What to invest in?

Over time you will likely find out what type of investor you are. Whether you are comfortable taking risks; are tolerant to market volatility; can control your temperament during market downturns when the headlines are telling you the world is ending; and whether you want to take an active interest in your investments.

Think first about your risk. Only then should you consider possible rewards.

Since its inception in 1957, the S&P 500, which tracks 500 large-cap American companies selected on the basis of certain rules, has returned an annualised ~8% to shareholders (and even more when going back to 1926 when there were only 90 vs today's 500 companies inside the S&P). Those returns are higher than any other asset class (i.e. real estate, bonds, etc.) has returned over the same time period.

However, stock markets do not go up in a straight line. As you can see in the table below, there are vast discrepancies between returns from year to year. And you never quite know what year you are going to get. This is why time and the temperament to stay in the market is your friend. The last thing you want to do is be a seller in the red years when the media may be shouting "SELL, GET OUT, RUN" and a buyer in the green years. Equities may be the only asset class people actually do not like to buy at a discount. Take a look at the headlines over the last ten years below and what indeed ended up happening if you had sold in those times, especially at the bottom when the pundits tend to get the loudest.

Time and time again, studies have shown that the best investment strategy is to do nothing and let your money compound over time, come rain, come shine. Warren Buffet acknowledged this when he said: "The stock market is designed to transfer money from the active to the patient". Hence, your emotions and temperament can be your own worst enemy. Daniel Kahneman won the Nobel Prize for showing that people respond stronger to loss than gain. It's an evolutionary shield: "Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce" he once wrote. So remember that when before you get tempted to hit the sell button.

Passive vs Active Investing

Passive investing involves buying an exchanged traded fund (ETF), a basket of companies that make up the market indexes it tracks, such as the S&P 500, FTSE 100, DAX, or Nasdaq 100. Holding one such ETF means paying a small annual fee to the issuer of the ETF (0.07-0.65% of the purchase price) and letting the underlying ETF rules make the investment decisions for you. ETFs are rebalanced on a quarterly to annual basis, meaning that any one company that grows faster than the rest of the companies in the index are trimmed to limit overexposure, and under-performering companies may be replaced with high flying companies. Indexes, which ETFs allow you to track, are commonly referred to as "the market" since the companies contained within them are the benchmark for a country's economic performance.

Active investing on the other hand, usually involves selecting individual companies with the hope that these will "beat the market" performance. For example, your aim may be to achieve better returns than the S&P 500 so you select individual companies that you have faith will perform better over the coming years than the S&P 500 as a whole. Take for example the performance of the so-called FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks over the last 10+ years, which have wildly outperformed the S&P 500 Index.

The challenge is, of course, to identify the next FAANGs, which takes a lot of active research into future trends, companies at the forefront of those trends, their competitive landscape, the quality of their management, and some feel for the future popularity of a trend. It's not always easy and you will get some things wrong. Netflix's co-founders were laughed out of out of the door by Blockbuster's then CEO when they offered up the company for sale to the video rental company for $50 Million in 2000. Now there is a single Blockbuster store left and Netflix is worth over $150 Billion. What looks obvious in hindsight, isn't necessarily that easy to identify at the time it counts.

The disadvantage of owning solely ETFs is that due to the rebalancing strategy that trims fast growers, with this investment choice you will never be able to take full advantage of the 6,450% gains companies like Netflix have had over the last decade. Hence, some people choose to own high conviction companies outright as well as ETFs.

Combining Active and Passive Strategies

Not every one of your actively picked companies is going to be the next Netflix or Amazon. Unless you are extremely lucky. Yes, luck will play a huge part in your investing journey. This is why you want to have a diversified portfolio. As a rule of thumb, you should aim to hold a mix of 40 different companies. As that is not necessarily feasible to begin with, it is a good idea to start by investing in an ETF as you will instantly and automatically be diversified by holding the basket of companies contained within that ETF. If you feel like you want to take an active role in your investment and are enthusiastic about a certain company and their future prospects, then you can also add individual companies to your ETF portfolio and follow their development over time. You will not be right with every investment you make but every Netflix or Amazon that you do have will compensate you many times over for any failures. In fact, even the most successful investors are more wrong than they are right when picking stocks, but it's enough to make outsized gains. Even within the S&P 500, less than 100 companies drive all of its returns, you just don't know which 100 companies it is going to be from year to year.

Personally, I like to combine the active and passive style of investing because I enjoy reading about future trends and companies. My main aim is not to outperform the market as such, though that is a nice side effect, but to steer my investments into the direction that I believe the future is heading and the future I want to see, which may not be fully reflected in the companies contained in the ETFs available on the market. I also like to take environmental and corporate governance (ECG) factors into considerations in my investments, which steers me away from certain ETFs that contain companies that I do not believe fulfil the ECG criteria.

A Note on Volatility

As discussed above, the stock market can be volatile at the best of times, and scare the hell out of you in the worst of times. Due to the vast number of companies the S&P 500 tracks, volatility is unlikely to be as vast as any one individual company you invest in, especially when that company is in its early innings. Amazon, for example, lost 90% of its value during the dotcom crash between 2000-2002, while the S&P 500 "only" dropped 49.1%. And look where we are now. The lesson being, volatility isn't necessarily a reflection of risk. Short term stock performance is based on the mood of the market at a given point in time, and more often than not, reflects trader's hands being forced into selling by margin calls. As Warren Buffet's mentor Benjamin Graham once said "In the short-run, the market is a voting machine, but in the long-run, the market is a weighing machine". So if you really believe in a company, the best thing you can do is buckle up and hold on during the bumpy ride.

Resources

Two of the best known companies issuing market tracking ETFs are Vanguard and Blackrock (iShares). These two companies have issued vast numbers of ETFs over the years, tracking a number of different market indexes. read more about ETF investing HERE.