The Rational Investor, Part I

post by wubbles · 2013-05-30T00:32:05.691Z · score: -2 (11 votes) · LW · GW · Legacy · 29 comments

First off, note that I am not in possession of any of the licenses that entitle me to call myself a financial advisor. However, the approach to investing I will present in this article is endorsed by many economists, Warren Buffet, and Vanguard. I personally follow it, and you can too.

What is the goal of investing? To turn money today into money tomorrow. There are several ways to do this, and people on Wall Street are constantly inventing new ones. What is more, you have professional competition in this activity: people who want to make money today into more money tomorrow then is otherwise possible. You are producing a commodity, and the better you understand this, the better investing decisions you will make.

What are the ways to make money today into money tomorrow? There are many ways. But we want to make money today into money tomorrow in the most efficient way that involves the least amount of worry.  After all, we have specialised in some other area of human activity, and are not good at this area. So we should pick an investment that requires no upkeep, no worry, and good returns. This rules out real estate entirely, and the last criterion rules out letting money sit there.

So how does money today turn into money tomorrow? First you pay taxes on the money today, then give the money today as a loan (called "buying a bond")  to someone who needs it to do something that will be profitable. Or you can purchase a bit of an enterprise that makes money (called "buying stock") and let it make money, and pay you in the form of dividends or appreciation of shares, as the company grows. Then you sell what you have or get payed back and get taxed again.

But what if they don't pay me back or the company fails? Then you are screwed.

So what if I put a little bit of money in each loan and each share? Then the failure of each one won't hurt you that much.

Okay, I'll do that! Got a few million lying around?

Nope. So I can't do that? Nope, you can't. Bonds come in units of $1000 face value, and stocks in lots of 100.

Wait, what if I got a bunch of my friends together, and we pooled our money? That's called a mutual fund, and you can buy them. But the person who manages the fund charges you money, and that comes right out of the money tomorrow, and sometimes out of the money you put in.

So I should try to minimize these charges? Exactly!

Someone promises me higher returns for his fees! He's lying: academic research has shown no evidence of after-fee returns beating the market in general. After all, wouldn't you keep this secret for yourself if it really worked? He gets paid the same even if you lose all your money.

So what is the fund with the lowest fees? Well, the Vanguard Admiral Shares S&P 500 has fees of 0.05% of your money. Check out the prospectuses before you invest: they list out all the things that can go wrong.

But I don't like the risk! Remember bonds? You are more likely to get paid back, but the price is lower returns.

But I want diversification! So buy a bond mutual fund as well. And as usual there are fees you want to avoid.

Do I need anything else? According to CAPM, no. (We can talk about international stocks, but the S&P 500 do business worldwide, and there are lots of details about the costs of diversification etc.)

But how much do I put in each? That's a research question. But there is plenty of advice on this one question, and it doesn't cost you anything.

What about taxes? That's between you and the IRS. But sign up for a 401(k), maximize it, put as much into an IRA as you can, consider carefully the Roth IRA, think about which bonds you want to hold, and don't trade!

Don't trade? Don't trade: remember, you have competition. Trading hurts retail investors: it is expensive and they aren't good at it.

But I have a really good idea! Then work on Wall Street and risk someone else's money. Best part: you get paid either way.

But I want to change which mutual fund I hold to one that got more returns! Don't do it: the high returns don't last. Reversion to the mean is a powerful force.

I want to move to bonds as I get older! Still don't do it: you get taxed on the realized gains. It's easier to buy new then to sell old.

So what should I do? Think of your portfolio as one thing, and think about how to minimize taxes and fees as you go from where you are now to where you want to be. Then do it. But think first! Buying doesn't destroy the basis the way selling does, and overbalancing in tax-deferred accounts cancels out imbalanced non tax-deferred accounts.

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Sources: http://www.vanguard.com/bogle_site/sp20051015.htm, 

http://online.wsj.com/article/SB10001424053111904583204576544681577401622.html

Buffet endorsing the index fund http://www.berkshirehathaway.com/letters/1996.html

http://johncbogle.com/wordpress/wp-content/uploads/2011/09/The-Professor-The-Student-and-the-Index-Fund-9-4-11.pdf

Similar sources exist everywhere. Ask your local economics professor what his investments are, and I will be willing to bet 10:1 odds that they are majority placed in an index fund.

 

29 comments

Comments sorted by top scores.

comment by [deleted] · 2013-05-30T05:57:10.536Z · score: 13 (13 votes) · LW · GW

by many economists, Warren Buffet, and Vanguard.

Warren Buffett's name is spelled with two Ts.

What is the goal of investing? To turn money today into money tomorrow.

You're skipping over a few important things (cash, savings accounts, CDs - which are too conservative for almost everyone, even retirees) and terrible ideas like speculation (e.g. gold). You're also skipping over inflation, which is important to understand long-term returns.

