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To review:
1. Why invest?
2. Information (and EMH)
3. Minimizing variance
4. Understanding costs
If you've been following along, I've talked about several things that should factor into your investment decisions, including objectives, variance, and cost. Now it's time to tie it all together and figure out what actually fit all of the following.
Criteria
1. Relatively lower risk, which can be accomplished through diversification. This rules out most individual stocks and any leveraged products.
2. In general, the more something trades, the smaller the bid-ask spread. Thus, the more popular something is, the less it costs to enter/exit positions. We want to pick products with lots of volume and market capitalization.
3. Finally, we want to avoid high fees, so be careful when you're looking at mutual funds or ETFs that have high management fees or expense ratios.
ETFs
In general, I advocate ETFs (exchange-traded funds) because they can meet all of the above objectives. If you were to create your own diversified portfolio, you'd have to go out and individually buy dozens of different things. ETFs are also pretty popular these days, so you'd face pretty small spreads for the important ones. Finally, they usually have lower fees than comparable mutual funds and certainly lower costs than actively managing your positions.
Here's a list of ETFs ordered by category from lowest to highest risk/expected return.
Fixed Income
Basically debt, these guys are considered safer than stocks because if a company goes bankrupt, these guys get paid first even if the stock goes to zero. They usually pay out cash on a regular basis (interest on the debt). This is good for people who want some regular income with no real intent to grow. This is more ideal for people who are retired and want to live off their savings.
TIP - US Treasuries. US government debt is the safest thing in the world. Note that the price can still change, but it can't ever really go to zero in the foreseeable future without the world burning and crashing.
LQD - US corporate debt of investment-grade companies (the ones considered safest). Higher interest than treasuries.
AGG - All US corporate debt. More payouts than just investment-grade companies, but also more risk. Still considered pretty safe as far as investing is concerned.
US Stocks
This category is the stuff that people are by far the most familiar with. Definitely should be part of any balanced portfolio.
SPY - The 500 largest public US companies. This is also the single most popular ETF.
IWM - Russell 2000 consists of the 1000th-3000th largest companies in the US. These guys are smaller and thus higher risk and their performance tends to be similar to the S&P 500.
QQQQ - NASDAQ 100 stocks. This index consists of the largest 100 companies on the NASDAQ, which in general contains a lot of tech stocks. It has some overlap with the S&P 500.
XLF, XLE, etc. Finance stocks, energy stocks, and so on. There's one for every sector of the economy as classified by S&P if you want a specific focus.
International Stocks
In general, it's a good idea to have some exposure to the rest of the world to further diversify your positions. Plus, a lot of people make the argument that there's more potential for growth especially in developing economies.
EFA - MSCI EAFE Index of stocks in developed countries. Biggest members: Japan, United Kingdom, France, Australia, Germany, Switzerland.
EEM, VWO - These two ETFs are basically the same thing. The MSCI Emerging Markets Index of stocks in developing countries. Biggest members: China, Brazil, India, Russia (aka BRIC)
FXI, EWZ, etc. China and Brazil, respectively, if you want a specific country focus.
Commodities
Generally speaking, I don't recommend investing in commodities for a pretty simple reason: they don't produce anything. Sure the price of gold might go up, but in the long run, it's just gold. Companies and economies can grow larger and produce more wealth, but gold just sits there. I suppose the coolest thing about these is that it has really made investing in gold/silver/oil/etc more accessible to the average person.
GLD, SLV - gold, silver, etc.
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Fuck me I'm cramming CFA level I right now...
X _ X
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Fairly nice summary. I would have to agree with most everything but commodities. Commodities are decent in the way of ETFs (mining firms especially) Although investing in gold itself is a bit suspect.
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How much money would you say is a good start for investing? How can someone who just got out of college in his first job get started with accumulating wealth?
EDIT: Oh, I'm sorry, I just read the first post in the series and you do explain it well there. Thanks, I've been enjoying this series.
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On December 01 2010 13:12 azndsh wrote:
Commodities
Generally speaking, I don't recommend investing in commodities for a pretty simple reason: they don't produce anything. Sure the price of gold might go up, but in the long run, it's just gold. Companies and economies can grow larger and produce more wealth, but gold just sits there. I suppose the coolest thing about these is that it has really made investing in gold/silver/oil/etc more accessible to the average person.
