Borrowed from Albert Chau Okay, so I'm sitting with my mate at a bar chatting over beers. "I'm looking to earn about 10 percent per annum, over a 10 year timeframe," I say to him, pretty pleased as punch. "10 percent? Ha! I can make that much in a day!" he says, doubtlessly laughing at my feeble attempts. "Or lose that much, but generally I make a lot more than I lose." I'm inclined to believe him. His portfolio is the stuff of legends. But that begs the question of how much work goes into such a portfolio. "Well, this one time, I had some money on the market. Took half an hour to do an essay for law, lost 2 grand." Ah, of course. Greater risk for a greater reward, after all. My friend trades in futures and options, and multiple times a day too. But let’s be honest here, the vast majority of us don’t see ourselves doing this sort of thing. People either have day jobs, or aren’t really interested in finance, or can’t handle that sort of high risk stress, or passionately hate bankers, all of which are perfectly valid reasons. I look to trade about once every 3 months, or even 6 months. I need about an hour to get my trading done, and then I can forget about it for another few months. While such a thought might be unfathomable for the financially literate, such as those in the industry, such a strategy serves quite well for those who really haven't the foggiest idea about finance. "Hey, you're doing commerce, right?" your annoying uncle asks at a family gathering. "I want to start investing in shares. What should I buy?" You sigh internally. But hey, thanks to this article, now you have an answer for him, and you can bugger off and have a jolly good old time talking about something else. Ladies and gentlemen, welcome to the boring, steady world of ETFs and buy and hold trading. What are ETFs? In case you didn't already know, ETF stands for exchange traded fund. While a multitude of ETFs exist, we're interested in index funds, which seek to track indices in particular asset classes (such as shares, real estate, bonds, etc.). For example, an ASX 200 index fund seeks to replicate the performance of the ASX 200. Such a fund holds all the shares the ASX 200 does, and in the same proportions. Buying into shares of the fund is effectively buying a tiny piece of all the companies that comprise the ASX 200. For those who are of the belief that diversification reduces risk, ETFs offer the ultimate in diversification. So why are ETFs so great? It's simple really. Stable long term returns. Over long periods of time, such as 10 or 15 years, the share market will almost always make a positive return. Even the American stock market, subject to cataclysms such as the Great Depression, the tech bubble crash or the Global Financial Crisis (GFC) has never had a single 15 year period over its 200 year history where it has made a negative return. Similarly, in the Australian stock market, the ASX has also NEVER had a 15 year period with negative return. How's that for stability? Historical averages show you can expect a figure of 13.1%, measured since 1950. Over the past 10 years, the ASX has returned 8.1%, which encompasses the entire GFC and the aftermath of the tech bubble crash. The above graph charting the All Ordinaries index shows you how a market can remain stable over the long term even though bubbles and crashes happen. The blue trend line shows the overall long term growth rate of the share market. The green line tracks the growth rate during and after the GFC. Note how the average growth rate from the start of the GFC onwards has barely shifted compared to the long term growth rate, thereby ably demonstrating how markets recover from crashes to resume their long term trends. But of course, that doesn't answer the original question of why ETFs in particular. The reason is management expense ratios (MER). Over the long term, managed funds consistently fail to beat market averages, and that's because of the expenses along the way. It is said in the finance world “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.,” but of course, that means that if you keep cutting chunks out of your pie as it grows the eventual pie is going to be a whole lot smaller. Have you ever wondered why investment bankers get so wealthy? The answer is MERs. An MER is the proportion that a banker or firm takes out of your investment in return for managing it. Shaving off the cream of the crop, if you will. Typically, this averages out between 1-3% per annum for the average mutual fund. While this may not amount to much, over time, this can add up to a staggeringly large amount of money. Let’s say George at age 25 invests $3500 a year for 40 years at the above rate of 13.1% . This adds up to a staggering $3 548 651 (note that this doesn’t account for inflation, and in the future, a dollar will be less valuable than today). However, if poor George pays 3.3% in management fees, his end result is $1 467 205, less than half the amount otherwise. Consider this. Let’s say that the ASX 200 earns 8.1% per year. Let’s say a fund charges 2% per annum in management fees. That means that this fund must beat the ASX 200 by 2% every single year, year after year forever just to break even. It’s not humanly possible, and that’s why so many funds fail to beat market averages. An index fund distinguishes itself from an actively managed fund by its low expenses. While the average super fund might attract