Oh, you do mention "letting money sit there" in passing, but this essentially assumes that the reader understands what "sit there" refers to.

Got a few million lying around? Nope. So I can't do that? Nope, you can't. Bonds come in units of $1000 face value, and stocks in lots of 100.

The bit about stocks is simply incorrect. Brokerage accounts allow you to purchase individual shares, so unless you're investing in Berkshire Hathaway's class A shares, you can buy anything.

(The one time I invested in an individual stock, other than employer stock awards, I lost over $9000 before I came to my senses. Now I'm fully invested in two mutual funds, but when I held that stock, my shares weren't a multiple of 100.)

After all, wouldn't you keep this secret for yourself if it really worked?

Not quite - you'd start a fund, and earn fees in addition to the returns on your own money. Then you'd eventually have to close the fund to new investors to prevent it from becoming too big.

Buying doesn't destroy the basis the way selling does

"Basis" is incomprehensible to newbies.

comment by shminux · 2013-05-30T03:24:25.304Z · score: 10 (10 votes) · LW · GW

TL:DR:

  1. Make a will
  2. Pay off your credit cards
  3. Get term life insurance if you have a family to support
  4. Fund your 401k to the maximum
  5. Fund your IRA to the maximum
  6. Buy a house if you want to live in a house and can afford it
  7. Put six months worth of expenses in a money-market account
  8. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement
comment by Larks · 2013-05-30T21:14:12.820Z · score: 1 (1 votes) · LW · GW

Surely 7. should come before 6., and probably 4. and 5. as well.

comment by wubbles · 2013-05-30T23:04:59.816Z · score: 0 (0 votes) · LW · GW

No, IRA's avoid a tax which the other investments don't, so money in an IRA is worth more than money outside. There is a cost, namely you have restricted access to it.

comment by 9eB1 · 2013-05-31T04:28:09.470Z · score: 1 (1 votes) · LW · GW

It's worth pointing out that the money you put in there can still be held in a money-market account or similar, and that it acts as an emergency fund because you can withdraw it or take loans against it, subject to modest penalties.

comment by Alsadius · 2013-05-31T08:02:57.890Z · score: 0 (0 votes) · LW · GW

Re #8, I actually prefer the rule of thumb of having (your age)% in a bond fund, and the balance in stocks. It's a nice transition towards conservatism with age. Also, this is what you should do with the money inside a 401k as well.

comment by johnjohn · 2013-05-30T09:39:05.537Z · score: 0 (0 votes) · LW · GW

Putting six months worth of expenses in a money-market account seems like a needless 'mental accounting' bias. You can easily and quickly liquidate a portion of your " 70% in a stock index fund and 30% in a bond fund" if you need the cash in an emergency.

The 70% stocks 30% bonds seems somewhat arbitrary. I remember reading a paper once that advocated allocating 130% equities through the use of leverage. Of course, there is always the chance that the stockmarket underperforms over the long run. But, that's the risk that you are ostensibly being compensated for.

comment by shminux · 2013-05-30T15:20:54.808Z · score: 3 (3 votes) · LW · GW

These are general guidelines/priorities for safe and effective financial planning, not the "best possible" investment. They are apparently vastly better than what most americans have now: no will, cc debt, unaffordable mortgage, no (liquid) savings, inappropriately conservative, reckless or high-fee investment etc. You can certainly optimize and customize these guidelines, but you have to know what you are doing, which most of us don't. These guidelines are probably not quite suitable for places other than the US.

comment by RichardKennaway · 2013-05-30T07:23:23.387Z · score: 7 (7 votes) · LW · GW

Is there someone who can translate the US-specific parts of this advice into the UK context? We don't have 401(k)s or IRAs, I'm not sure about mutual funds and money markets, and as far as I can see from a quick search, I can't deal with Vanguard directly for less than £100,000, only through third parties with their own charges. So while the general form of the advice might be sound, I can't translate it into any concrete actions.

comment by Alsadius · 2013-05-31T07:58:05.647Z · score: 0 (0 votes) · LW · GW

Index funds are available through a few million places these days - check your local bank, if it's big enough to have an investments arm.

As for the 401k bit, that's just tax avoidance(the single most important concept in finance). 401ks are tax shelters, where money can grow completely untaxed until withdrawal. I'm sure the UK has an equivalent - what's your national retirement account of choice?

comment by Larks · 2013-05-30T21:13:04.854Z · score: -2 (2 votes) · LW · GW

I can't help with most of it, but I can tell you that UK stocks are generally much cheaper - more like £1 or £2, as opposed to $100 in the US.

Maxing out your ISA is probably a good bet; you should be able to buy an index fund "inside" the ISA.

disclaimer: this is not financial advice, I am not a financial advisor

comment by [deleted] · 2013-05-30T21:37:33.368Z · score: 3 (3 votes) · LW · GW

I can't help with most of it, but I can tell you that UK stocks are generally much cheaper - more like £1 or £2, as opposed to $100 in the US.

