Breaking Down Capital Markets - Part 2
Starting the Investment Process - Application and Construction
Practically & Practicalities
Now that we have gone through some of the basics in Part 1 regarding the review of certain knowledge requisites, we can now turn to the practical application of the knowledge, namely, investing and creating an optimal portfolio. As intimidating and off-putting as this may sound, beginners may be happy to learn that in its simplest form, investing can represent little hassle relative to its upside. In fact, this is how we approach most situations in the financial world, through the lens of risk and return, i.e) downside vs. upside risk. For the more active investor, we will further delve into which portions of the investing process that may be more enterprisingly managed to additional benefit. As of date of publish for Part 2, I have edited Part 1 and added more content, I suggest you take a read if you have not already. Part 3 will be a more in-depth exploration that expounds the details within Part 2.
Starting the Process
The question of starting and maintaining an investment portfolio often presents itself as an onerous process, as the presence of thousands of stocks, bonds, and financial instruments contrive a sense of ostensible impossibility of entry. Fortunately, starting is usually the most difficult portion, and a relatively safe portfolio can be maintained with little direct intervention. Of course, added knowledge and purposeful tweaks can augment these returns when handled carefully. Mainly, becoming a successful investor and making financially sound decisions need not require deep knowledge of the subject, but rather senses of patience and reasoning.
**THE FOLLOWING SHOULD NOT BE CONSIDERED PROFRESSIONAL INVESTMENT OR FINANCIAL ADVICE OR A DIRECT SOLICITATION TO INVEST IN ANY OF THE SECURITIES MENTIONED BELOW, AND IS JUST FOR EDUCATIONAL PURPOSES**
For one, the process of stock investing has become more beginner-friendly than it has ever been, and when approached with a correct mindset, can be very unintimidating. As a beginner, you do not need to invest in any singular “stock", but rather, an INDEX of stocks, often called an Exchange Traded Fund, or ETF, usually without a penalty or transaction fee. For most people, this is the safest, easiest, and most economically sound decision.
While picking individual stocks may seem overtly risky, we can mitigate this process through investing in a “bundle” of stocks that has already been pre-made for us.
Consider the following example below:
The S&P500 is a stock market index of 500 large and profitable American companies that is supposed to accurately represent the healthy of the overall U.S. market. Essentially, the level of the S&P500 (Currently around $3,800) is a measure of the weighted average of the market values of these companies. Because the S&P500 is just a composite acting as a “tracker,” you could not easily invest in it prior to the existence of an ETF.
Instead of investing in a single stock or series of stocks, you can now invest in an ETF or Index Fund that tracks this benchmark or any other benchmark. Popular ETFs that track the S&P500 are available across any stock platform. Large financial instructions work to build and maintain the ETF that accurately tracks the weight and price of the index. Although the ETFs wont have the same price of the actually stock market index, the returns will be essentially the same. The S&P500 composite moving from $3,800 to $4,180 would mean any pure-index ETF tracking the S&P500 will return 10% as well.
Some well known S&P ETFS below:
VOO: $349.59
IVV: $381.77
SPY: $380.36
*The differences in prices imply nothing meaningful, these funds are essentially identical to each other.
The beauty of these instruments are thus in the power to achieve scale of diversity without paying out hefty costs, ETFs usually charge fees of less than 1%. Previously, if you were to invest in singular stocks, you would be exposed to the individual risks of those respective companies. If you were just a beginner, this may have presented itself as especially intimidating given the lack of knowledge across many fronts.
If you held three stocks before - just one going bankrupt would have destroyed your portfolio. Conversely, if out of serendipity, you stumbled upon a company that miraculously cured all disease, your portfolio may rise to the moon, as they say. That said, risk-management is crucial to any portfolio. Both scenarios are obviously, both prone to inducing extended bouts of anxiety and a precipitous descent into financial ruin. That way lies madness.
However, by investing in an ETF, you are essentially protected from the company-specific risk described above, in other words, you are diversifying and building a portfolio that, on average, when approached intelligently and patiently, goes up at a consistent pace - all-else equal.
You need not know anything special about certain stocks or the granular intricacies of stocks, but rather just carry the assumption that the U.S market will continue to exist throughout your lifetime without any very long-term major hiccups. This is the easiest and most approachable way to start investing, and represents an inherently less risky way to build your portfolio than actively picking individual stocks out.
See the comparison of the S&P ETF - SPY compared to returns on the S&P500 Composite over time
… Now What - How Much and When?
Now that we have hopefully come to the reasonable conclusion that most readers here would benefit from holding a portfolio of index funds / ETFs, we now come to the inevitable questions of How Much and When.
