The topic of investing is a sizeable one. Investing is different things to different people. Speculating and gambling are often lumped in under investing. The shorter our time horizon the more investing turns into speculating and gambling. Investing done right is boring. It all comes back to our investment philosophy. As this is a financial planning podcast, I will be talking about the basics of what investing is to a financial planner, why we invest and how best to get started. Money is a means to an end and not an end in itself. Investing to make more money is of course the motive but not an end result. An investment goal is to be financially independent, help send the kids to college, be able to give back to our communities and create intergenerational wealth. Investing brings financial risk into our lives, therefore we need to ask ourselves do I need to invest and if so why am I investing, what are we trying to achieve?
Not to flog a dead horse but we should hold off on investing until we know how much our current lifestyle costs us, spend less than we earn, save a fully funded emergency fund, pay off all non-mortgage debt and have saved for a deposit on a home if applicable as outlined in episode 3. Believe it or not the greatest determining factor in building wealth is our savings rate, not investment return. Without a consistent savings rate investing alone will never get us where we need to go. Savings are the foundations on which investing can build. Our end goal will determine what our savings rate needs to be given the risk we are comfortable taking. In money terms we seek a positive return on our investment, but the outcome of our investing will hopefully allow us a return on life.
What is investing?
In general, the word invest means to devote one’s time, effort &/or money to a particular undertaking with the expectation of a worthwhile result. We invest in ourselves, in our families, in our careers, in our colleagues, in our businesses, in our communities and in the world at large. Investing has many similarities to planting a tree. It all starts with a single seed. We sow the seed in nutrient rich soil to give it the best opportunity for growth, we water it regularly, make sure it is getting good sunlight and wait. When we start investing, we start small, make sure we are setup right for investment growth, we contribute regularly, remain disciplined and wait. As Warren Buffet has said: Someone is sitting in the shade today because someone planted a tree a long time ago. We save for short term needs and invest for long term needs. Savings are certain and relatively risk free, investing involves risk.
Investing money means putting our savings at risk long term in the pursuit of achieving a positive return. Long term is measured in decades not years, the longer the better. We seek a positive investment return to preserve or grow the value of our money into the future. We invest by buying assets that go up in value, provide an income and an income that rises over time. We invest in asset classes. An asset class is the categorizing of assets with similar characteristics together. Examples of the main asset classes are businesses (commonly referred to as stocks, shares or equities), government and business debt (commonly referred to as bonds or fixed income), and property (commonly referred to as real estate). In my opinion cash is an asset but not an investment asset class. Our fully funded emergency fund and any additional amount of savings we need to get comfortable investing should be kept outside of an investment. Cash drags down the performance of an investment due to little or no return, inflation, fund charges and tax if applicable. There are other asset classes but businesses, government and business debt and property have proven themselves to appreciate, provide an income and a rising income consistently over the long term.
We invest in public businesses. A public business is one that is registered on a stock exchange and ownership of its shares is available to the general public. The primary aim of a publicly available business is to generate a profit for it’s shareholders. We access ownership of a public business by purchasing its shares. When we invest, we become part owners in these businesses however small that may be. We do this in anticipation of the businesses going up in value, and receiving a share of the business profits which is known as dividend income. Assuming the business is well-managed and profitable, this dividend income can rise over time. Not all businesses go up in value, provide an income & a rising income but collectively as a group or asset class they have gone up in value, provided an income and a rising income over time. It is worth remembering that many of us work in businesses, run our own businesses, and spend our money on goods and services provided by the very businesses in which we can invest. Becoming part owner in these businesses allows us share in some of their growth and profits into the future. We are investing in the collective human ingenuity of some of the best businesses in the world. Businesses and governments also use the goods & services of many public businesses and their subsidiaries on a daily basis. A subsidiary is a company owned by another company. Instagram and Whatsapp are subsidiaries of Facebook.