expenses ranging from 1 to 2 percent, or even higher, index funds get by with expense ratios under 0.5%. An index fund doesn’t require a building full of analysts or exorbitant transaction costs. It doesn't take much work to just replicate an index after all, and therein lies your key to good returns. "Hold on, that's not right!" you indignantly tell me. "You're saying that even though there are thousands of fund managers out there, they still can't beat the index? Why bother paying them at all?" Well, dear reader, that's exactly what I'm saying. Even better yet, I can prove it. Take a look at the table above. The table shows Australia's top performing super funds. Australia has just under 300 operating super funds today according to APRA’s Superannuation Fund-level Profiles and Financial Performance report. However, we're only concerned really with the biggest and the best. Out of the top 10 best performing super funds in Australia, exactly 2 of them have beaten the market average over a 10 year time span, meaning you have an almost zero chance of selecting the right fund to beat the market average. So maybe there's something to this market index business after all. Sounds good? So how do I get started? This is the section your annoying uncle has been waiting for the whole time. I’m going to dip into a bit of basic personal finance however, so I beg your forbearance. Step 1: Emergency fund Absolutely everybody could use an emergency fund. Emergency funds exist to cover unexpected expenses, such as medical bills, traffic fines, textbooks you forgot to save for, etc. The rule of thumb is to have enough for about 3 months of living expenses. For a university student, something like $1000-2000 will do the job. In a world of credit cards, however, this isn’t as crucial as it once was. That said, I still advocate emergency funds for 3 main reasons. Emergency funds don’t charge you ridiculously high interest rates. You can take as long as you need to replenish your fund. Whereas if you can’t pay back a credit card, your bank will come howling for your blood. Most credit cards require an annual income of at least $15 000 a year, which many students fail to meet. Furthermore, you should set up automatic saving. So when your paycheck comes in, your bank grabs a chunk of it and puts it in a savings account. Since your bank saves it for you as soon as the pay comes in, you’re not going to miss it, and all the money you have left can be spent guilt free. Step 2: Asset allocation So now we’re getting into the real meat and potatoes of it. Returns of portfolios are largely decided by asset classes. This means dividing your money into the share market, bonds, real estate and foreign shares. Firstly, different asset classes have different movements. Bonds tend to go up steadily over time. Shares grow at a higher rate than bonds over time, but have more volatility year to year. Foreign shares move like domestic bonds, but move up and down at somewhat different times to the Australian market. So of course, the question arises of what goes where. “Hold on, if shares earn more than bonds, why put money into bonds?” Good question, intelligent reader! Well, put it this way. If shares are down 15% in a particular year, and bonds are up 5%, then bonds are a more profitable investment, on top of decreasing the year to year fluctuations of your portfolio. Of course, that raises the question of how to make sure you’re putting money into bonds when shares are down, which I will address shortly. But for now, how do I allocate my assets? A good rule of thumb is as follows: your age as a percentage in bonds, and the rest in the stock market. I suggest you put your money into government bonds in particular, with those being the lowest risk form of bonds that are commonly available. With the stock market, have two thirds in Australia, and one third international. Simple, right? The rationale behind this portfolio is that spreading your investments both increases returns as well as decreases volatility Furthermore, as you get older (perish the thought), more and more of your money is shifted into the safer asset class provided by bonds. Step 3: Get started The great part about the internet is that today, share investing has become ludicrously simple. Assuming you’re with any of the major four banks, simply sign up for their discount broking service. These brokers charge $20 per trade, which is extremely cheap. CMC markets offers broking for $13, however you gain convenience advantages by signing up for your bank’s broking service, like being able to transfer money easily between savings and your brokerage account. Application is pretty easy. The form takes about half an hour to fill out, and it takes your bank a few days to get back to you. Okay, so you’ve got a brokerage account! Good work! Now how do you get investing? Say for example’s sake, you’ve decided to invest $5000. You want to invest 50% ($2500) in Australian shares, 30% ($1500) in international shares outside the US (which tends to move similarly to Australia), and 20% ($1000) in government bonds. While several index fund ETFs exist on the market, my personal recommendation is the range of products by Vanguard. They’re simple to use and cover a fairly comprehensive range of asset classes, allowing you to easily invest in the areas you want to. Most importantly, however, their management expense ratios are extremely low, ranging