Like the answer to all great questions, the answer is - it depends. Although I have made the case that starting the investing process can be less intimidating and difficult that many believe, investing in the stock market does bear risk. Although stocks, on average, have only risen since the market’s inception, the implication is then, that they invariably go down as well. Luckily, we are able to approach these situations intelligently, and never let ourselves be caught off-guard, possibly putting us in the position for bargain buying. However, for one, we never want to over-invest past our liquidity, and be forced to sell stocks at cheap prices to cover our living expenses. Moreover, investing to the point where frugality is required to survive is not ideal either.
Then conceptually, we can determine that the adequate amount to invest is therefore in-between the amount of cash needed for necessary expenses and the amount of cash needed to live a comfortably. Still not concrete enough? Depending on your appetite for saving and budgeting skills, this could be between 15% to 25% of your gross income per pay-cycle. A similar exercise can be done for those who aren’t working, most ideal would be to direct a portion of your savings to an investment account, leaving yourself with 3+ months of expenses in cash. Intuitively, the most profitable situation would be to hold as little as needed for liquidity / emergencies in cash, as savings rate are currently at an abysmally low <1%. Of course, this advice is situationally dependent, and to provide a degree of flexibility, I have laid out possible scenarios which you may consider.
Consider these examples below:
You are a recent college graduate working full-time earning at least $60,000. You currently do not need to support anyone and are debt-free, but you also do not have any financial support available from family. You have $10,000 saved and estimate a 3-month emergency cash need of $5,000 including rent. In addition, you believe your job is relatively stable and will likely have a modestly appreciating salary each year. You do not foresee making any large life changes like moving, buying a house, going back to school, etc.
In this situation, we would consider your risk-bearing ability to be relatively moderate to high. Note the difference between personal risk-appetite, and the ability to bear risk. With no dependents and a stable income, the risk of you having to resort to drastic measures during a stock market downturn is much lessened. And with no foreseeable events requiring a large movement of cash, your liquidity needs are considered low, and you may opt to keep more of your money in riskier investments. Depending on your living costs, you could easily invest 15% of your salary, possibly even more each year in ETFs with likely no sleep lost. Even more aggressive savers may elect to contribute the full IRS allowed of $19,500 per year into a company sponsored 401(k) plan, or personal IRA plan, which offer even more tax benefits. In addition, college-graduates with a stable salary also do not need any form of consistent income offered by bonds, and are able to allocate at least 80-90% of your portfolio in stocks themselves, given the current low interest rate environment.
A hypothetical simple portfolio would be as follows:
$5,000 from the bank account to purchase ~120 shares of SPY at $400 each
15% of your income ($9,000 annually) to purchase 200 more shares of SPY.
It can really be as simple as that. This portfolio in itself contains ample diversification and growth prospects. We can get more into specifics later, but this can be an ideal start.
If the situation were that you happen to be in a family that was willing to provide you financial support, you could even more aggressively invest your savings as well, although this should be sorted out on a personal level first.
Example 2:
You are a recent college-graduate attending or seeking to attend higher education (MBA, Doctorate, Masters, etc). You have accumulated student debt somewhere in the range of tens of thousands of dollars. You expect to graduate in 2 - 8 years with an approximately 6-figure or more stable salary. You anticipate needing to purchase a house in 5-10 years as well. You have no dependents, and have little financial safety if you were to go “broke:"
The situation may sound familiar to you, and I commiserate; it is tough. However, with the proper intellectual approach, we can maintain as much flexibility as we want and can tailor a situation to match. For one, the ability to bear risk is strikingly low in this case, and would be even lower with any dependents. An important consideration is how much savings you have entering into this situation. If you are only able to cover your living expenses, then unfortunately investing would likely require a more stable situation. However, upon graduation and entering the workforce, you are able to apply the since principles of investing, albeit with more caution. Assuming you being making the anticipated salary, your priority should be building up emergency savings and then paying off your debt ABOVE the minimum payment, ideally within a specific timeframe that you have calculated. This is highly depending on the interest rate of the loans / debt. If we say, on average, the stock market returns 7% annually, juts comparing whether your student loans incur an annual cost lower or higher is not enough. For one, paying off student loans offers tax-deductions and is a guaranteed return, while stocks are volatile. 7% on average does not imply every year you would be returning 7%, and it may be more prudent to continually pay off your loans. However, for the purpose of this example, let us say your student loans have a 5% interest. In this case, we would recommend you first calculate the minimum payment at the very least, and expect to pay more. After netting all your expenses from your income and deciding an investing rate of between 15-20%, we would recommend taking 20-30% of that amount and putting it words paying off the debt, with the rest investing in a bundle of diversified securities expected to appreciate at an above 5% level. For the expected purchase on a house, or otherwise substantial investment, it would then be wise to invest in a safer portfolio with less volatility that, while will not return as much, will leave your portfolio with a modest up-tick in value with less volatility in time for your purchase. We will get into these types of portfolio allocations further below.