When going about our day, think of all the products and services, we interact with that public businesses provide. From the phones we use (Apple, Samsung), the platforms we use (Facebook, Amazon, Google, Netflix, Disney, Airbnb), the roads & transport that gets us from A to B (CRH/Applegreen/Ryanair/FBD Insurance), the tools and software we use at work (Microsoft/Zoom), to the medicines we use when sick or need a vaccine (Pfizer/Johnson & Johnson), the food we eat (McDonalds/Kerry Group/Tesco), the beverages we drink (Diageo, C&C), the clothes we wear (Nike/H&M/M&S/ASOS) are just a snippet of familiar businesses that are publicly available. Businesses as an asset class have historically provided the best returns, roughly 10% per year on average, over the long term. However, they can be quiet volatile over the short to medium term. Public businesses can be bought and sold quickly, it is a highly liquid, and intangible investment. Public businesses pose the highest risk and reward of our three asset classes.
Government and business debt have historically returned between 4-5% positive return over the long term. When we purchase shares of debt, we become part loaner to governments and businesses. We loan our money to governments and businesses by purchasing shares of their debt and in return we receive a regular interest payment. A mortgage is somewhat similar but instead of us paying interest on a debt we are receiving interest on our investment as we are the lender. Government and business debt as an asset class is less risky when compared to public businesses. Less risk means lower potential returns too. Government and business debt can be bought and sold quickly, it is a highly liquid and intangible investment.
Property has historically returned between 3-5% positive return over the long term. It is an investment close to Irish hearts. Largely because we can drive down the road and see it, it is tangible, we can touch it. We can invest in property through purchasing shares in property funds or by investing directly into a rental investment property. Buying a rental investment property is the preferred option in my opinion. Property funds can do well but in general offer up a myriad of problems. The cyclical nature of property performance as an asset class, its inability to be bought and sold quickly and fund fees make owning shares in a property fund unattractive relative to the investment return. Borrowing to invest in property adds financial risk to our lives. If we are fully funding our financial independence goal through our pension, paying off the mortgage is our next priority. If we have paid of the mortgage, we have a decision to make. Enjoy living a little more or save to buy a rental investment property to help boost income in retirement.
Now that we know about asset classes, we turn our attention to how we construct our investment portfolio. Asset allocation is how much of each asset class (businesses, debt & property) is represented within our investment portfolio. For example, we could have a balanced portfolio of 50% businesses & 50% debt, a conservative portfolio of 20% businesses and 80% debt or an aggressive portfolio of 80% businesses and 20% debt. Our asset allocation decision is the biggest determining factor in the returns we can achieve. How we choose our asset allocation will depend on our savings rate, risk tolerance and time horizon. Jack Bogle the founder of Vanguard once stated a very general rule of thumb that holding the same percentage of debt as our age with the rest invested in public businesses. So, if we are 30 years of age, we hold 30% debt, 70% businesses. If we are 70 years of age, we hold 70% debt, 30% businesses. This approach assumes we can stomach the temporary market declines. It also clearly demonstrates the inversion of risk and time. The more time we have the greater the risk we can take and the less time we have the less risk we can take.
Diversifying our investment portfolio across businesses, debt and property is all about managing risk and return. We not only diversify across asset classes but also within those asset classes. For example, when it comes to public businesses we diversify across different countries, different industries, different sizes (small medium large), and different factors (value, growth, quality). When it comes to debt we diversify across different countries, different time horizons, different types and quality. Correlation is a statistical measure of how asset classes and the assets within asset classes rise and fall in value relative to each other. In other words, if public businesses rise in value, does the value of debt rise, fall or stay the same. Without getting too technical, diversification and correlation seek to maximize potential returns for a defined level of risk.
There are two main types of investing, active and passive. Active investing involves a person or team of people making the buying and selling decisions when it comes to picking which public businesses or debt investors’ money is invested in. Active investing seeks to identify, research and invest in assets that are mispriced or undervalued. Active managers seek out investment opportunities that may have been overlooked by the investment market as a whole. They seek to find and profit from the needles in a haystack. The objective of active investing is to outperform the market and index to which they benchmark themselves.
