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Still remember the three levers of financial independence? Income, Expenses and Investing. In this letter, we will focus on how to invest your money.
Why not first focus on income? Simply because I personally feel that for the three levers of financial independence the order of importance is 1) expenses, 2) investing and 3) income.
There is one part to investing which can seem like magic and I will explain what it is during this letter. However, it is important to understand that there is not one right way for investing. There are tons and tons of books on this topic and everyone has a different philosophy.
The process I will describe is built for the long-term. It will not make you rich over night, but will help you accelerate your path to financial independence step-by-step. Again, if you are looking for a get-rich-overnight solution, then throw these letters away and start searching for that rich Russian oligarch.
First, I want to walk you through the different investment types and then discuss their advantages and disadvantages. Where is the magic you ask? Be patient and we will get to it soon (can you feel the suspense?).
Investment Type Number 1: Individual Stocks
Every company in the world belongs to someone. Private companies belong to individual people, families or investment companies. You and I cannot invest in these companies without knowing someone who knows someone who is willing to sell their stake.
However, public companies are publicly traded on a stock exchange. That means that each public company has a specific number of shares and the more shares you own, the more you own of the company. For example, if Chocolate and Money Ltd has 100’000 shares and you own 3’000 of these shares, then you own 3% of Big Ben Ltd. Following me?
The great thing about publicly traded companies is that anyone with money can buy their shares through an online broker. Each share will be traded on a stock exchange and will have a specific price. But you need to understand that this price can go up or down. The more people want to buy shares of this company, the higher the price goes. The more people want to sell shares, the more the price falls.
For example, if you own 3’000 shares of Chocolate and Money Ltd. and the price of one share is CHF 10, then your shares are worth CHF 30’000 and this is the amount you would get if you wanted to sell all these shares.
If suddenly the news comes out that the CEO committed fraud, then most likely the share price will drop, let’s say to CHF 7 per share. Suddenly your 3’000 shares would only be worth CHF 21’000.
On the other hand, if the sales numbers and profit of the company have grown beyond expectations, then the share price might go up (e.g. to CHF 13) and your shares would increase in value as well (e.g. to CHF 39’000).
When you own shares of company you can earn money in two ways. A) the share price goes up (naturally, you can also lose money if the share price goes down) and B) the company pays dividends.
Public companies always must decide what they want to do with the profits that they generate. They can re-invest them into the business to grow sales and profitability, or they can hand it out to the owners (aka the shareholders). This is called a dividend.
In our example, if Chocolate and Money Ltd made an annual profit of CHF 1 mio last year and decided to keep 50% of the profit and pay the other 50% to the shareholders, then CHF 500’000 would be paid out as dividends. In our case, you would receive 3% of CHF 500’000 which would be CHF 15’000.
Investment Type Number 2: Index Funds
Now let’s assume that you do not want to choose individual stocks to invest in, but you would much rather prefer to own a little of every company in the US or only the top 50 companies in Europe. Then you can invest in an index fund.
Index funds consist of pre-defined baskets of companies. For example, the index fund Vanguard Total Stock Market Index Fund (VTSAX) consists of all publicly traded companies in America, weighted by their size. Right now, that would be around 3500 companies in America. The largest companies have a larger weight in the fund, for example Microsoft makes up 4.8% of the whole fund.
Another example is the Euro Stoxx 50 Index which consists of the largest 50 public companies in the Eurozone. Therefore, if you buy one share of the Euro Stoxx 50 Index fund, you own a little piece of each of the largest 50 public companies in the Eurozone. If in total, the shares of these 50 companies go up, then your share of the index fund will go up. Similarly, if the shares of these 50 companies go down, then your share of the index fund will go down.
These are just two examples. There are tons of different index funds out there. Some are country specific like VTSAX, others track a specific industry such as healthcare or technology, and even others focus on specific topics such as sustainability.
The great thing about owning index funds is that you are not dependent on the performance of one individual company. For example, if you own a share of VTSAX, you are not just dependent on the performance of Microsoft. If Microsoft’s shares go down, but the shares of Amazon go up, then you do not lose money.
In essence, index funds spread your risk across a much broader basis than owning shares of one single company.
