www.globalspdrs.com/
There are many more, but I'm more familiar with these.
Forth step:
Open a brokerage account. Nowadays there are many online brokerage firms offering access to worldwide markets and commissions as low as 1$ per transaction. I opened an account with Interactive Brokers, since I'm younger than 26 there's a minimum monthly activity of 3$, even if I don't do any trade that amount will be debited from my account, however I add more funds every month or rebalance my portfolio if necessary, so those 3$ are often spent in transactions. For individuals older than 26 the minimum monthly activity is 10$. Put it this way: Assuming you trade in American and European markets, each transaction will cost you in average 2$. For 120$ per year you can do 5 transactions per month. Other brokerage firms don't require a minimum monthly activity but will charge you 10$ for a single transaction. If you plan to add funds or rebalance your portfolio only once per year you might be better with one of those, otherwise consider my suggestion.
Can one justify why is a 7 tones elephant afraid of a 100 grams mice?
Human beings are driven by fear, all our actions and decisions or lack of both are based on that. As all feelings, fear is irrational and hard to justify, being aware and above of it translates in a state of freedom, personal growth, a frame of mind able to explore and take more risks that often produce positive outcomes and in last instance, happiness. An enlightened guy can see further, thus, rational and intelligent decisions are made based on knowledge and good thinking.
If you live deeply rooted in fear, don't think about investing. Instead, build a bunker, get your own water supply, grow vegetables inside under artificial lights, get some gas masks and above of all, pray a lot.