Passive investing bypasses active managers and invests in an index fund. An index funds job is to mirror a market’s performance as closely as possible. Instead of searching for the needles in the haystack, we buy the entire haystack. For example, the S&P 500 is one of the most commonly used index funds which is made up of the top 500 businesses in the United States. When we buy the S&P 500 index, we buy part ownership of each of these 500 businesses.
Actively managed funds can outperform the market. However, it is hard to discern skill from luck in the short term. A guess or calculated guess has a probability of being right or wrong. If we make enough guesses, we are bound to be right some of the time. Some build a reputation on the correct outcome of a big guess. This does not mean they will continue to be correct into the future. With each year that passes the odds of an actively managed fund beating the market, reduce significantly. For example, say 50% of actively managed investments beat the market in the first three years, by the time a couple decades have passed 80 to 90% of actively managed funds will have underperformed their own benchmark. The small number of actively managed investments that do consistently outperform the market are largely unavailable to the everyday person. Sovereign wealth funds, endowment funds, pension funds, family offices all falling under the umbrella of institutional investors and high net worth individuals are first in line to these unicorn active managers who have a consistent track record of beating the market over many decades.
Given so few active managers beat their own benchmark over the long term it may come as a surprise that we will also be charged fees for the possibility of outperforming the market without the active fund actually having to deliver market beating returns. We take the added risk and have to pay for the opportunity of market beating performance that rarely happens over the long term. When we deduct the fees paid to active managers, even fewer actively managed funds outperform the market. When I talk about performance, I mean both negative and positive. So, an active manager beats the market when they lose less and make more than the market. It is estimated as much as 80% of actively managed funds are actually index fund huggers and plenty of active managers have their owning savings invested in passive index funds.
Passive investing doesn’t pretend to be something it’s not. Our investment will rise and fall as the market rises and falls. Public businesses and debt can fluctuate wildly in the short term to medium term but reach new highs over the long term. Passive investing doesn’t seek to time the markets but rather rewards those for time in the markets, the longer the better. The fees for passive investing are or at least should be significantly lower than active funds. This is because we are not paying for a team of individuals to identify, research and transact investments on our behalf. We are buying an index fund that mirrors the market it is tracking and therefore fees can be exceptionally low.
A few examples of how annual investment fees can impact our wealth building efforts. Say we are starting our investment journey today and invest €500 per month for the next 30 years. If we are charged a total of 1.5% on our investment annually and receive an average return of 6% annually, we will have accumulated a fund of €374,915 and have paid €114,714 in fees. If there were no fees, we will have accumulated a fund of €489,629 or 30% more. Similar to when we are paying interest on a mortgage, a small percentage interest rate or fee over a long period of time adds up to a sizeable amount.
To give us a better picture of how fees build up over time let’s take €10,000 €100,000, €1,000,000, €100,000,000 and €1,000,000,000 and see how much a total annual fee of 1.5% is in money terms across those amounts. So, 1.5% of €10,000 is €150, of €100,000 is €1,500, of €1,000,000 is €15,000, of €100,000,000 is €1,500,000 and of €1,000,000,000 is €15,000,000 in fees, every year. So, wherever we fall on the wealth spectrum be sure to remember what we are paying every year and why we are paying it. The fund charge, the platform charge, the adviser charge, the list goes on. Value for money and added value are worth paying for.