Situations are obviously complicated and dependent, and I have only outlined two of the millions of possibilities. Please reach out personally if you have a specific situation that you want input for. Do not consider anything here as professional investment advice, but rather my personal thoughts.
Ok… What about when?
The answer to this question presents more complexities than you may have thought. For decades, practitioners, academics, and regular investors have all claimed knowledge on knowing at what point the market looked attractive or unattractive to invest them. And (almost) uniformly, they have been right or wrong, usually around the 50% rate. The “when” is a very subjectively ambiguous judgment, but can luckily be approached with the same tempered caution as with investing in general. We will approach the different complexities and nuances of marketing timing in later issues, but from a beginners standpoint: it is often most effective to continually investing on a routine basis, and almost always outweighs the benefits of attempted to time the market. Consider a situation where we were to invest $5,000 a year in the market. In the first year, this may buy 50 shares of something, while the next may buy 25 shares because prices have gone up. Let’s say, in year 3, stock prices go way down as the economy suddenly goes sour, and many companies begin going bankrupt, and your portfolio is now worth 50% of what it was. Because we have intelligently planned our budget and assessed our needs, we do not need to panic and do not need to sell anything for quick cash. By approaching this calmly, we can use the same $5,000, but maybe purchase 100, or even 200 shares of the market ETF, setting us up for more gains as the market likely recovers, seeing as we are not exposing ourselves to the singular risk of any single stock or company defaulting or going bankrupt
Effectively, we are deploying dollar-cost averaging, and not over-exposing ourselves to the current market pricing. Intuitively, this method makes it so when the market is low, we buy more shares than usual, and when it is high, we buy less. By investing in ETFs, we are also eliminating the volatility of investing in a singular stock, and can take more comfort in knowing that, on average, the entire U.S market has gone up since its existence. In fact, periods of rapid declines in stock value may seem gut-wrenchingly agonizing, but actually offer a likely bargain buy for the future.
In short, the “when” is often less important than the “how much” and “why” for a beginning investor. You should invest as soon as you are financially capable and responsible to.
Optimal Portfolio Construction
Now that we have hopefully reached a point where we have established a rough guideline of how much to invest and when, we can finally go into more detail of the what. As I have alluded to above, for most beginners, starting with a core portfolio of market-index ETFs will likely be the most optimal decision for now. For those who wish to go even further an establish an even further optimized portfolio, we will discuss some other options at length, although I preface that this Part is mainly directed towards novices.
While the S&P500 offers great scale of diversification and returns, it can have its downsides. For one, the index is based on the market-value of stocks, meaning that stocks with the highest market cap (number of shares outstanding in the public multiplied by the stock price), will effect the returns of the index the most. As of now, this means riskier technology stocks make up a heavier weight in the S&P500, for better for worse. We can mitigate some of this risk by holding total stock market ETFs instead, offering exposure to thousands of stocks, instead of just 500.
Although we can fully appreciate the value of diversification and capital appreciation (otherwise known as stocks going up) with a single ETF, we must remember that there exists markets outside the U.S in which we may easily invest in as well. To fully appreciate the benefit of global diversification, we have to introduce the concept of correlation. If you’ve taken a statistics course, you are more than likely familiar with the term.
Consider the following example of a 2-stock portfolio:
Given these two identical stock portfolios, we see that the bottom portfolio has a higher standard deviation, but the same return. This is due to the correlation component. If we recall, stocks do not only have a return component, but also have a risk one as well. We usually refer to this as standard deviation, or average deviation from the mean (7.5% in this example). The correlation of the stocks in a portfolio is incredibly important implication regarding diversification. For one, a correlation of 1 implies the two stock prices move directly in tandem with each other, all else equal. For any correlation less than 1, any falls in price for one stock, will be mitigated by a less severe loss by the other. In other words, a correlation of .5 implies that, a movement of 10% for Stock A would only effect Stock B by 5%. This, in turn, reduces the overall standard deviation of the portfolio by more than just the weighted average of both components.
The full formula is as follows with W representing weight, STD - Standard Deviation, Correl - Correlation: Sqrt((W1 x STD1)^2 + (W2 x STD2)^2 + (W1 x 1W2 x Correl x STD1 x STD2)).
