How you should invest depends on your situation in life. If you are young and don’t need the money in the next 30 years you should be investing differently compared to if you are saving for a house down payment in 2 years or if you are planning to retire soon.
The two most important factors to consider are the risk and the return. Another thing to consider is the liquidity of the investment, but let’s assume in this post that we are only investing in liquid assets (ones that are easy to sell). Ideally, everyone would like the highest return with no risk. However, the risk free investments typically have very small yields and will give you poor returns. See an example of Irish bonds, the rates are terrible, but the risk is very small if the inflation is low. The rates on the savings accounts are similarly poor.
There is one exception to that, which is paying off debt. Some people say “why should I pay off my debt, while I can make xx% in the stock market”. Paying off your debt is literally the risk free return, especially if you have high interest debt. Stock market on the other hand can be very volatile and you are not guaranteed high returns (even if on average they are pretty good, good returns in the past will likely mean worse returns in the future, since things tend to average out).
If you have credit card debt with a typical interest rate paying it off will give you likely higher return than the stock market with zero risk. When you are comparing the return between paying off debt vs investing, you also need to account for taxes on the investments. For example if you compare expected 6% return from a stock market investment, but taxed at 41% to paying off your mortgage, paying off your mortgage might be not such a bad idea.
However, let’s assume that you don’t have any high interest rate debt and you are not happy with the returns offered by risk free investments. This means that you will have to take some risks to get higher returns. Ideally, you would like to maximize your returns for a given amount of risk. This is not a new problem in finance, Harry Markowitz (https://www.investopedia.com/terms/h/harrymarkowitz.asp) came up with the Modern Portfolio Theory (MPT) that got him a Nobel Prize in economics that focuses exactly on that problem.
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Key takeaways from Modern Portfolio Theory for everyday investors
- combining multiple assets can lead to significantly lower risks without impacting the returns too much if those assets are not correlated and have different volatility (don’t go down at the same time, their price changes are unrelated)
- for a given level of risk there is a maximum level of expected returns - efficient frontier
In other words, you should be combining various assets that are not correlated and you can pick your relative risk level where the risk is generally related to volatility (how much the portfolio can go down). Ideally the assets you would be combining would have similarly high returns, otherwise combining your portfolio with an asset that has lower expected return will lower the expected return of your portfolio. However it still might be worth it for the decreased volatility.
Provided that you are diversifying with high quality assets, the more diversification the better. Two high quality stocks are better than one. Stocks from different sectors are better than from only having stocks in the same sector, because the stocks from the same sector will likely be correlated (go down or up at the same time and don’t improve the stability of your portfolio). Stocks from across different markets, e.g. US, China, Europe, etc are better than only US stocks.
Investing in the whole market is the easiest way to capture the average market return. Beating the market can be the result of luck, but to do it consistently you need a lot of skills and professionals often fail at this. Luckily it’s very easy to invest in very broad index funds - with one fund you could invest in the whole world and capture the whole world’s average returns and likely outperform many active investments.
Combining stocks with other asset classes
Even the most diversified stock portfolio is vulnerable to whole market swings. This is where other asset classes come in that you can combine with stocks to make your portfolio less volatile. You can see the correlations between major asset classes here.
This could be bonds, gold, crypto, real estate, private funds, etc. However, the most typical portfolio is part stocks, part bonds. If you combine two assets, their expected return would be proportional to how much of each you included. If we expect yearly returns of stocks to be 8% and bonds to be 2% (those are just a illustration, not a actual market prediction) and we make the portfolio of 50% stocks and 50% bonds, then the expected combined return would be 0.5 * 8 + 0.5 * 2 = 5. For a portfolio of 90% stocks and 10% bonds, the expected combined return would be 0.9 * 8 + 0.1 * 2 = 7.4, which would be significantly higher, but the performance would be more volatile. However for a long term investor, 30 year of compounding at 5% vs at 7.4% would make a huge difference.
To illustrate that, 10k compounded at 5% rate for 30 years will give you about 43k. 10k compounded at 7.4% rate will give you about 85k.
Investing is scary because, it’s inherently risky, so you might be leaning on the conservative side. But this can be very costly and might be more risky long term (e.g. not having enough to retire after fees, taxes and inflation). This brings me to the next part of the article.
Real risks and volatility risks
Many people treat volatility and risk as if they were the same and I don’t like that approach.
There are some real risks of investing, for example If you invest in an individual company and that company bankrupts, your shares will practically become worthless and that company will not recover from that . You might also just be unlucky and buy a struggling company that never grows. This risk is largely eliminated if your investments are diverse enough, because good performers should compensate for the poor ones on average.
The bonds are also not without risks. Two main risks related to bond investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. And since the interest rates are very low right now, it’s more likely that they will grow than fall in the next couple years, especially as the economy improves. The credit risk refers to the possibility that the issuer of the bond (a government or a company) will not be able to repay the principal and make interest payments and the bond might become worthless. And let’s not forget about the inflation, which can very negatively impact real returns from bonds. See this article to learn more about the impact of inflation on bonds.
On the other hand, volatility is much more often caused by a public opinion than real problems and as long as you don’t sell while things drop, you don’t realize your losses. Because of that it’s easier to tolerate it especially if you have a long time horizon.
For example with a long term horizon you can tolerate pretty high volatility (e.g. 50%) drop as long as the investment can recover from it and it typically will. Especially if we are talking about whole markets and not individual companies. If you have a short term horizon and need the money it might make you sell at a lower price and realize the big loss this way making the investment actually risky for you.
Practical recommendations
If you don’t have any stock investments yet and if you want to invest post tax (outside of the pension), pick a single stock ETF that covers the all world (developed and emerging markets) and a bond ETF.
My top pick for a single stock market ETF portfolio would be: Vanguard FTSE All-World UCITS ETF (USD) Accumulating
Here is why, it’s:
- Irish domiciled (simplifies taxes for Irish investors and makes the fund more tax efficient internally)
- Extremely well diversified
- Low cost (0.22% fees a year) and from a trusted provider (Vanguard)
- Accumulating (instead of paying the dividend out it’s automatically reinvested which makes it more tax efficient and increases compounding)
Bonds - I am not a bond expert, but I would not recommend investing into Irish bonds directly. They have low rates and low liquidity. You would be better off with a Bond ETF (like this one). You can find a comprehensive guide to bond ETFs here.
Depending on your risk level, pick the proportions of stocks and bonds. If your time horizon is 30 years or longer, you might be fine without any bonds or with less than 10%. You can always shift more towards bonds later as you are approaching your investment horizon to solidify the stock gains. If you are investing for 3-5 years, consider picking a higher portion of bonds.
If you want to avoid ETFs because of how highly they are taxed, you can take a different approach. You could create an ETF like portfolio of individual stocks, that will avoid the deemed disposal tax and will be overall taxed at a lower rate. See an example here. However that would be much more complicated and wouldn’t guarantee similar or better results.
If you already have a bunch of specific investments, picking a whole world could result in you overweighing certain markets more than others, e.g. if you were combining S&P 500 with All World FTSE you would heavily overinvest in the US stock market. To avoid that you could instead buy an similar looking ETF (low fees, Irish domiciled, accumulating, etc) that would complement the diversification you already have or alternatively, you can sell your less diversified fund and buy a more diversified one. But then you would have to pay the taxes from the gains.
There are tons of options for funds and ways to create a portfolio. However, it’s unclear if it’s worth to make your portfolio more complex. You don’t need to make it complicated as long as you stick to solid fundamentals.