Share prices are essentially meaningless (with obvious exceptions at the ends of the spectrum: Berkshire Hathaway Class A and penny stocks). It's the conversion ratio between actual money and notional units of a company, and the ratio can be changed without affecting anything in the real world (stock splits). Basically, the only issue is that high share prices (e.g. GOOG at $870) make purchases somewhat inconvenient since brokerages are stupid about fractional shares for individual stocks (as opposed to mutual funds, where you give them a certain amount of money, and they give you the right number of fractional shares down to thousandths).

Real changes in share prices are, of course, meaningful.

comment by Decius · 2013-05-30T04:46:05.124Z · score: 4 (4 votes) · LW · GW

Until you know what you will do with money tomorrow, investing advice is premature.

I want money tomorrow because I have specific dreams and goals that require money to implement; I should allocate money today in the manner which has the best chance of providing sufficient money tomorrow to support those dreams and goals. That might involve being heavily involved in high-risk investments, because the small chance of being wildly profitable is the only chance of having enough money to fund my dream. It might mean putting everything into FDIC-insured savings accounts, because that has the lowest chance of losing too much money to fund my dream.

It would be pure happenstance if the highest expected return also had the highest probability of returning a total of X or higher.

comment by AspiringRationalist · 2013-05-31T04:17:39.874Z · score: 2 (2 votes) · LW · GW

stocks in lots of 100.

No, they don't. Back in the days before online brokerages, (I'm not sure when the practice was abandoned), it was customary for brokers to charge "odd lot" fees for trades that weren't multiples of 100 shares, but now you will have no trouble trading any small-ish whole number of shares.

Of course, if you want to trade derivatives on stocks, then you are still generally stuck with lots of 100.

comment by roland · 2013-06-02T18:52:14.816Z · score: 0 (0 votes) · LW · GW

but now you will have no trouble trading any small-ish whole number of shares.

Usually those are priced differently and will be more difficult to buy/sell. Most trading still goes on in lots of 100.

comment by Alsadius · 2013-05-31T07:48:43.031Z · score: 0 (0 votes) · LW · GW

But the cost of derivatives is generally so much lower that it's not really a big deal.

comment by AspiringRationalist · 2013-05-31T22:26:29.781Z · score: 0 (0 votes) · LW · GW

Although the price of options is lower, the fact that you have to trade in blocks of 100 is still a big deal, because in absolute dollar terms, you are still as sensitive to price swings#Delta) as though you owned significantly more shares than that money could buy. This volatility can make it harder to stay solvent longer than the market stays wrong.

comment by Alsadius · 2013-06-01T05:42:36.895Z · score: 0 (0 votes) · LW · GW

If you don't value leverage, you shouldn't be playing in the options market in the first place.

comment by Randy_M · 2013-05-30T19:59:11.942Z · score: 2 (2 votes) · LW · GW

We were told by our investment firm at a seminar at work to rebalance our accounts often. They had a justification for it (soemthing about having the percentage you want in each because low and high earning ones won't be that way consistently) but I suspect their fees are the real reason.

comment by Alsadius · 2013-05-31T07:55:00.352Z · score: 2 (2 votes) · LW · GW

Rebalancing is actually a good idea for two reasons. One, if you had a target asset allocation for a good reason in the first place, you want to keep to it. If you want 50/50 stocks/bonds, and your stocks double, then suddenly your portfolio is a lot more stock-heavy and volatile than you want. Two, it's a rules-based method of buying low and selling high. You're basically unloading things that have just done well and buying things that have just done poorly, which assuming some sort of regression to the mean means you're making a trading profit on net.

The average retail investor shouldn't rebalance more than perhaps twice a year, outside of extreme volatility. As you say, fees start to eat the rewards of the strategy if you do it too much. Personally, I rebalance with newly-invested funds - no trading fees, just use the new money to return to the strategic allocation. My investments are a high enough portion of my portfolio to make this easy, though, which may not be true of everybody.

comment by johnjohn · 2013-05-30T09:25:43.996Z · score: 2 (2 votes) · LW · GW

that requires no upkeep, no worry, and good returns.

It is plausibly the "worry" (or discomfort) that is required for good expected returns. For instance, CAPM, implies you are being paid to hold undiversifiable risk. You get paid for it because of people's distaste for it.

Your expected returns for a corporate bond, for example, might be because of the worry that it defaults (the extent to which this is undiversifiable, as there is a tendency for bond defaults to co-occur in bad times.), and an illiquidity premium --- in bad times when you'd like to be able to liquidate your position, you're likely to find no one who wants to buy it from you. This is why you can expect to get a return that more than compensates you for the expected loss.

This rules out real estate entirely, and the last criterion rules out letting money sit there.

