How to Invest: Navigating the Brave New World of Personal Finance

Logo: The Economist

Navigating the Brave New World of Personal Investment

How to Invest

Peter Stanyer

Masood Javaid

Stephen Satchell

Words and phrases that appear in bold within the text are explained in the Glossary on pages 207–21

.

Introduction: We’re all investors now

MY FATHER CALLS ME LAST week. ‘I need your help, son. My golf buddies have been trading Robinhood. I just opened an account. What do I buy?’ ¹

Robinhood, a low cost and user-friendly online stock trading platform, was a high-profile US success story from the early days of the covid-19 pandemic when it made an impressive leap towards its avowed mission to democratize finance for all.

Most new investors on retail trading platforms do not have a smart financial adviser in the family to ask for guidance. Instead, during the pandemic large numbers tuned in to social media. In 2020, Robinhood and its competitors spawned the phenomenon of the crowd-promoted meme stock. This was the name given to equities that attracted followers on social media leading to widespread purchases, with apparently little attention to the reasonableness of the price being paid.

Easy to use, instantly available, inexpensive stock trading platforms have become an unmissable feature of personal investing in recent years. But how do new investors decide what to buy and how much? And should they join the reported 100 million-plus worldwide who have ventured into buying cryptocurrencies, and if so, which cryptocurrencies? These are archetypal 21st-century investment challenges for individual investors. This book provides signposts to help steer though the fog, and sometimes the excitement, that clouds the way through.

It is easy to miss how fast the world of personal investing has changed. Love it or loathe it or just not interested in it, tens of millions are now directly involved in investment markets to a degree not known by earlier generations. This includes many millions who now have personal pension accounts and personal responsibility for pension savings and their retirement income in a way that was largely unknown in the last century. The shift of financial accountability from employers to employees has been breathtaking. Many, though, have probably gone with the flow and scarcely noticed it.

And now in the second decade of the new century, fintech innovations seem on the cusp of transforming banking and payments systems and perhaps going on to change the nature of money and with it our understanding of safe assets.

This comes after years of loose monetary policy, low interest rates and seemingly expensive stock markets. In combination with ready access to the new trading platforms and financial sector innovation, we are facing a situation that, in all likelihood, makes sudden financial crises more likely. All investors have been challenged by cautious investments that offered little secure income and the prospect of losses in value when interest rates and inflation rose. In our opinion, these are compelling reasons to keep investments simple and not get carried away by the prospect of making easy money. There is, we believe, simply no such thing.

The aim of our book is to help investors navigate this new world. As markets are transformed, investors need to be able to think beyond dodgy online chatter and to challenge investment company salesmen who will be motivated to recommend the latest new financial product.

Instead, we offer 18 key principles that will help investors make sensible decisions when they feel tempted that they ought to be able to do better. For example, our first chapter is called Where’s the beef?, a reminder to us all that we should only make an investment if we find the investment case convincing. The investment principles that underpin the book will help investors reduce the chance of making major investment mistakes. They are:

1.Always look for the substance in any investment proposal (Chapter 1)

2. When investing, take time to decide, then do it (Chapter 2)

3. The glory of compounding accrues most easily to those who adopt a sensible strategy and add regular contributions to it over long periods (Chapter 3)

4. Expensive fees are a dead weight that drag down living standards in retirement (Chapter 3)

5. If you see easy money to be made in the stock market or anywhere else, you have not looked hard enough (Chapter 4)

6. Star managers don’t walk on water (Chapter 4)

7. Most stocks underperform the stock market (Chapter 4)

8. Be modest in your expectations for investment returns, and over time compounding will look after you (Chapter 4)

9. When investing for the long term, it is better to be a tortoise than a hare (Chapters 1, 4 and 5)

10. We don’t believe anyone knows where interest rates and inflation will be in 15 years’ time, and this matters (Chapter 5)

11. You will not be able to avoid the surprising bad times in the years ahead so you should know how you and your savings will cope with them (Chapter 5)

12. Investing in a global equity tracker fund can be a surprisingly sensible way to invest in equities (Chapters 6 and 8)

13. If adjusting your investments to reflect environmental, social and governance priorities, remember to keep your investments well diversified (Chapter 8)

14. In times of acute crisis, government bonds are still the investor’s best friend. But over time, they are always vulnerable to inflation (Chapters 4, 5 and 9)

15. In bad times, corporate bonds always show their intrinsic and unhelpful link to stock market volatility (Chapter 9)

16.Property is at the heart of everyone’s finances and well-being

17. Patient individual investors in real estate investment trusts can be in a stronger position than many institutional investors to benefit from investing in real estate (Chapter 11)

18. Investing in things you enjoy owning or supporting gives you more than just monetary rewards (Chapters 8 and 12).

Look out for these principles throughout the book.