The big question remains: should you invest in individual stocks or in index funds? And within each of these, which stock or index fund should you choose? To answer these questions, let’s first look at one other investment type before we move on.
Investment Type Number 3: Bonds
Bonds are not as easy to understand as stocks, so let me bring back Nice Guy Andy and Bad Ass Mike to explain the concept of a bond in simple terms.
Because of the economic crisis, Bad Ass Mike lost his job and is in financial trouble. He needs money desperately. He calls up his old friend Nice Guy Andy and asks him to loan him some money. Andy agrees to give Mike CHF 60’000 so that Mike can at least cover the expenses for his ultra-expensive apartment for one year. They agree on the following conditions:
- Andy will loan Mike an amount of CHF 60’000 on 1 Jan of Year 1.
- Mike must repay the total amount of CHF 60’000 on 1 Jan of Year 2 in full.
- In addition, Mike must pay a “rent” every month for using Andy’s money. This rent will be 1% of the total CHF 60’000, i.e. CHF 600, every month.
You can imagine the CHF 600 as being like a rent. Instead of renting an apartment or a house from Andy, Mike is renting the CHF 60’000. In this example, Mike is the “issuer” of the loan.
Why is Andy asking for rent? Because Andy is taking a risk. If Mike goes bankrupt between
1 January of Year 1 and 1 January of Year 2, then Andy will not get his CHF 60’000 back, because Mike will have no money to repay the loan. For taking this risk, Andy wants to be compensated with a rent.
This concept is a bond, except that instead of Mike being the issuer, bonds are normally issued by governments and corporations, and the duration of bonds can range from 1 year up to 50 years.
In a normal case, the riskier the situation of the issuer of a bond (i.e. Mike in our example), the higher the rent, also called interest rate, must be. The higher the risk, the more money you want.
Remember, with stocks and index funds you earn money by the stock price going up and companies paying dividends. With bonds, you earn money because of the rent.
Other Investment Types
Next to stocks, index funds and bonds, there are also other investment types such as gold, real estate funds and commodities. The only other investment type that I would consider for my portfolio is gold. I will not go into these types of investments as I do not have any experience with them.
However, I do not believe it to be necessary to include them in your investing strategy. In the end, we are looking for a simple investment strategy where you do not have to think too much and which is easy to implement. In my opinion simple is best, that is why I suggest sticking with the three investment categories introduced here.
Where to invest: Stocks / Index Funds vs Bonds.
First, let’s compare the asset class of stocks against bonds. When I talk about the asset class of stocks, then I am putting both individual stocks and index funds in one bucket. Both are stocks: the first is just an individual stock of one company, the second is a bucket of stocks of multiple companies.
Let me show you some data from 1960 to 2019 for the US and the performance of stocks vs bonds. All track the performance of CHF 100 invested at the beginning of 1960.
My initial reaction when I saw this graph for the first time: Stocks rock!
Over a long period of time stocks clearly outperform bonds. They have a higher rate of return and therefore increase your portfolio faster than investing in bonds.
Remember, a rate of return tells you by how much your investment would have increased in one year. So, for stocks, the average annual rate of return was 11.34% from 1960 to 2019. Therefore, CHF 100 invested in stocks would have increased on average by CHF 11.34 every year to CHF 111.34. In summary, if you had invested USD 100 in the S&P 500 in 1960, these USD 100 would have multiplied into USD 31’235 by the end of 2019 (vs. USD 11’034 for bonds).
“Ok Mr C&M, let me throw all my savings into stocks” is what you are saying right now?
Before rushing into conclusions, let us look at the data a little closer. On average, stocks have a higher average rate of return than bonds (11.34% vs 8.42% for corporate bonds).
However, at the same time they are much more volatile. This means that in one single year you can lose much more than when you are invested in bonds.
For example, in 2008 stocks fell by 36.55% in one year alone. That means if you had invested USD 1 mio in stocks, after just one year your investment would have been reduced to USD 635’000. That is a minus of USD 365’000 dollars in one year!
Personally, I would have been close to heart-attack looking at that reduction, especially not knowing how fast they would have recovered. In the same year, bonds increased in value by 1.37%.