GLD, SLV - gold, silver, etc.
Is that your professor's opinion or your own? Perhaps this isn't you but people come out of their economics/finance classes starry eyed and voice the above argument as gold. I guess I detested when people would downplay commodities arguing no value added. Fact is, they don't but they do play a central role in pricing. Furthermore, commodities have allowed corporate farmers and companies hedge. Commodities may not produce something physically but act as an enzyme to pricing.
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how is that at all relevant to investing your savings? I never said the goal here was to price things accurately.
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Happy to see a finance thread on TL! I think you should also add REITs and FX (not recommended for amateurs). REITs pays very nice dividends and could be a diversifier (although correlation to equity is pretty strong).
There are 2 key concepts in fixed income: credit quality and duration/maturity. The lower the credit quality, the higher the interest rate (as well as the risk for default). The longer the maturity/duration, the higher the sensitivity of the bond is to the change in interest rates. If you have a view that interest rates are going up, stay away from the long duration bonds.
In terms of credit quality, after treasury and TIPS comes Municipal bonds, these are issued by states/local govt, with slightly higher interest rates and very good for tax purposes (you can wiki it for more info). I am not a huge fan of Fixed Income nowadays because rates are so low, but you can go a little bit beyond corporate aggs in the credit spectrum into things such as High Yield, commonly associated with junk bonds with high default rates. These give you stock-like returns with stock-like risks.
I think applying a moderate amount of leverage to fixed income portion of the portfolio (assuming you have significant allocation to equity) can actually helps improve return without increasing risks too much.
It seems that OP works in finance, if you are going to continue with this series, the next step could diverge into more specific topics such as duration in fixed income, earnings/PE, etc., or portfolio theory: basic definitions of correlations, volatility, efficient frontiers, capital market lines, etc. Keep up with the good work!
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I also agree with OP's thesis on commodities. Institutions use it more often as a hedge against inflation, it should never be a central part of the portfolio if you are seeking returns as a individual investor. You should not look at commodities as return generating assets, but more as demand/supply driven items, they are cyclical and can be extremely volatile to manage.
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On December 01 2010 22:28 azndsh wrote:
how is that at all relevant to investing your savings? I never said the goal here was to price things accurately.
I recommend investing in commodities because of one simple reason, I can see where people are hedging and take advantage of an upcoming potential price swing.
See what I did there?
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On December 02 2010 04:49 Crabby wrote:Show nested quote +On December 01 2010 22:28 azndsh wrote:
how is that at all relevant to investing your savings? I never said the goal here was to price things accurately. I recommend investing in commodities because of one simple reason, I can see where people are hedging and take advantage of an upcoming potential price swing. See what I did there?
well, I imagine this guide must be quite useless to you if you can predict the future.
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On December 02 2010 00:57 Glacierz wrote:
Happy to see a finance thread on TL! I think you should also add REITs and FX (not recommended for amateurs). REITs pays very nice dividends and could be a diversifier (although correlation to equity is pretty strong).
There are 2 key concepts in fixed income: credit quality and duration/maturity. The lower the credit quality, the higher the interest rate (as well as the risk for default). The longer the maturity/duration, the higher the sensitivity of the bond is to the change in interest rates. If you have a view that interest rates are going up, stay away from the long duration bonds.
In terms of credit quality, after treasury and TIPS comes Municipal bonds, these are issued by states/local govt, with slightly higher interest rates and very good for tax purposes (you can wiki it for more info). I am not a huge fan of Fixed Income nowadays because rates are so low, but you can go a little bit beyond corporate aggs in the credit spectrum into things such as High Yield, commonly associated with junk bonds with high default rates. These give you stock-like returns with stock-like risks.
I think applying a moderate amount of leverage to fixed income portion of the portfolio (assuming you have significant allocation to equity) can actually helps improve return without increasing risks too much.
It seems that OP works in finance, if you are going to continue with this series, the next step could diverge into more specific topics such as duration in fixed income, earnings/PE, etc., or portfolio theory: basic definitions of correlations, volatility, efficient frontiers, capital market lines, etc. Keep up with the good work!
Nah, this just about wraps it up. This is like a dummy's guide to investing money long-term without getting picked off. I think all the rest is either too academic or specific to really be useful to the majority of people out there.
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EPT
