Investing in Equities (Part 3 of a five-part series)
Working with your savings of $1,000 per month and a realistic targeted investment return, your next job is to identify the appropriate investment vehicles to begin your multi-year process of passive wealth generation.
What Drives Equities Higher?
We have seen how over the past 15 years stocks (and real estate) have outperformed bonds and cash. This tendency of equities to beat fixed-income instruments over the long haul is a familiar pattern. As discussed in this blog a couple of years ago, the historical record shows that stocks have generally outperformed bonds across international markets from as far back as the data go (i.e., from the late 1800s to the present). For anyone interested, see books such as Jeremy Siegel's Stocks for the Long Run and Elroy Dimson's Triumph of the Optimists, both published in 2002, for informative background reading on the topic.
Despite the historical evidence in favor of equities, it is also important not to assume blindly that the recent 15-, 25-, 50- or 100-year period will necessarily repeat itself. To quote Dimson, et al, from a paper titled "Irrational Optimism" (2003):
- Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed [italics added] superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.
It is important, then, to keep our optimism in check, noting that, while the outperformance of equities over bonds and cash in the 15-year horizon we are considering is arguably likely, it is by no means a certainty.
To add perspective to the quantitative analysis cited above, I now give a qualitative argument for why equities ought to continue to outperform bonds and cash: Our economy is fueled by investor greed but steered by government policy. Entrepreneurs and investors, driven by their "profit motive," expend their time, effort and capital to develop technology and build companies that produce consumer goods and services. The government, presently under the direction of Fed chief Ben Bernanke, targets a narrow band of moderate inflation (about 3% to 4% per annum) by periodically adjusting short-term borrowing rates higher or lower to control the availability of capital in the financial system and, in so doing, manages (to the extent possible) the overall rate of corporate expansion and economic growth.
The two key elements in this mechanism are: a) government-mandated inflation, and b) technological innovation. With 3% to 4% inflation in consumer prices, the revenue of the companies producing the goods and services that consumers buy naturally rises. The "cost" side of the income statement is also impacted by moderate inflation; however, increasing efficiency from improvements in technology keeps expenses in check, allowing profits (i.e., revenue minus expenses) to rise at a rate significantly higher than inflation. Rising corporate profits, in turn, drive stock prices higher--at a rate of appreciation higher than the inflation rate. Through substitition effects, the value of other equity-based assets (real estate, collectibles, commodities, etc.) likewise rises.
Regarding technology, a solid argument can be made that innovation and corresponding equity returns are not just increasing but are actually accelerating (e.g., see the discusssion of Ray Kurzweil's so-called "law of accererating returns" in a prior post). In short, the combination of government-mandated inflation and efficiencies brought about by technology gives us good reason to expect that equity returns will continue to exceed bond returns over the decades ahead.
Common Equity Investments
I use the term "equities" to include stocks and real estate. Three broad equity asset classes available to us as passive investors are:
- U.S. Stocks: Investors can buy individual stocks (e.g., Exxon (XOM), GE (GE), Wal-Mart (WMT)), stock mutual funds (actively managed by "stock-picking" fund managers), and index or exchange-traded funds (ETFs, which track market indices instead of attempting to pick the highest-performing stocks). A tremendous variety of stocks and stock funds is available to suit the gamut of investing styles and preferences: large-cap, mid-cap, small-cap, value, growth, income-oriented, sector-specific, geographically oriented, etc.
- Foreign Stocks: A good selection of large-cap (and to a lesser degree, mid-cap and small-cap) foreign stocks is available as ADRs (e.g., Petrochina (PTR), Toyota (TM), Vodafone (VOD)). As with U.S. stocks, exposure to foreign stocks is also available through mutual funds and ETFs.
- U.S. Real Estate: Many homeowners consider their own home (and any vacation home they may have) to be investments. Single-family rentals, multi-plexes and larger apartment complexes are more typical residential real estate investments. Commercial properties (office buildings, retail centers, mixed-use developments, etc.) are common investments for individuals, partnerships and LLCs seeking direct exposure to the real estate market. Publicly listed and traded real estate investment trusts (REITs) offer individual investors an indirect but "hassle-free" way to invest small amounts of capital into the real estate market.