Sequence of return and market price are among the most underrated aspects of investing. Sequence of return refers to the order of our investment returns across a given time period. Market investment returns can be positive or negative depending on the year. What investment returns we receive in our first number of years can have a significant impact on our potential overall investment returns long term. This is less important for those contributing to investments on a regular basis and more important to those investing lump sums or folks drawing on investments in retirement. For example, the loss ladder highlights what gain we require to get back to where we started should we suffer losses. If we lose 10%, we need an 11% gain to return to €100, if we lose 20% we need a 25% gain to return to €100, if we lose 40% we need a 67% gain to return to €100, if we lose 50% we need a 100% gain to return to €100 and if we lose 80% we need a 400% gain to return to €100. The gains ladder is much the same. If we gain 10% a loss of 9% will have us back at €100, if we gain 20% a loss of 17% will have us back at €100, if we gain 40% a loss of 29% will have us back at €100, if we gain 50% a loss of 33% will have us back at €100 and if we gain 100% a loss of 50% will have us back at €100. When it comes to risk the idea is not to do a hail Mary and look to shoot the lights out with large returns quickly. This is because it is equally as likely we shoot ourselves in the face and lose ourselves a lot or all of our money just as quick from which we may never recover. The more risk we take the more flexible and accepting we have to be with the potential outcomes. Price of the market. The current price of the market as a whole is what we pay to purchase assets. The cheaper the price the better the value, the more expensive the price the worse the value. One of the main measures of market price is the price to earnings ratio. This ratio can fluctuate up or down but based on the past it provides us with a rough guide as to whether the current market is expensive or cheap.
A positive return on an investment over time will lead to compounding. An example of compounding is when we invest a €1,000 and let’s say we receive a return of 3% over 4 years. The first year our investment value rises to €1,030, the second year we also earn a 3% return on our new investment balance of €1,030 which equals €1,061, the third year €1,093 and the fourth year €1,126. If we had just added the 3% or €30 for each of the four years, it would equal €1,120 but instead we accumulated €1,126. This may not seem like much but given time it can have a profound impact on our wealth. The key ingredient is time and as much of it as possible. It will feel like little is happening for a long time. This is the equivalent of rolling a snowball in the snow until it has reached the point of critical mass. That is, it is large enough to continue rolling unaided, under its own momentum. The point at which we begin to see compounding really take hold is roughly €100,000 to €200,000 where 3% investment return is now €3,000 or €6,000, respectively. Compounding is frequently touted as the 8th wonder of the world.
Our time horizon and self-discipline are some of the most important aspects of investing. Investment markets are volatile in the short to medium term. Short to medium term is anything less than ten years. Over the long term, time smooths the volatility of short to medium term markets. Investment markets have risen and fallen in the past and there is no reason to suggest this won’t continue into the future. In the last twenty years we have had the dot com bubble of 2000, the financial crisis of 2008 and the Covid crash of 2020. These were all significant temporary market corrections where the value of businesses declined significantly. The Nasdaq, a stock exchange for technology businesses fell 77% and the S&P 500, fell by 49% in 2000 during the Dot Com Bubble. The S&P 500 fell again by 57% during the financial crisis of 2008 & 2009 and by 34% during the Covid 19 crash in early 2020. When investing in businesses as an asset class it can be a case of taking the stairs up and the elevator down. When markets fall and fall fast we are our own worst enemies. Panic and fear are contagious. Our fight or flight instinct kicks in and screams at us to do something. The drop in investment value remains on paper and is only locked in when we take action by selling or switching to cash. Businesses rebound quickly and subsequently go on to new highs. These gut-wrenching drops are the emotional price we pay for long term rewards. Oddly enough, when businesses do drop in price and we are investing regularly we are purchasing these businesses at a sizeable discount. It’s the equivalent of heading into a grocery or clothing store and seeing everything at half price. If we do sell or switch to cash, we will get investor returns and not investment returns. No one can time the markets consistently. Temporary market corrections are part of the journey. We must be optimistic, dance with uncertainty and have a healthy, lifelong relationship with investment risk to reap the rewards. The one certainty is uncertainty. None of us know what the future holds. If we had invested 40 years ago, we wouldn’t be regretting it today. Being good with money is 80% psychological and 20% knowledge the same way a healthy lifestyle is 80% nutrition and 20% exercise.
