I’ve done a fair bit of reading on personal investing, and taken some advanced actuarial science courses on the theory behind investing. I’m not going to provide you specific investing advice here, instead I’m going to touch on some topics that you can research further to hopefully start making sense of the advice you do read online.
Goals
When you’re starting out, your goal for investing/savings might be as simple as ‘to get the best interest rate or returns’. Unfortunately, to actually succeed, stating your goal like that is NOT enough – there’s not enough clarification in that simple goal.
Instead, let me suggest the following goal for consideration: “I want the highest rate of return, with the lowest risk, over my timeframe until retirement’.
That’s quite a bit different, and highlights a few things that you should be taking into consideration. First, of course we want high rates of return. But, we have to balance that with risk. Bitcoin might provide a high rate of return, but if you have a high probability of earning a negative rate of return, it’s not a sensible approach to long term investing. Similiarly you could go to the casino and bet it all on black – that would potentially provide a high rate of return, but the risk is not going to be worth it. These types of investment strategies that are short term and focused just on immediate high returns always come with a high probability of failure. Conversely, if you have a long timeframe then simply saving in a low interest vehicle like a GIC is counter to your goals as well – you can certainly find higher rates of return over the long term than a GIC. (and by contrast, if you’re investing over the short term, then something like a GIC may actually be the lowest risk, highest rate of return).
Here’s an example of the goal in action. Lets say we have a 30 year timeframe for our investments – from age 35 to age 65. We don’t care specifically what any given rate of return is in any specific year. We should instead stay focused on our overall rate of return between now and our endpoint at age 65. If we can earn say 6% between now and 65, that may be a reasonable goal. So we’re targetting a consistent 6%, with little volatility, over that 30 years. We care less if we can somehow earn 12% in a single year – particularly if attempting to earn that 12% means we might not obtain it and instead we end up with less than 6% overall over the next 30 years. In summary, look at your overall return goals over the long term and focus your investments on that, while mostly ignoring individual volatility on a year by year basis.
This strategy is the foundation for common phrases like ‘time in the market beats timing the market’. If you’re goal is 6% over 30 years, and your strategy is designed to achieve that, then moving your savings in and out of the market to chase short term gains is actually counter to your stated goals (because you’re taking risks by timing the market, and thus open to not obtaining your long term goal).
Asset Allocation
There are something called ‘asset classes’. These are things like real estate, money market, stocks, bonds, etc. They’re various types of investments. To meet the goal that we stated above, we generally don’t want to invest in a single asset class like say stocks. Doing so increases our risk because it increases volatility – we might see high gains in one year, but negative returns in another. So we want to tamp down that risk or the swings.
The way to do that is to build your portfolio with different asset classes. Not all stocks, not all real estate. Instead, choose asset classes that are either negatively correlated, or uncorrelated. Negatively correlated means when one asset class goes down, the other goes up. Uncorrelated means when one asset class goes up or down, the other asset class is unaffected.
By doing this, we lower our swings in our overall investments and savings; if we have savings in stocks and stocks crash (as they tend to do sometimes), we then also have savings in an asset class that goes up when stocks crash, and other savings in asset classes that are unaffected when stocks crash.
Choosing your asset allocation or distribution of your savings amongst various asset classes is not really a DIY job, it’s something you want to seek out the advice of a professional.
Modern Portfolio Theory, CAPM sort of, and Index Funds
Modern portfolio theory is complex and has been shown to be imperfect, but a very simplistic version along with some theory called CAPM can be useful for us. Here’s how it works.
Say you choose one stock that you think is going to take off. Unfortunately, by taking a single stock we are extremely exposed to the downside – that stock could go to $0. So we could have an upside of 12% and a downside of -100%.
To combat that risk, we add a second stock. Now our returns are an average of both stocks – so not likely 12% upside and -100% downside. Maybe now our risk is 8% possible positive returns, and only -50% downside.
So we keep adding stocks until there’s none left. For our savings that are in stocks, it’s been shown mathematically that the highest rate of return with the lowest risk is exactly ‘all stocks in the market’. In other words, keep adding stocks to your investments until there’s none left to add. That will give you the best possible returns with the lowest risk – which is a big part of our stated goal.
‘All stocks in the market’ is the opposite of choosing blocks of types of stocks. i.e. investing in tech stocks, or oil and gas, or whatever subset of industries you like. Mathematically, better than any specific block of industries, is ‘all’ industries.
Investment people realized this many years ago and created something called an index fund. An index fund is basically ‘all stocks on the stock market’. They’ve become extremely popular over the last few decades and are often a part of many investment/savings portfolios. There are some variations on this, a common one is the S&P 500, which isn’t all stocks, but instead is all of the top 500 stocks on the S&P. Again, be aware of the concept of index funds, then you’ll need the advice of a decent financial advisor to help you wade through specific options.
Summary
So here’s the real quick beginner’s guide. Clearly state your long term goal, and realise that focusing on short term goals or returns can hurt your long term goal. Learn about the different asset classes, then work with a pro to combine those available asset classes in the right mix to reduce volatility and risk. And for the stock asset class,, look into index funds that are designed to stabilize returns and limit risk.