Hedge funds and private equity funds are also available to individual investors but these investments tend to cater to those who already have a net worth in the millions.
Basic Considerations In Selecting Equities
Determining the most promising investments from this wide range of investment alternatives can be a bewildering experience. A few very basic guidelines, however, should help narrow the field considerably:
- Suitability: Know thyself. It is important to select investments that are a good match with your interests and personality, since doing so will give you an "edge" over the average investor in the same securities or properties. If you naturally follow the news about a particular industry, it is more likely that you will be a better judge of which companies have more competitive products and will be able to generate higher long-term profit growth. If you tend to follow general market trends but do not pay close attention to particular companies, ETFs may be a better investment vehicle for you than individual stocks. "Hands-on" investors who enjoy negotiating with buyers and sellers and engaging in property management may wish to invest directly in real estate properties.
- Simplicity: Keep it simple. Given two investment alternatives that you view as comparable from a risk-reward perspective, always choose the one that is easier to analyze and understand, involves less paperwork, and is generally less time-consuming to manage. Personally, I prefer stocks over real estate because stocks are simpler to buy, sell and own. However, there are certainly times when knowledge about a local real estate situation can lead to an opportunity that is "too good to pass up," thereby justifying the additional administrative time needed to work with brokers, banks, escrow companies, inspectors and property managers to close a deal. I believe that success in investing comes largely from "buying right," and consequently recommend focussing on the investment decision (i.e., deciding what to buy) instead of overtrading your portfolio.
- "Lumpiness": Limit diversification. Owning few good investments is generally better than trying to keep track of a large number of holdings that inevitably include losers along with winners. I find that a "lumpy" portfolio of just 10 to 20 different stocks and real estate properties gives me adequate diversification, while allowing me to feel the impact of the individual investments on overall portfolio performance. To profit from the higher GDP growth offered by economies outside the U.S., it is important to have international exposure, which generally comes from owning ADRs, international mutual funds or ETFs. Investors with a global mindset should consider weighting exposure to major international markets along the lines of GDP (see graph below). Note that, while the U.S. has the world's largest economy, it comprises just 28% of the world's total GDP.
- Quality: Buy quality. When considering what to buy, do your own due diligence to make sure that the companies underlying the stocks you buy have strong businesses and are likely to thrive and remain leaders in their particular market niches over the next 10 to 15 years. If you are buying mutual funds, pay attention to who is managing the fund, inspecting both their qualifications and their track record. When buying real estate, keep in mind that properties in better neighborhoods generally show more predictable returns and tend to be less time-intensive to manage.
- Efficiency: Strive for high efficiency. Portfolios built on longer investment horizons are usually more efficient. Benefits of lower portfolio turnover are deferral of capital gains taxes (or use a 1031 exchange for investment real estate), minimization of trading costs, and reduction of administrative time spent executing and accounting for transactions. When investing in mutual funds, select a quality fund with low advisory fees. Keep in mind that round-trip fees can be very high in less liquid markets. For example, real estate deals typically involve round-trip fees and costs in the vicinity of 5% to 8% of property price, which translates into 10% to 16% of equity amount for 50% leverage, and 25% to 40% (wow!--that's astronomically high compared to stock commissions) of equity amount for 80% loan-to-value--which is why it is so difficult to make money quickly by "flipping" properties.
By adhering to these basic guidelines, most investors will end up investing most of their savings in highly liquid, mid- to large-cap stocks and ETFs, with some allocation to local real estate. I would recommend using the following "model" portfolio as a starting point for asset allocation:
- Individual stocks (can include REITs): 40% to 60%
- ETFs (or mutual funds): 10% to 30%
- Real estate (including own home): 10% to 30%
- Cash, CDs: 5% to 15%
For my own portfolio, I am heavily weighted in individual stocks and very light on cash, with a modest amount of real estate and little to no allocation to mutual funds and ETFs.
Next week: Why fees and expenses matter