Investment controversies

There are many popular investment books, but few provide a dispassionate up-to-date review of the controversies that surround the management of personal savings and wealth in the 21st century. How safe are government bonds and could crypto assets (and especially that subset of crypto assets called stable coins) provide an attractive alternative? How should the threat of man-made climate change affect investing? Is index investing (buying an index fund that looks to replicate the performance of a chosen stock or bond market, also known as passive investing) compatible with good governance? How much do we know about future inflation and interest rates? Is a global approach to investing best or should we have more in our home markets? These are some of the controversies that are explored in this book.

There is no need for investors to reconcile competing arguments, or to align strongly with either side of a dispute; instead, they need to think through how unresolved debate influences the uncertainty that accompanies their investment strategy. That is what this book seeks to do, in a way that is intended to be of practical use.

No investor, however large or small their wealth, needs to feel bamboozled by advisers into adopting a complicated strategy they do not understand. The book does discuss more sophisticated ways of investing, but any investor can always sit back and say, No, I want to keep things simple but appropriate.

There is always a suitable strategy for any investor that simply combines cash, well-diversified equities and government bonds. Investment managers will almost always recommend a more expensive and more complicated strategy and they often suggest that diversification now requires an allocation away from the stock and bond markets to private markets. Private markets carry high fees, are less transparent than they sound, less flexible and normally require longer-term commitment. The arguments in favour of private market investing are less persuasive than they sound. Our book gives investors the knowledge and vocabulary they need to understand and, if necessary, challenge strategies that complicate how their money is invested.

Despite the revolution in online trading platforms, financial markets should be seen as a place to protect and grow wealth. But it is not a reliable place to grow wealthy. It is an environment in which the patience of the tortoise can compound investment returns on regular generous pension contributions into a decent pension or savings pot. The skittishness of the hare, however, is most likely to end in disappointment. Most who try their luck as full-time day traders soon conclude that it is not a sustainable career choice.

Some basic investment terms

The world of investment is full of terminology that can feel intimidating for personal investors. Here’s an explanation of some of the most common terms that will appear throughout the book. The glossary at the back of the book provides another reference, with the terms explained there shown in bold in the text on first mention.

Equities, also known as shares or stocks, represent part ownership in a company.

Fixed income or bonds are investments that have a predetermined schedule of interest payments (also called fixed-interest coupons) and a fixed redemption value at maturity. They represent lending to governments and companies. Creditworthy governments are expected to honour the payment terms of their debt, so government debt such as US Treasury bonds bear minimal credit risk and are described as safe harbour investments. Companies may, and sometimes do, fail to meet their payment obligations and so corporate bonds are considered to be risk assets. A credit portfolio is a portfolio that gives exposure to corporate and other bonds.

Cash represents investments that could earn interest as bank deposits, holdings in money market funds or in shorter maturity government issued paper (such as Treasury bills). Money market funds are professionally managed funds that invest in cash and lower risk cash-like investments.

Safe-harbour assets are expected to provide shelter against a storm and can include cash and government bonds. The protections against different risks (including loss of capital and exposure to inflation) provided by different types of government debt are discussed in Chapter 4.

Risk assets are exposed to various underlying risks and include equities, corporate bonds (and portfolios exposed to credit risk), and real estate.

Public investments are usually listed or quoted investments for which prices are regularly quoted on a formal stock exchange at which, or close to which, transactions can be completed.

Private markets refer to unlisted or unquoted investments for which price quotations are generally not readily available.

Leverage is an indication of the extent to which an investment, and thus its performance and risk, is geared or multiplied through the level of debt embedded in it.

Short selling arises when investors sell an investment that they do not own, either through selling futures or borrowing it (by providing collateral to the stock lender). In contrast, a long position is an investment that is owned.