If our money decisions were entirely rational mathematical decisions, I wouldn’t have a job. We are the sum of our experiences and no one person’s experiences are alike. We are emotive beings. Instinct and emotions are what’s allowed our ancestors and ourselves to survive. Our ancestors were focused on finding and eating their next meal while avoiding being eaten. The modern world is very different to the one our ancestors lived in. Instinct and emotions are short term whereas good money habits and investing are long term. Now that we have discussed what investing is, why invest our savings given the risks and uncertainty?
When it comes to risk in our lives, there is investment risk and inflation risk. What happens if we don’t invest and leave our savings as they are? The value of our savings will slowly decrease over many years as the cost of goods and services increase over time. Essentially our savings stay static whereas the cost of living gradually rises. The gradual rise in the cost of goods and services over time is called inflation. It will slowly erode the purchasing power of our money into the future. Excluding 2011 & 2012 inflation has been very low for the past ten years in Ireland. However, inflation was very high in the 1970’s and early 1980’s. The average inflation rate for the last sixty years in Ireland is 4.82%. Today the European Central Bank targets an inflation rate of 2% per year. Inflation can fluctuate wildly, from negative inflation or deflation where the cost of goods and service decreased by 5% in 2009 to very high inflation where the cost of goods and services increased by 23% in 1981. In order to keep pace with or outpace inflation we invest. The time value of money means €10,000 today is more valuable than €10,000 in 10 years’ time as we won’t be able to purchase as much in the future. For example, my grandparents were born in the 1920’s and 1930’s. A basket of Irish goods costing the equivalent of €100 in January 1930 now costs €5,413 in January 2021 or fifty-four times what it did in January 1930. In other words, if we held onto our €100 from 1930, we could only afford 2% of the basket of goods in January 2021. Our purchasing power today is virtually nonexistent. This is a lifetime of inflation but simply put €100 today will be worth less in ten, twenty, forty, eighty years’ time. Given the turn of the New Year, the average life expectancy of a baby born in 2021 will be 105 years. Another way of thinking of how inflation affects us in our everyday life is to remember back to our childhood or young adult years. How much was a haircut, makeup, newspaper, stamps, sweets, a pint, a toy, pocket money or money gifted at religious ceremonies such as communion, confirmation, or weddings. If we are young, ask our parents or grandparents what money they remember spending on everyday items we purchase today. Another example is the football transfer market. I remember seeing Rio Ferdinand ‘s transfer fee of £30 million pounds back in 2002. It was jaw dropping. Fifteen years later Neymar is bought by Paris Saint Germain from Barcelona for just under £200 million pounds. Madness. What we spent or received in the past is less than what we spend or receive today. Last example, the average price of a secondhand house in Ireland in 1988 was a little less than £40,000 Irish punts. The average price of a house in Ireland as of December 2020 is a little less than €270,000 euro. That is nearly a seven-fold increase in thirty-two years. Based on the past we are certain to become increasingly poor if we do not invest our long-term savings. Given inflation is guaranteed can we afford to not invest? Do we have a choice? We run the risk of running out of money before we run out of life.
When discussing investment risk, we start with the risk free rate of return. The risk-free rate represents the interest an investor would expect from a risk-free investment. Deposit interest earned on our savings would be considered riskless. Given our current low interest rate environment there is little to no return available. Any interest we receive is subject to Deposit Interest Retention Tax at 33%. The next level of risk is government and business debt where we receive a positive return slightly above inflation over the long term. Following this is public businesses with a positive return of double and sometimes triple that of inflation over the long term. At the absolute minimum we want an investment return on our money that matches the sum total of inflation, fund fees and tax if applicable all added together. Example, say over the course of our pension inflation is 2% and fund fees are 1.5% annually. This means to maintain the same level of purchasing power for our money into the future we will need to achieve a minimum positive investment return of 3.5% annually.
How do we invest and where do we start?