Notice in the second example, a correlation of 1 implies a standard deviation of 11%, or the weighted average of 15% and 7%, because both stocks move exactly in tandem, eliminating the benefits of diversification. Of course, this applies for gains as well, but incrementally, we achieve more return per unit of risk with lower correlated stocks. Luckily, there are plenty of ETFs that track emerging markets and varying geographic regions, eliminating the need to individually pick these out. These handy funds usually break out the percentage of exposure as well.
We can now apply this theory to portfolio construction. Generally, markets outside the U.S are classified as Emerging Markets (AMEA - Parts of Asia, Middle East, and Africa) or Developed (Western Europe, U.S.A, Japan, etc). Emerging markets are generally countries with less than fully developed markets, although the classification of giants like China presents some controversy over the definition. For one, these markets, on average, grow faster than their developed counterparts, but are more risky (higher standard deviation). On the flip side, these markets happen to have a lower correlation to U.S stocks than U.S stocks do to each other, and can represent a great way to diversify a portfolio while generating more returns. Be aware that you would be taking on a larger absolute level risk, but generating incrementally more returns. I personally keep at least 20% of my portfolio in international ETFs, and generally suggest that others do the same as well.
Of course, an increasingly globalized world means that all stocks are becoming more and more correlated, and emerging markets do not always guarantee a higher return than developed ones. There is data that heavily indicates that historically, stocks with an international exposure have out-performed pure U.S portfolios, however. We can always considered developed markets as well as an alternative, for one, European and Japanese stocks, although they usually offer less return (also less risk) than their emerging counterparts.
We can also look to securities outside the range of conventional stocks. In fact, the bond market is larger than the stock market. If you are unfamiliar with bonds, please see Part-1 for definitions. For a quick-recap, bonds are liabilities for those who issue them. When purchased, they promise (usually) semi-annual payments of a certain percentage of the face-value, and at maturity, they return the full face-value plus an additional coupon.
Consider this example of a hypothetical bond purchase with a price of $900 and face value of $1,000:
Usually, the coupon payments of bonds (the $25 in this example) are fixed, meaning there is less standard deviation, or risk. Conversely, the returns are relatively capped. Although Bond prices often differ from their face value ($900 vs $1,000 in this example), they will usually never appreciate at the same rate as stocks. Although this has not always true, bonds will usually have a negative, or at least low correlation with stocks. The safety of the bond market is more valued during times of uncertainty, and people will buy into bonds, driving up the price in an environment where stocks should be going down. In other words, bonds can offer another avenue of risk diversification and safety, as well as an annual income. However, the fixed nature of these payments make them exposed to inflation risks. See Part-1 for a breakdown of the implications.
With current bond interest rates so low, its hard to argue to buy them now, especially since we’re so young and do not need the safety of principal (stocks can go to 0, bonds usually don’t). However, over the long-term they provide a strong level of risk diversification and consistent return. As a general rule, we can say that as we get older, we should divert more bonds for their safety and increased certainty. As well, there are indexes that track bonds (look for government, or investment-grade bonds as the safest), and can be easily invested in with monthly distributions that mirror the bond’s coupons. We can also use high dividend-yield stocks as a proxy for bonds. Although it is hard to recommend a certain % of weighting of bonds in one’s portfolio in this environment, I would say that by the age of 30, at least 10% of your money should be invested in bonds, if rates do not continue to be abysmally low.
Recapping it all, TL;DR - You should probably be buying ETFs
The deluge of information aside, I hope we have arrived at the conclusion that starting an investment portfolio can be done relatively simply and safely, and generate returns that, on average, outweigh the risks if approached in the right context. Starting now, and consistently is the most important. Without the need to identify individual stocks by purchasing ETFs, we can achieve scale of diversification and consistent returns. We can further this profile through the inclusion of international stocks/ETFs and bond/bond funds.
I have included a list of ETFs for reference and have labeled them accordingly:
S&P500 ETFS / Mutual Funds - These funds track the S&P500 global market index, and are great universal investment vehicles with divarication of scale:
SPY, VOO, IVV, SWPPX, VFINX, FFAIX
Russell 3000 / Total Market ETFs - These funds track 3,000 American stocks, offering less of a technology weight then the S&P500 index and more exposure the broader American economy and market:
VTHR, VTSAX, SWTSX, IWV, WFIXV
Emerging Market ETFs - These funds offer exposure to developing markets internationally:
SPEM, SCHE, EEMV, MCHI, EEM, SPEM,SCHE, GEM
International ETFs - These funds are exposed to developed international economies (Europe, Japan, etc)
EFA, IEFA, SCHF, VEA
Investment Grade / Government Bond Funds - Offers exposure to investment grade / longer duration bonds.
LKOR, SPLB, FLTR, EDV, ZROZ, TLT
