An introduction to investing

03.05.2020

An investor’s goal is to find a way to put capital to work in order to have more of it in the future. I will describe a simple, low cost method for long term investors. This text is not a manual to get rich quickly; it is a blueprint on how to build wealth over decades.

Instead of investing, one could also leave money in the bank. Due to an annual inflation rate of around 2% (that’s the rate many central banks in wealthy nations aim for) and record low interest rates, owning cash is a guaranteed way to lose purchasing power over time. To put this in less abstract terms: if the price of milk rises over time (inflation), then the same amount of money will buy less and less milk.

Financial markets bring two groups of people together: those who need capital to pursue projects and those who have excess cash that they want to deploy productively. Investors have many different choices before them. It is possible to buy: an apartment, a wine collection, credit (bonds), gold, Bitcoin, a section of a forest or a piece of a company.

In order to fund their operations, companies need capital. They might have to lease airplanes, pay the people in the accounting department, build a chip factory or pay for fire insurance. Broadly speaking, there are two ways for companies to get money from outside. They can borrow (credit) or they can exchange ownership in themselves (equity) for cash. From within, companies are also free to keep profits from their operations and reinvest them.

Companies that have their shares traded on a stock exchange are public, companies that aren’t are private. It is much harder to buy a piece of a local restaurant than to become co-owner of Google. You don’t have to go to the notary, you don’t have to ask for permission; you can invest relatively small amounts and it is easy to look up the financial data of a listed company to underpin your decision.

The stock market is a secondary market, so investors trade shares with each other: they don’t buy or sell from the company directly. Two exceptions are capital raises, first when companies exchange newly created shares for cash and second buybacks, when companies buy back their own shares. Whenever you think it is a good idea to buy part of a business at a given price, somebody else thinks it is a good deal to sell at that price (and vice versa). If you consider the person you are trading with to be well-informed and intelligent, that can be a scary thought. What do they know that you don’t?

Active vs. passive investing

When investing in stocks, there are two approaches you can follow: active and passive. An active investor uses a particular strategy to find mispriced assets: this might mean studying individual firms or particular industries. There are countless sophisticated strategies people use in order to make money. Buying something for less than it is worth is fantastic - imagine somebody were to offer you to buy $100 bills for $70 - a very good deal! These inefficiencies are rare and finding them is hard work. What seems like $100 often turns out to be worth $40 in the end. Finding mispriced companies is called stock picking. It can be rewarding and interesting, but it is very hard and requires a lot of skill, knowledge, time and emotional self control. Most stock pickers underperform the market, so they waste both their time and their money.

Prices of a stock can change second by second but in principle this is true for all other assets as well. Imagine you received 50 offers for your house every day. Prices would change and be a function of the quality of the house, the economic environment, interest rates and the news cycle: prices are always in flux, the economy is a highly dynamic system. Just because these changes are visible for the prices of listed companies, we shouldn’t assume that this price volatility automatically makes company ownership more risky than other asset classes. Looking at the daily changes of a company’s valuation is emotionally taxing and should be avoided.

Everybody should own a part of a business, because that’s where value is captured in a capitalist system. Most large fortunes were made through company ownership and owning stocks gives you a way to participate. As a side effect, widespread stock ownership reduces the tension between owners and employees and can help, in the long term, to narrow the wealth gap. Unfortunately, many people on this planet cannot earn enough to build up savings (or get out of debt), because their earnings just barely cover their expenses, but a substantial portion of the population could start investing yet doesn’t. Most savers hold cash and maybe some real estate, but participation in company ownership is still low. In a world of near zero interest rates, those who own assets are being rewarded while those who hold cash are slowly robbed.

In stark contrast to the stress associated with active investing, a passive approach means buying shares in an index of companies and not worrying about finding pricing inefficiencies but to assume that successful enterprises become more valuable over time.

Beating the market and the case against active management

How good of an investor somebody is can be expressed in relation to all other investors. Imagine you buy a house and a few years later you sell it for 10% more than you paid initially. It’s nice to have made 10%, but if everybody else's house in the same neighborhood has increased in value by 20%, then the 10% gain is a rather sad outcome. The same principle holds for the stock market: we can look at the valuations of all public companies and then see how the fund manager has performed in comparison to the average. A bigger return than average is called alpha. Consistently outperforming the market (“generating alpha”) is incredibly challenging: it might be the most competitive game in the world and almost nobody does it over a long period of time. The majority of fund managers cannot outperform the market. More than half of a group of people cannot be taller than the entire group on average.

While getting above-average returns is insanely difficult and might well lead to below-average returns, getting the exact average of the market’s performance is trivial: just buy an ETF on an index and sit back.

Fund managers take other people’s money and invest it in return for a fee. If you do choose to entrust your money with such a manager, you are only making a good deal if this manager beats the market after the fees are subtracted. Let’s look at an example:

Some funds take 2% of the volume of the investment per year plus a performance fee of 20% on gains. Imagine you invest 100 and the fund returns 10% in one year. You now have to pay 2% of 110, so 2.2 plus 20% of 10, so 2, equaling 4.2 in total. Even though the fund increased in value by 10, you only get to keep 110 - 4.2 = 105.8 and that’s before tax!

For long-term investors, it is absolutely crucial to keep costs low. You should avoid paying a fund manager or investment advisor: they are almost never worth what they cost. The active fund management industry is in steady decline, because more and more investors are waking up to this truth. A classic book alludes to the problem with the title “Where are all the customers’ yachts?”.