Risk tolerance is an investors ability to psychologically endure the potential of losing money on an investment. We can discover what level of risk we can handle by completing a risk tolerance questionnaire. We then use this result along with our time horizon and investment goal to determine what our savings rate needs to be. For most of us, saving into our pension should be the start of our investing journey. It is always a good idea to keep and save 20% or 40% more of our hard-earned income. Tax deferred accounts will almost always be preferable than taxable accounts. We start with investing our pension savings because it typically has the longest time horizon, not just up to retirement or financial independence but after too. A forty-five-year-old based on the traditional retirement age has 20 odd years to retirement and hopefully two to three decades thereafter. That’s 20 years’ worth of saving and twenty to thirty years of spending for a total investment time horizon of 40 to 50 years. Focus on investing our pension savings in businesses, government and business debt linked to our investment goals. Back testing is not a terrible idea but don’t read into it too much. This is where we look back on historical returns over the same time horizon of our investment into the future. If we invest outside of our pension, we will pay exit tax or capital gains tax (CGT) on any gains. Exit tax is 41% and this type of investment structure is ideal if you don’t have an accountant and want a relatively hassle-free life. CGT is taxed at 33% and falls under self-assessment of tax. CGT has an annual exemption of €1,270 on any gains. CGT accounts are also useful when offsetting past investment losses on future gains. The question is often asked which is better, investing regularly or lump sum. A lump sum investment is likely to do better over the long term due to the initial size of the investment. Regular investing foster’s a good saving habit and help us psychologically with the rise and fall of the market because we are buying businesses and debt consistently. We buy when the market is falling (rising in value), and also buy when the market is rising (falling in value). We should review our investment portfolio annually and rebalance if necessary. When there is big money to be made and lost there will never be a shortage of exotic investments and financial trends. Bitcoin, peer to peer lending and so on. Stick with the tried and trusted and tune out the noise from financial media’s attempts to make you feel like you are missing out on something. If we absolutely must dip our toe, create a fun fund that is a very small fraction (no more than 5%) of our overall wealth and be comfortable potentially losing it all, speculating and gambling. Unless of course you have an addictive personality.
We could talk about investing till the cows come home. In summary, it’s time in the markets not timing the markets. If we don’t invest our long-term savings, we are guaranteed to get poorer each year due to inflation. We invest in businesses and debt for the long term. No one knows when the bottom or top of the market is reached. If someone does forecast the future they are either guessing or lying. Investing done correctly is not trading, speculating or gambling. Trading, speculating or gambling are short term in nature and high risk. As always seek good advice specific to your circumstances.
This week’s book recommendations are Stocks For The Long Run: The Definitive Guide To Financial Market Returns & Long Term Investment Strategies by Jeremy Siegel. The Little Book of Common-Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John Bogle. The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street by Justin Fox. The Intelligent Investor by Benjamin Graham. The Warren Buffet Way by Robert Hagstrom. The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom and Enlightenment by Guy Spier. When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein. And last but not least Dear Mr Chairman, Boardroom Battles and the Rise of Shareholder Activism by Jeff Gramm. I have intentionally given a blend of passive and active investment book recommendations. It’s never a bad idea to educate ourselves on the merits of both investment strategies. Another fantastic resource is JP Morgan Guide to the Markets. A reasonable level of investment knowledge is required to understand some of the books and most definitely JP Morgan’s Guide to the Market. I find the Animal Spirits podcast hosted by Michael Batnick and Ben Carlson informative and entertaining. All of Warren Buffets shareholder meetings going back to 1994 can be found under Enceladus Capital on iTunes. This week’s movie recommendations are The Big Short. The movie follows a number of opportunistic investors who are betting against the American housing market. The movies characters bring a dull topic to life and portray a glamourous yet reckless industry culture where governments, regulators and big business were asleep at the wheel.
Link to Spotify podcast episode: https://open.spotify.com/episode/7wYxDkZcfAnonGYnNWn4nf?si=0c4404a663884495
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s1-e8-investing/id1539630506?i=1000504395271
For personal financial planning advice email email@example.com or call (01) 539 2670.