Financial derivatives are investment contracts that are designed to replicate risk and return of direct investment in, for example, the stock markets, bond markets or foreign exchange markets.

Multi-asset funds are investment vehicles that invest across multiple types of investments, strategies and fund managers.

Hedge funds are best understood as private entrepreneurial investment companies that operate with few constraints using their own research to identify opportunities to target high returns.

Investment managers work at firms that provide investment management services. Consultants and advisers are professionals who assist investors on a broad range of financial and investment issues ranging from individual pensions, financial planning to selecting investment managers.

Road map of the book

The book unfolds over twelve chapters.

Chapter 1: Where’s the beef?

We begin by emphasising the importance of seeking out the substance behind any investment proposal. Investing has become much less expensive and much more accessible so far this century. The covid-19 pandemic provides a perfect illustration of the difference between uncertainty (which we cannot measure) and risk (which we can try to measure). It’s a reminder that the most common measure of investment risk – the volatility of investment value – is only ever a partial measure.

We also discuss the importance of financial literacy as a safeguard against fraud and betrayal and the different indicators of risk tolerance (used by advisers) and risk aversion (used by economists). The risks that matter for an investor often cannot be measured and those that might be measured often are not. The key question is, How much risk can you tolerate?

Chapter 2: Know thyself: can I trust my own advice or do I need an adviser?

Do investors need advisers? Investors can often be their own worst enemy when they take decisions on their own; even self-confident investors can benefit from the much broader financial planning advice from a compatible adviser. A reasonable financial plan for the future in 2022 should seem disappointingly modest compared with past market experience. We emphasise the importance for both the investor and adviser to feel that the fee rate is commensurate with the service provided.

We also explore how economics says investors ought to invest and behavioural finance’s explanation of how investors invest in practice. We contrast investor preferences (which should be respected) with investor biases (which frequently lead to investment mistakes). In so doing we discuss how behaviour can help and hinder people as they invest their savings.

Chapter 3: The personal pension challenge

A defining feature of the new world of individual investing is the personal pension fed by automatic payroll deductions. We illustrate the pernicious impact on living standards of even modest inflation during retirement. We encourage those nearing retirement to explore options to delay and so increase entitlement to inflation-linked state pensions and social security. Often, this will be the most competitively priced old age insurance available. We also discuss the likelihood of incurring substantial care costs in old age and different approaches to drawing down a pension pot.

Chapter 4: What drives performance?

One of the features of personal investment during the pandemic was herding towards specific stocks and, at least for a time, driving their performance. We put this in the context of the returns to be expected over time from stock markets. We suggest that it is normally better to go with a less exciting, well-diversified off-the-shelf investment strategy. Counter-intuitively, new research shows that any typical stock is likely to perform worse than the market, because the exceptional performance of a very few lifts the whole market with them.

Chapter 5: Inflation, interest rates, booms and busts: is anything safe?

Many have opinions, but no one knows where interest rates and inflation will be in the decades ahead. This matters for investors.

One consequence is that the fair value of government bonds is questioned and with it the fair value for the stock market. This is just the type of environment to encourage many to look for secure premium returns. These do not exist. We discuss whether other forms of diversification and would-be safe harbours for an investor’s wealth, including gold and cryptocurrencies, are useful alternatives to government bonds. In our view, they are not, but extreme political conditions might justify such investment decisions. Nevertheless, we readily recognise that the growth of cryptocurrencies and its associated block-chain record of transactions are likely to lead to an epoch-defining change in banking and in how wealth is kept secure and verified.

We also look at the recurring pattern for stock and credit markets to alternate between extended periods of deceptive calm, lasting years, and dangerous shorter episodes of manic disruption.

Chapter 6: Will model allocations help me invest better?

We suggest that a simple model allocation – or benchmark – for dividing assets between equities, bonds and cash makes sense for investors. Model allocations are used by investors large and small all around the world. The most aggregated allocations impose discipline on investment decision-making and risk-taking, even though the volatility in markets, and thus the risk of loss in investor strategies, can still fluctuate alarmingly.

We also look at how models say investors should invest and show summary data for how they actually do invest.