Would you have been able to sleep well at night when from 2000 to 2002 stocks first fell by 9%, then 12% and in the third year by 22%, also reducing an initial savings of USD 1 mio to USD 632’000? That is three straight years of seeing your savings fall. Bonds would have increased your investment to USD 1.1 mio had you invested everything in bonds in the same three-year period.
“Ah right, I do not want an emotional roller coaster. Let me put everything in bonds”.
Hold it right there. Before making any decisions, let’s summarize what we have learned.
Over a long period, stocks outperform bonds, meaning they let our savings grow faster than bonds. However, bonds are less risky and do not go on roller coaster rides.
The key is to understand in which phase of your life you are and based on this decide how much to invest in stocks and how much to invest in bonds.
If you are building up wealth (Wealth Accumulation Phase), invest most of your money in stocks.
If you are close or at retirement (Wealth Preservation Phase), invest in both stocks and bonds.
During the “Wealth Accumulation Phase” invest between 80% and 100% of your savings into stocks and the rest into bonds. This is the phase where you still have a nice income from a job every month and your main goal financially is to pump more and more money into your investments.
During these times, you can handle the financial turmoil and you are investing for the long-term (20+ years). You do not care about 30% drops in individual years, because you know that the market will recover eventually and give you a good average rate of return in the long-term. Plus, you are earning a pay-check which covers your normal day-to-day needs.
During the “Wealth Preservation Phase” you do not have any consistent income anymore, but you are using money from your investments to live. This means you do not like risk that much anymore and you need your investments to be more stable.
In this scenario, it is recommended to have somewhere between 40-60% in stocks and the rest in bonds. This way you can still take advantage of the growth of stocks and keep your investments stable by mixing some bonds in there.
Once a year I would look at your investments and do a so-called portfolio rebalancing. This means that on a fixed day per year (e.g. your birthday) you look at your portfolio and see how the percentages have changed. Stock prices can go up and down so your percentages will change.
If you are aiming for an 80% stock / 20% bond portfolio and you realize that your portfolio has shifted to 70% stock / 30% bond, sell some bonds, invest it in stocks and get the percentages back to the level you want. The same is true vice versa. Of course, if you invest 100% in stocks, then this rebalancing will not be needed.
How often you do this rebalancing does not matter. Research showsthat there is no material difference between rebalancing once per year or once per month.
My advice: do it once per year and then “forget” about your portfolio until the next year. Do not look at the performance of your investment and play dead for a year so to speak. This also saves you a lot of emotional turmoil in the case of a financial crisis and your portfolio going down.
You will not be tempted to sell any of your portfolio, except maybe during that one time a year when you look at your investments.
The last comment I want to make in this section is that you could also replace bonds or part of your bond investments with gold. Gold is a very controversial investment vehicle and has been quite volatile in terms of its performance.
Some people think it is a good investment, others think it is a bad investment. The only thing most everybody agrees on is that it is good to have some gold when stock markets crash or go on roller coaster rides. People tend to invest in gold when they do not trust the financial system.
Therefore, it is an excellent investment if you want to diversify your portfolio and have some stability in times of crises. However, I would avoid putting more than 10% of your investments into this category.
Picking Stocks and Timing the Market
“Ah I have the solution, I will just sell my stocks when they are at the highest level and buy them again at the lowest level, don’t worry about it bro”. Or you might be thinking: “Don’t you worry, don’t you worry child, I will only buy the good stocks and sell the bad stocks”.
Yeah, good luck with that. If it were that easy, then everyone would be doing it and getting filthy rich. The following is key and it is best to burn it into your mind:
Successfully timing the market and picking stocks are both near to impossible in the long-term. Only absolute geniuses like Warren Buffet, the Oracle of Omaha, can do it consistently.
You are not one of them. Neither am I. Accept it and deal with it.
Why is it so difficult you ask? You never know when a market or an individual stock will go up and when it will go down. You just do not.
It is a pure guess.
Professional investors try it all the time. And while they may succeed occasionally, maybe even over a couple of years, no-one is able to do it consistently over long periods of time (10+ years).
To time the market profitably, you need to be super lucky twice: First you need to have a “golden nose” when selling your stocks at their highest level, which is already a great feat in itself. But then in order to make a great profit, you have to be twice lucky in buying stocks again at the bottom.
