My notes from reading Investing Demystified, by Lars Kroijer.
Investing Demystified was one of the first investing books that I read, around 3 years ago. Finding myself in a reading mood, I thought I would revisit it and see how it holds up.
As with the Intelligent Investor, I thought that taking notes would help me to remember more of the information contained within the book, and also serve as a useful intro for readers of this blog.
Investing Demystified was written by Lars Kroijer, a former hedge fund manager. The core premise of the book is that the markets are efficient. Even if some people can outperform it, most people cannot. The person who accepts this is a rational investor, and will therefore adopt a rational portfolio.
- Does not think that they can outperform the market
- Does not pay high fees
- Invests in a tax efficient manner
The book in 60 seconds:
- You don’t have an edge, so act accordingly
- The optimal portfolio combines the highest-rated government bonds with a world equity portfolio, in the proportions that suit your circumstances
- Think hard about your risk appetite
- Minimise taxes
- Minimise costs
- Don’t trade often and keep your investments for the long run
What is an edge?
You have an edge if you can consistently outperform the market. For example, could you choose a subset of companies from the S&P 500 index which could beat the index itself? If so, you have an edge. If not, you don’t.
You are competing against everyone else, including people who invest for a living. They have access to countless in-depth reports and the time to read them all. They attend all the conferences and have a number of very smart people working for them. What is the likelihood that you, who can only spare a couple of hours a week on stock picking, will be able to outperform them?
Most people are better off assuming that once a company is listed on the stock market, the price that it has is probably a fair reflection of its true value. Not all publicly listed stocks are good, but the price is a fair reflection of the potential for a future return from it.
Clearly markets are not efficient all of the time; but it is very difficult to know when that is the case.
Time and money costs add up
It might take hours and hours of research to outperform the market. For example, let’s say you value your time at £50 per hour. You spend 10 hours per week researching. £50 x 10 hours x 52 weeks = £26,000. When you consider that the rational portfolio is ‘set and forget,’ whatever outperformance you achieve needs to be greater than this in order to be worth it.
Likewise, Kroijer highlights that transaction costs add up. This has possibly been almost eliminated nowadays though, thanks to the arrival of Freetrade and Trading212 in the UK, Robinhood in the US and presumably similar companies in other countries. Even then, you have to pay 0.5% stamp duty if buying in the UK.
Why not just give your money to someone who does have an edge?
How would you know that they have an edge? Past performance does not indicate future success.
If you choose a fund that favours, say, technology, then you are effectively claiming an edge over the market.
Mutual fund / active managers are expensive. They may charge up to 2% per year, vs ~0.1-0.3% that low-cost global index trackers cost.
The average professional investor does not beat the market over time, but under-performs by approximately the fee amount that they charge.
The components of the rational portfolio
There are two components to the rational portfolio:
- A minimal risk asset (typically highest rated and liquid government bonds, preferably in your local currency)
- A high-risk asset – a (cheap) world equity index tracker
Combine the two according to your risk preference.
The former gives you safety, the latter gives you high expected returns but with greater risk. You could also add other government bonds and corporate bonds, but you don’t have to.
Don’t put all your non-investment eggs in one basket. E.g. you may own a house in the UK. If you then buy a second property in your area, you are heavily exposed to the UK market.
Reducing tax and expenses has a large impact on long-term returns.
Once you have set up your rational portfolio, there are a few ongoing questions to ask yourself approximately once a year:
- Are there better or cheaper products?
- Has your risk appetite has changed?
- Can you improve your tax situation?
The minimal risk asset
Buy government bonds in your base currency if credit quality is high.
If credit quality is subpar, you can either take a credit risk with your local government bonds, or a currency risk with high quality foreign government bonds. For example, say you live in Brazil; you could take on credit risk with Brazilian government bonds or currency risk with US government bonds.
Consider diversifying against the risk that your government fails, even if that currently seems unlikely – global mix of high-quality government bonds, e.g. a UK investor might go for a mix of UK, US and European bonds.
Match your time horizon
Short term bonds are lowest risk, but probably lowest return.
Long term bonds have greater interest risk – the value of a bond fluctuates with interest rates. All bond values decrease as interest rates increase. But long-term bonds will decrease by a greater amount for the same interest rate rise.
Buy a bond fund so that you don’t have to keep selling old bonds and buying new ones in order to keep up with your time horizon.
World equities – increased risk and return
You should own shares in each market according to their fraction of the market’s overall value.
You can achieve this by buying a world equity index tracker.
It’s as diversified as possible.
Simple portfolio to construct, and hence cheap.
You can expect returns of 4-5% on average, after inflation (this is a similar expectation to what Benjamin Graham said in the Intelligent Investor).
Investing is not without risk. Equity markets can be very volatile. It can take years to recover from losses of over 50%.
Markets don’t always recover! See Japan.
Past returns are not an indicator of future success. However, they are the best (only?) guide we have!
Omitted from the rational portfolio
Lars recommends avoiding the following:
- Real estate, excluding primary residence
- Private equity, venture capital and hedge funds
- Private investments
These all typically require an edge, are expensive to hold, increase your exposure to one specific market, or some combination of all three.
You will be exposed to some of these asset classes anyway via the stock market.
Financial planning and risk
It is important to work out how much you need in retirement, and how much you can save each year leading up to retirement.
Over time, you will fare worse than the compounding of your average returns. As an example, consider these two scenarios. At the start of year 1, you deposit and invest £100. In year 1, you earn -20%. In year 2, you earn 30%. The average annual return is 5%. However, you will only have £104 after those two years. However, if you received exactly 5% in both year 1 and 2, you would have £110.25 after two years. (This is a very interesting point that I don’t think is talked about enough).
There is always the risk that you will reach retirement without enough money to last. You can counter this, to an extent, by:
- saving more each year in the run up to retirement.
- spending less each year in retirement
- taking on more risk in retirement (i.e. keeping more of your portfolio in stocks, rather than switching most of it to bonds)
Minimise your investment expenses. They can compound hugely over the course of 20-40 years and greatly affect the final value of your retirement pot. Reduce investing costs and local taxes accordingly.
Pensions are typically very tax-efficient, but have their limitations. Check for high fees, suitable funds, etc. Also bear in mind that you may not be able to access the pension until retirement age (likely to be at least 68 in the UK).
My main takeaways
If you have an edge, great! Exploit it and make lots of money.
In the more likely event that you don’t have an edge, then you should embrace that fact and stick with two investment products; a global equity index fund and a bond fund.
Lars mostly focuses on buying bonds from your local government, with the option of buying foreign bonds for some diversification. I’d have to do some more research to figure out if this is better than buying a mix of global bonds. Monevator posted a very interesting article on this topic a few months ago – Do US Treasury bonds protect UK investors better than gilts?
My opinion on the book
When I first read this book, the only thing I took on board was the central message. I feel like I have learned more on this second read! The take home message is very clear and simple. But the book goes beyond that and includes plenty of more complicated stuff. You don’t need to read the difficult chapters to construct your ‘rational portfolio,’ but it is interesting for those who want a more in-depth understanding. Definitely highly recommended for beginners and experienced investors alike.
Over to you
Hopefully this convinces any new investors that investing for the future doesn’t have to be difficult.
I would be interested to hear if any readers have looked at this book and if there is anything important I have missed.
Thanks for reading.