Chapter 7: Liquidity risk: in bad times, cash is king

An inability to turn investments into cash quickly without incurring a significant loss is known as illiquidity. This has been described as the most dangerous and least understood financial risk. Ironically, it encourages two notable heresies. One is that investors can take comfort from the reported low volatility of infrequently traded investments. The other is that if an investment is illiquid, it will offer a premium rate of return to compensate for its inflexibility. Both are misplaced.

The next four chapters examine the place of risk assets in an investor’s strategy.

Chapter 8: Risk assets: global equity markets

There are currently two defining trends for equity investing. One is the enormous rise in index matching or tracking equity strategies. The other is the rise to prominence of environmental, social and governance issues.

We look at different styles of investing in stock markets, and in particular how much to invest abroad, and whether international investments should be hedged to manage currency risk. We conclude that an unhedged global approach to investing is usually the practical best approach for individual investors, as equities are risky whether or not they are hedged. However, there are exceptions and there are arguments for some home-country bias in allocating investments.

Chapter 9: Risk assets: global credit

We look at the role of corporate bonds and other types of debt. We explain how the pricing of these credit portfolios varies with stock market volatility, which is why they are properly considered to be risk assets. In times of crisis, government bonds are still the investor’s best friend.

Chapter 10: Multi-asset funds and alternative investments

Multi-asset funds can be one-stop shops to meet all an investor’s needs. They include simple combinations of index funds of equities, bonds and cash. More often they provide access to a wide variety of alternative investments which are not otherwise available to most individual investors. At their best, actively managed multi-asset funds have industry-leading risk management, using leverage and short selling to optimise their chances of outperforming while managing the scope for underperformance. More complex funds usually come with a much higher burden of fees than their keep-it-simple index fund competitors. But they can give access to streams of revenue and risk not otherwise easily accessed by private investors.

Chapter 11: Home ownership and real estate

Everyone needs a home, and for many the wealth committed to their house is their most valuable investment. Housing is different because it meets the need for shelter and so can be low risk, even if its price is volatile. There is often an emotional attachment to housing which echoes the appeal of art and other treasured possessions.

Investing in commercial real estate is different. This is a market that has been upended by the covid-19 pandemic. Personal investors usually invest through real estate investment trusts. They enable investors to gain the advantages of real estate investing more flexibly than institutional investors, such as pension funds and insurance companies, who directly own buildings. In the UK, traditional property funds which rely on less volatile surveyors’ valuations are a less efficient way for individuals to invest in commercial property.

Chapter 12: Art and investments of passion

Plenty of people have collections of paintings, or treasured possessions items such as stamps, rare books, watches or classic cars, on which they have expended significant amounts of money. The prospect of earning an emotional, not financial, dividend from owning a beautiful work of art is invariably the catalyst for a decision to buy. This is just as well. Others have noted soberly that almost all paintings that are bought will eventually be thrown away.

Technology has transformed the making, buying and recording of ownership of much art this century. This has made the markets for fine art and treasured possessions much more efficient. We discuss how art prices appear positively correlated with income inequality and wealth.

If there is one overriding message we want readers of this book to absorb and reflect upon, it is the importance of always asking of any investment proposal, Where’s the beef? Allied to this is the message that if something has gone up in price and many are buying it, that alone does not make it a worthwhile investment.

Peter Stanyer, Masood Javaid, Stephen Satchell

October 2022

1

Where’s the beef?

Always look for the substance in any investment proposal

Isaac Newton, widely recognised as one of the greatest mathematicians and physicists of all time (and presumably rational), should have trusted his first answer to the question in this chapter heading. Instead, his greed got the better of him in the get-rich-quick speculation of his time, now known as the South Sea Bubble. Having already made a substantial profit in the early months of this early 18th-century mania, he risked three times as much, at the top of the market, and lost it all.

In the 17th century, the apocryphal speculative buyers of Dutch tulips probably saw a beautiful answer to a question that runs repeatedly throughout this book: why do you think you are making a worthwhile investment? Crypto investors should keep asking it too. Without asking that question, investors in funds that fed the enormous fraud of Bernie Madoff didn’t stand a chance, whereas those who did ask, not seeing a convincing answer, steered clear.

Financial excess has repeatedly generated periods of widespread frenzied attention, as individuals think they have found a shortcut to get rich. But frenetic activity in a well-hyped, fashionable investment opportunity does not, by itself, justify involvement by more thoughtful individual investors.

Modern investing

The development of online trading and wealth management platforms this century