Let me give you one story which will help make my point even further, both for timing the market and picking individual stocks:
Fidelity is one of the largest asset management companies in the world, meaning people can invest money in their products, such as index funds and other financial products. In 2014, they performed an internal reviewof their customers and their success for the period between 2003 and 2013.
The results sent shock waves through the whole financial industry. Who do you think were the most successful investors during this 10-year period?
The most successful “investors” were people who were either dead or who had forgotten that they had money invested with Fidelity. These are the two most extreme cases of not timing the market and not picking stocks.
Please note that this analysis included all kinds of investors, including professionals who pick stocks for a living. They could not outperform dead people over 10 years.
Now I am not suggesting that you kill yourself or forget about your investments. What I am saying is that you should not try to time the market or pick individual stocks. Choose an index fund (aka you buy a basket of companies rather than just one company) and play dead.
Do not sell your index fund, especially not when it dropped by 30% in one year. Just let it be. It will recover.
In these cases, it is important to not freak out and sell anything, no matter how difficult it is emotionally.
Remember that 36% drop in 2008? If you had invested USD 1 mio right before the stock market crashed, your investment would have been reduced to USD 635’000 within a year.
Guess what?! the full amount was recovered within four years and more than doubled within 10 years. Your original USD 1 mio was worth USD 2.2 mio in 2017 and that is your worst-case scenario if you had done nothing with your money.
If you had invested some more money in the months and years after 2008, you would have recovered much faster than those four years.
I can guarantee you that the next stock market crash is coming. When? No-one knows.
You do not. I do not. And the so-called experts in news shows do not.
Just be sure to keep on pouring money into the stock market when a crash comes. Do not sell anything, but invest. My view is that when a crash comes, stocks are on “sale”. They will recover back to original prices, but you have this unique chance of buying them at a discount.
Investing in Index Funds: How to Choose?
Now we have talked about stocks and from the discussion above you know that you should not be picking individual stocks, but that you should be focusing on index funds. But what kind of index funds? A technology index fund? One just focused on stocks in Bangladesh for whatever reason?
The answer is again simple:
Focus on expenses.
Broadly speaking, there are two different types of funds: passive index funds and active funds.
Passive index funds simply track a market or a basket of companies, such as the entire American stock market (e.g. VTSAX) or the entire Swiss market (e.g. SPI index). No-one is picking stocks.
Active funds are actively managed by investment professionals who selectively choose companies to invest in. This means that they buy and sell companies based on their own analyses and own judgement.
Every fund, no matter whether active or passive, has an “expense ratio”. This is the cost you need to pay the investment firm for managing the index fund and is expressed as a percentage of your investment. For example, if your fund has an expense ratio of 0.5%, you will pay them 0.5% of your money invested every year, so CHF 0.5 for every CHF 100 invested.
Expense ratios for passive index funds are always lower than for active funds. For passive index funds, they are somewhere around 0.2%, whereas for active funds they are normally somewhere between 0.5% and 1.0%. Seldom do they exceed 2.5%.
Why are active funds more expensive? Because they need to cover more costs.
Passive index funds track a bucket of companies. No trading happens. Little to no employee costs need to be covered, because no effort is required by the investment company to manage the fund.
Every time a manager in an active fund sells or buys a stock, he or she needs to pay a so-called transaction fee to the stock market. The more they sell and buy, the more costs they generate.
Also, they spend a considerable amount of time analyzing stocks and picking the “right ones”. Therefore, they need to cover their own salary as well. This means that active funds need to have a higher expense ratio to cover all these additional costs.
However, they “promise” that they generate better returns than a passive index funds.
The word promise is key in the last sentence, because the active fund manager never guaranteesa specific performance. If they underperform the passive index fund, they still get the full higher expense ratio. It is not lowered or forfeited.
If they do not achieve a high rate of return, they will also not give you the “missing” money. This means that everything is just a promise. The investment manager always gets paid, no matter how much of your money he loses.
And let’s just be clear, he is losing Your money, not his own.
But do active funds outperform the market?