from 0.15% to 0.21%. By rule of common sense, the less money your investment takes to sustain itself, the more money flows into your pocket. The funds we’re interested in are the Vanguard Australian Shares Index ETF (VAS); the Vanguard Australian Government Bond Index ETF (VGB); and the Vanguard MSCI Index International Shares ETF (VGS). So with our fictional example, type VAS into the buy window of your stock brokerage site, buy $2500 worth of VAS shares, and you’re done! You now have 50% of your investment in Australian shares. Rinse and repeat for Vanguard MSCI Index International, as well as Vanguard Government Bonds. And that’s it! With the simplicity of three purchases on eBay, you now have a low cost, stable, high return portfolio! Tah dah! Step 4: Maintenance Okay, now that you have your portfolio, you can’t just leave it there. This is where rebalancing comes into play. Let’s say with the portfolio we just made, Australian shares go up by $4500, bonds go up $1500, and international shares go down by $1000. These rates of return are ridiculous, but they allow ease of calculation for example’s sake. What does this mean? Since Australian shares and bonds have gone up, they’re more expensive now, and it makes sense to sell them. Since international shares have gone down, it makes sense to buy more of them. Our imaginary portfolio is now worth $10000, and is made up of 70% Australian shares ($7000), 25% government bonds ($2500), and 5% international bonds ($500). Massively out of whack. So all you need to do is sell Australian shares and government bonds, and buy international shares until you’re back to your asset allocation, i.e. the percentages we decided on earlier. Asset Class: Initial Value After Growth After Rebalancing Australian Shares $ 2 500 (50%) $ 7 000 (70%) $ 5 000 (50%) International Shares $ 1 500 (30%) $ 500 (5%) $ 3 000 (30%) Government Bonds $ 500 (20%) $ 2 500 (25%) $ 2 000 (20%) This is called rebalancing. Easy! It should take you about as much time as it took to set up, which is to say next to nothing. Ah, but alas, if only humans were such rational creatures. Behavioural market analysis has revealed that people have a tendency to sell shares that decrease in price and hold on to those increasing in price, to their eventual detriment (see the dotcom bubble). Allow me to rephrase this as reasonable sounding, but ultimately stupid things that people say. “Hey, since these stocks are going up, if I hold on to them a little bit more, I can buy or pay off <X>.” Or conversely; “Hey, these stocks are dropping like rocks. I should sell them before I lose even more and they become worthless.” These are pretty common things that people say, right? It’s important to make sure you don’t fall prey to such traps, in which case it’s important to stick to your asset allocation. Your asset allocation avoids these by making sure you stick to rules you set and keeping your emotions in check. You sell things when they rise in price, and therefore are overvalued, and buy things when they drop and are undervalued, which is what a rational investor aims to do. “Buy low, sell high!” is the much touted but sadly rarely followed adage of the share market. How often should you rebalance? Research is inconclusive as to whether a 3 month or 6 month rebalance is best, however, at periods beyond a year, portfolios suffer poorer returns, with a marked decrease in performance of portfolios that never rebalance. This raises another question. When should you get in to the market? When do you buy? Thankfully, the answer to this one is a lot simpler. You can’t time the market. Study after study after study has shown that methodologies that try to time the market end in failure, due to the limited psychic abilities of humans to tell the future. Here’s a table of predictions made by stock market experts as to what the Wilshire 5000 index would be in a year, with a starting value of 1148. The closing value was 880. Not a single expert got it right, and in fact, only one expert even guessed that the index would drop. So, just buy whenever! Mr. 50 million dollar suit working on top of a skyscraper has as much chance of getting it right as you do. And that’s it! You’re done! You have now successfully created a portfolio that will last you for the rest of your life. Closing thoughts Let’s throw back to where we were at the beginning of this article. "Hey, you're doing commerce, right? I want to start investing in shares. What should I buy?" “Get a savings fund, open a brokerage account, and buy index funds. Every now and again, check to make sure things are still on track. This will make sure you get steady returns over time and you barely have to do anything!” “That can’t be right, it’s too simple! Can’t you give me something more complicated?” Yeah, well nuts to your crazy uncle. I give up. By Albert Chau 2nd year mechanical engineering student Bio: Albert is a second year engineer interested in all things financial. He is a financial god whose investment prowess is unmatched. His theories have been analysed both at home in Australia and in Washington by governments seeking to drive their countries to prosperity. He not only perfectly predicted the Global Financial Crisis, he has also in fact predicted another financial catastrophe beginning in March 2017. It is only a matter of time before his nigh-omniscient intellect is once again proven correct by the market.