How to invest your money – the long version

It is 2020 when I write this. In parts of the world people are dying of hunger and thirst. Those people are mainly investing in clean water and food to survive the next day. If you have a lot of money please help them to buy more food and have more clean water.

I was growing up in a rich country. The salaries here are so high, that after buying food, water, electricity, paying for rent and other enjoyful experiences, people still have money left in their bank account. Those are the people my following advise is adressed to – people who have achieved, that their income is higher than their expenses.

Everybody is an investor.

If you are keeping money in your bank account, you are investing it in the currency, that your country is using. This is a very safe way of investing your money with low volatility and your expected annual return is the yearly inflation/deflation rate of this currency.

Annual return = How much the value of your asset has changed over 1 year.

The yearly inflation rate is about 1,5% per year for most of the globally used currencies. If you want to achieve better annual returns than this, you have to invest in different asset classes.

Asset class = A group of financial instruments with similar behaviour.

There are three main asset classes:

  1. Equity = Stocks –> Highest risk, highest expected returns
  2. Fixed Income = Bonds –> Medium risk, medium expected returns
  3. Cash and equivalents = $, €, ¥, …–> Lowest risk and lowest expected returns

By investing money in equity you are also highly increasing the risk of losing money. Important to understand is:

Higher returns are only possible by taking higher risks.

The most important question in investing is how you want to weight those different asset classes in your portfolio. This is called asset allocation:

Asset allocation = Investment strategy, that is describing the percentage of all assets within an investment portfolio.

When setting you asset allocation you should be aware of the effect of diversification on your investment portfolio:

Diversification = Technique to reduce risk by allocating capital into different asset classes and assets.

By diversifying your portfolio over different asset classes, you can optimize your risk-reward-ratio. Have you set your asset allocation? Then you are ready to go on a shopping tour on global markets!

When assets are traded, there is two sides – people who want to sell assets and people who want to buy assets. This demand and supply is defining the price of an asset. By buying assets at low prices and selling them at high prices you can outperform the average market returns. Very few people have managed to do this over a long period of time. It is impossible to predict which stocks will overperform and underperform in the future. For every person outperforming the market, there is another person who is underperforming, compared to the average market returns.

The smartest choice for private investors is to invest globally diversified.

To realize average market returns you need to invest in the average market. For the part of your asset allocation in equities, this means that your biggest allocation in stocks is in the biggest company on the world. Your biggest allocation in government bonds is in the country with the biggest GDP and your biggest cash allocation is in the most valuable currency of the world. This method is called market-cap-weighted investing.

There are a lot of companies, countries and currencies in our world which makes it quite complicated for private investors to realize a global portfolio like this. The values of the companies and GDPs of the countries are also changing over time. Adjustments would be necessary all the time to keep your portfolio in line with the market caps. Currently the best investment vehicle to realize a globally diversified portfolio for private investors is by using Exchange Traded Funds (ETFs) that are tracking global indices.

Exchange traded fund = Investment fund that is traded on stock exchanges

Index (in finance) = Hypothetical portfolio of assets representing particular parts of the market

The advantage of using ETFs compared to other investment vehicles is, that they are diversifying over a big number of assets while having comparably low costs. An alternative especially for US investors can be mutual funds with low fees. The costs of investing into a globally diversified portfolio make a big difference for your net worth in the long term so it is very important to:

Keep your investment costs as low as possible.

In an ETF those costs are defined as Total Expense Ratio (TER) and describe the yearly costs of an ETF. On top of that usually your broker is charging you transaction fees. Compare those costs of different brokers and different ETFs.

The previous investment guidline can now be further specified:

  1. Set your personal asset allocation
  2. Invest your stock allocation into a globally diversified stock portfolio
  3. Invest your bond allocation into a globally diversified bond portfolio
  4. Invest your cash allocation into a globally diversified currency portfolio
  5. Rebelance your portfolio to be aligned with your asset allocation.

All this stuff sounds complicated. If you do not understand it, read it again. Do further research online and understand everything before you start with investing.

The stuff above is important stuff.