Remember who the most successful investors were in the Fidelity study? Exactly, dead people and those who had forgotten their investments. Not active fund managers.
So, which passive index fund should you focus on? As mentioned before, focus on expense ratios.
Let’s play with some numbers and bring back Bad Ass Mike, Nice Guy Andy and Smart Pants Susan.
Forget all the lifestyle choices they have ever done and just assume that at age 30 all three of them have saved up CHF 100’000 and want to invest them 100% in stocks and funds as they are all in the Wealth Accumulation Phase of their lives. They make the following decisions:
On one of his vacation trips to Ibiza, Bad Ass Mike met an investment manager at a bank, Sneaky Pete.
Sneaky Pete manages an active fund and explains to Bad Ass Mike all the high level, super cool analyses that he does to choose “good stocks”. Bad Ass Mike is so impressed that he invests his CHF 100’000 in Sneaky Pete’s active fund, The Cool Guys Fund. The expense ratio is 1.0%.
Nice Guy Andy does not like the concept of active funds and is looking for a passive index fund. So, he sets up a meeting with his local bank advisor at UBS, where he has all his money.
The local advisor tries to sell him active funds, but Andy stays strong and sticks with a passive index fund. They settle on the UBS SPI ETF, which includes all the stocks on the Swiss Market. The expense ratio is at 0.15%.
Smart Pants Susan does not even call up her banker, but goes online and just searches for low-cost index funds. She then signs up for an online broker and ultimately chooses the passive index fund with the lowest expense ratio she can find: Vanguard’s VTSAX which includes all stocks on the American market and has an expense ratio of 0.03%.
Let’s show for both a 10-year period and a 30-year period how much their money would have transformed into by the end of these periods for different average annual rates of return:
I highlighted the 10% average annual returns because the S&P 500 returned an average of 9.8% from 1928 to 2016. The S&P 500 is often used as a benchmark for passive index investing.
If all three funds have the same performance, and that is a big IF, the differences after 10 years are not major but still quite significant.
For example, with a 10% average annual return the difference between Mike’s investment and Susan’s investment is CHF 24’000. That is 24% of their initial investment. The difference between Andy and Susan is only CHF 3’000, which is still a 3% difference of their initial CHF 100’000.
The 30 year figures become very interesting. For the same average annual return of 10%, Mike owns CHF 438’000 less than Susan. That is a whopping 438% of their initial investment! Basically, Sneaky Pete “stole” CHF 438’000 from Bad Ass Mike by only performing as good as a normal index fund. In my opinion, even the difference between Andy and Susan is quite significant (CHF 61’000, 61% of the initial CHF 100’000).
Of course, the big assumption in this example is that all three funds have the same annual rate of return. In reality, they will be very different. But remember the Fidelity study?
Dead people perform best. No-one can beat passive index investing by picking stocks during a ten-year period, not to mention a 30-year period.
Let me quote some lines from the blogof passive index investor JL Collins:
“As you may know there is a school of thought that suggests that even the super-star investors, think Warren Buffet, are simply lucky. Even for a hard-core indexer like me, that is tough to wrap my head around. Yet there’s research that suggests that only the very top-tier of money managers outperform and that when they do it is almost impossible to distinguish skill from luck (…).
Many years ago, I had a martial arts instructor who was talking about effective street fighting. On the subject of high kicks, he had this to say: “Before you decide to use kicking techniques on the street ask yourself this question: ‘Am I Bruce Lee?’ If the answer is ‘no’ keep your feet on the ground.” Good advice when you’re playing for keeps.
The point is this: As cool and effective as kicks look in the movies, tournaments and in the dojo, on the street they are very high risk. Unless you are both very skilled and significantly more skilled than your opponent (something unknowable in street fighting or investing) they are likely to leave you exposed and vulnerable. Even, and this is critical, if you’ve had success with them before.
So too with investing. Before you start trying to pick individual stocks and/or fund managers ask yourself this simple question: “Am I Warren Buffett?” If the answer is “no,” keep your feet firmly on the ground with indexing. (If the answer is “yes,” it’s nice to have you here, Warren.)”