When you buy or sell a financial asset, both your broker and the stock exchange take a fee. When using active management, you should avoid making many transactions, because your returns will be hurt otherwise.

Taxation

When you sell shares at a profit or when you receive a dividend, you typically have to pay a tax. You should check how much you have to pay given your tax residency and income tax situation. I cannot give general recommendations about this! Some countries have flat taxes, meaning you pay the same percentage on your gains irrespective of how much you earn. Others have progressive taxes: your marginal tax rate rises as your gains get bigger. Please research how capital gains and dividends are taxed for you and consider getting professional advice.

Indices and ETFs

An index is a collection of firms that are selected according to a specific rule. For example “All companies with a red logo that operate in the Netherlands and sell cookies” or, more realistically, “The biggest 50 companies in Europe in terms of revenue”. A few well-known indices are: the S&P 500 (the 500 biggest US companies), the MSCI world (~1600 biggest companies around the world) in Europe there are the FTSE in the UK, the CAC40 in France and the DAX in Germany.

It is reasonable to be happy with average returns by just owning a sliver of all listed companies. A low-cost and easy way to do this is to own an exchange traded fund (ETF) on a broad index. This financial instrument replicates an index of companies and makes it easy to invest in them and charges you about 0.15% per year on the volume of your investment.

How much to invest

Without savings, we cannot start investing. Before taking on any risk, you should have some funds for emergency situations. Investing is risky. There is no sure way to make money, especially over the short term: crises happen and the value of your portfolio can swing widely. For these reasons, you should only invest what you can afford to lose without destroying your life. A loss on paper of 50% should not derail your personal life (rent payments, holiday plans, rainy day fund). Some speculators take out loans on their home to buy financial derivatives (contracts that give you financial leverage) and quickly ruin themselves in the process. They don’t just lose all of their investments but also their home. You will be well served by never borrowing to invest and for the most part to stay away from derivatives. It is easy to self destruct with those instruments. You should start slowly, by putting 50% of what you save in a month into your portfolio.

Valuation

The beauty of the passive investing approach through regular purchases of ETFs on index funds is that you don’t have to worry about valuation and timing. There are two big problems with passive investing and at least one prominent investor has referred to the “ETF bubble”, one is that many millions of investors are already blindly buying and the other is that valuations of stocks are at a high level. It would be naive, and all too human, to assume that what has worked in the last 10 years will work in the next 10 years as well.

Evaluations of individual firms are hard to get right, but we can use crude metrics to approximate how expensive the overall market is in relation to historical averages. One way to do this is to look at the relation of the annual profit of all firms and the price of all firms in a given country. This method is far from perfect, because we don’t know how high profits will be in the future and the stock market is fundamentally based on future expectations.

For many years, interest rates have been extremely low, which incentivizes governments, corporations and consumers to borrow heavily. Lower interest rates lead to higher prices of assets like real estate, bonds and stocks because buyers can finance their purchases with borrowed money and because companies spend less on interest payments and are thus more profitable. Leverage is another word for indebtedness and I think about it as a kind of fragility: a company with lots of debt will have a hard time coping with an external shock, because interest payments gobble up such a large part of cash flows and debt can come due at inopportune times. Both the debt loads companies carry and the strong deviation from historical average in the relation between profits and prices for companies suggest that stocks are very expensive at the time of this writing.

Shorting

Few investors bet on falling prices, a practice referred to as “shorting”. There are several ways to benefit from falling prices, but I won’t get into the technical details here. Almost everybody is betting on prices to go up. Given high valuations and record returns of stocks over the last decade in combination with a global pandemic and economic crisis, it strikes me as prudent to have a short position in expectation of a reversion to the mean of valuations that follows the cyclical nature of a credit based economy. Inverse ETFs are a way to short without leverage. If the index goes down by 1%, the instrument’s value goes up by 1% and vice versa. Having some shorts is a nice addition to the index based ETF portfolio.

Conclusion

I advise you to buy ETFs on large indices like the S&P 500, the MSCI World and Stoxx 600. It’s extremely simple: you buy some shares in a regular interval (e.g. every month) and then you wait for decades. No expertise required! No study of balance sheets, competitive positions, corporate taxation issues or management teams needed! It's boring, but it works. The nice thing about automatically investing every month is that it takes the question of timing out of your hands. You don’t have to ask yourself whether now is a good or a bad moment to invest.

If you are in Europe, you can open an account with the Dutch discount brokerage Degiro. they have a reputation for some of the lowest costs. I have an account there, but most banks allow you to have a portfolio as well (carefully study the costs!)

For readers based in the US, here’s a good article that provides some background on taxation, retirement accounts and good brokers to choose:

For the ETFs themselves, you can look into products offered by Blackrock’s iShares or Vanguard, but there are many others. As long as you can find an ETF on the index you want to invest in, cost is the most important factor to consider.

Further steps

Once you spend less than you earn and you invest on a regular basis into ETFs on large indices you can start extending your approach to investing. You can consider buying individual shares of companies that you think are really promising or you can take short positions. Having a sizable portion of your portfolio anchored to market returns should give you good results over several years.

If you have questions or feedback, please feel free to reach out to me:

maximilianbschumacher@gmail.com

Thanks a lot to Jessica Marquis, Gregor Weber and Constance Peruchot for reviewing this article