You can invest in a real estate fund, which is probably a good idea for diversification purposes

get payed back and get taxed again.

typo: payed-> paid

So I should try to minimize these charges? Exactly!

Agreed: this is key.

Someone promises me higher returns for his fees! He's lying: academic research has shown no evidence of after-fee returns beating the market in general.

A lot of money managers are probably not lying in the sense that they probably do believe they have skill even if they don't. Also: some money managers probably do have skill: you just have no good way of determining which ones they are.

Do I need anything else? According to CAPM, no.

The CAPM is great in theory, but there is little evidence that it holds in practice. Within stocks, the longterm historical data shows that riskier stocks have a tendency to have lower returns. (CAPM on the other hand says undiversifiable risk will be priced; that is, you'll get paid to hold it.). There does seem to be an equity premium over bonds though (i.e., across the asset classes, but not within). Excess returns can be earned through liquidity premia, exposure to various 'factors' such as value, momentum, low vol within stocks.

Look on Google Scholar for the works of Ilmanen, Asness, Fama, Carhart, and others to find out what works in investing.

CAPM is considered to be a clever model of a world that is not the one we live in. This is probably because people have some irrational behavioral biases, do not have the utility functions assumed by CAPM, and are exposed to principal-agent problems because money managers incentives are not directly aligned with their clients.

Owning the market through an index fund is not a bad idea. But the reason why it tends to work well is because of low costs and exposure to the equity premium over bonds. When you the own a market cap weighted fund you are getting some undesirable exposures too, such as companies that are not low vol or value. Dimensional offers low cost funds with factor exposures. AQR Capital is another one to look at.

comment by wubbles · 2013-05-30T23:04:16.737Z · score: 0 (0 votes) · LW · GW

CAPM explains 70% of equity returns, Fama French model 90%, but over the 20th century it's not clear what the Fama-French factors are. I fully agree with your minor quibbles. As for upkeep and worry, yes, risk leads to return. But it is an input, and like any sort of input it should be minimized for a given level of output.

comment by Alsadius · 2013-05-31T07:48:09.083Z · score: 1 (1 votes) · LW · GW

But we want to make money today into money tomorrow in the most efficient way that involves the least amount of worry. After all, we have specialised in some other area of human activity, and are not good at this area. So we should pick an investment that requires no upkeep, no worry, and good returns. This rules out real estate entirely, and the last criterion rules out letting money sit there.

This is pretty obviously wrong. Minimizing worry usually involves investments like T-bills or money market funds, which are notable for high security and rock-bottom returns. The trick is to make the reward/worry ratio worthwhile, not to take worry minimization as a goal in and of itself.

I'm all for index funds - my own portfolio is a collection of 4 index funds. But there's a place for investments in other things. I've seen several folks do the "Buy a house near my kid's university, have them do all the tenant-management crap, then either foist it off on a property manager or sell it afterwards" investment plan, for example, and it usually works well.

comment by ChristianKl · 2013-06-03T21:25:03.088Z · score: 0 (0 votes) · LW · GW

However, the approach to investing I will present in this article is endorsed by many economists, Warren Buffet, and Vanguard

Of course Vanguard endores that investment approach. It makes money with selling those funds. Just because some people besides yourself endorse that approach.

Over the last 5 years the S&P 500 produced a return of 3.5% per year. That's not a lot. Do you believe that it will again produce a higher return? If so, what's your reason for expecting again a higher return?

I don't think that there a good reason to focus all investment capital on the 500 biggest companies the way you do when you buy S&P 500 shares. Angel investments do provide good returns for the average Angel investor: http://techcrunch.com/2012/10/13/angel-investors-make-2-5x-returns-overall/

A lot of the economy consists of small businesses. If you are a smart person you might want to find local investment opportunities that aren't on the radar of the big banks.

comment by wubbles · 2013-06-07T00:50:43.312Z · score: 0 (0 votes) · LW · GW

Small business are illiquid. They also have capital requirements that might not fit your investment needs. If you have enough money that these two problems aren't an issue, as well as the skill in finding small business that won't fail and that are on the market, and have the time to supervise them/manage them, then they could be a good investment. But that isn't a lot of people.

comment by blashimov · 2013-06-04T15:35:23.333Z · score: 0 (0 votes) · LW · GW

Isn't angel investing for the relatively wealthy? What do you do around the 10k range? Especially considering that the less capital you have, the better working relative to spending time investing becomes.

comment by ChristianKl · 2013-06-05T10:52:48.760Z · score: 0 (0 votes) · LW · GW

Around the 10k range you are right that Angel investing probably isn't optimal. On the other hand 10k doesn't pay for any retirement either.

comment by blashimov · 2013-06-06T20:19:21.993Z · score: 0 (0 votes) · LW · GW

True, so when I finally have money I guess I will take another look.