Not only does an active investor generally perform worse than a passive index fund, they also charge a hell of a lot more. Of course, it is much cooler to tell your friends that you have invested in this cool and hip active fund. My own philosophy is:
Be boring. Invest only in low cost index funds. Nothing else.
Except for some bonds based on the Wealth Conservation Stage of your life.
I am not saying that this is the only way to invest. For me, it is the safest and simplest way to invest, and have good returns in the long-run.
Again, we are not trying to get rich overnight, we are trying to make many good small choices which will bring you financial freedom in the long-run.
My own portfolio looks like this:
- 25% in low cost index fund for Switzerland
- 25% in low cost index fund for EU
- 25% in low cost index fund for Asia
- 25% in low cost index fund for the US
One of the easiest ways to invest in these index funds is to go through an online broker. You can search for these online and open an account relatively easy. Again, make sure that you use a low-cost broker. Those fees just eat up so much of your gain otherwise.
Compounding Interest: Time Value of Money
So where is the magic you might be asking yourself right about now. “He promised me magic beans!”.
Well I did not exactly promise magic beans, but I did show you the magic of “compounding interest” when we looked at the 30-year comparison for expense ratios. Let’s take a closer look at Susan’s rate of return again:
If her index fund VTSAX had achieved an 10% average rate of return over 30 years, her investment would have grown to?
CHF 1.7 mio! That is 17 times what she originally invested. Crazy!
Now even if she had below average returns, such as 7%, her investment would have grown to USD 754’000. Still over 7 times what she originally invested. Why does it increase so much in both scenarios?
The answer is “compounding interest”. Let me explain.
In the first year, Susan invested CHF 100’000 (the base). Let’s assume that she generates 10% every single year and ignore any expenses for the sake of this explanation. In her first year, she will have generated an additional income of 10% times CHF 100’000 which is CHF 10’000 (the return).
When she now starts in year 2, her new base will be the base of the previous year and its return, so CHF 110’000. In year 2 she will then generate 10% on the new base which is CHF 11’000. In year 3, the new base is then CHF 121’000 and so forth.
The magic lies in time.
The longer you are invested, the longer your investment has time to compound and generate returns on even higher bases. That is why a Swiss franc invested today is worth much more than a Swiss franc invested in 10 years time. Because it has more time to generate interest and increase the base.
It is not about timing the market, it is all about time in the market.
See the magic now? Did I promise too much?
To paraphrase the words of JL Collins: Make sure to invest in low-cost index funds and then forget about them. 30 years later when you look at your investments, make sure to have a cardiologist next to you, just in case you have a heart-attack by looking at those large numbers.
In general, I would highly recommend reading JL Collins’ book “The Simple Path to Wealth”. He is one of the gurus of the FIRE community and all the concepts explained in this letter are explained in much more detail in his book. Alternatively, you could also just read his “Stock Series” on jlcollinsnh.com which will give you the same information.
Conclusion: How To Invest Your Money
One last point to mention before we close out this letter: putting money in the stock market can be emotionally quite a roller coaster. In some years, you will gain 30-40% on your investments. In other years, you will lose 30-40% of your money.
In those situations, it is important to not pull out your money, but to stick it through. Just accept that at some point in your life there will be a market crash, maybe even twice or three times. In those cases, it is important to just play dead. In the long-run you will be better off for it.
Let’s summarize the key points of this letter:
- Do not time the market and do not try to pick stocks.
- Choose an allocation of stocks vs bonds based on your stage in life. Rebalance once per year.
- Invest only in low cost index funds.
Keep your expenses low to generate savings and invest those savings based on the rules above and you will be able to retire faster than you think. I hope that you are now clear on how to invest your money in a simple way.
Now that we have covered expenses and investing, let’s focus on the last lever of financial independence: Income.
- If you have an investment portfolio, review your investments for expenses and adjust your portfolio if necessary.
- Mentally makes sure that you are prepared to not take out money from the stock market in case of a crash. Maybe even create a large sticker and hang it on the fridge: “Do Not Sell During a Stock Market Crash!”
- Choose a portfolio allocation based on our stage of life and invest your savings accordingly.
Do you have any questions, concerns, feedback or constructive criticism? Let me know in the comments or send me an e-mail at firstname.lastname@example.org. Anything is highly appreciated.