If you are a young professional and you’re making your first savings, and wondering what to do with them, this post is for you. Disclaimer: I am not an economist. But that’s probably a good thing. Why? Read on.
With a very insightful post, Scott Adams, of Dilbert fame, made me realize that, when it comes to choosing which stocks to invest in, financial experts can’t beat a blindfolded monkey throwing darts at a newspaper’s financial pages. Don’t take his word for it: this has been proven many times, and the best investors (at least those wise and honest enough to admit their limits) all seem to agree. The monkey analogy actually comes from a seminal book eloquently called A Random Walk Down Wall Street.
What really drove the point home for me, though, was Nassim Nicholas Taleb’s famous book, The Black Swan. Nassim points out that not only do the self-proclaimed finance experts not have any useful insights, they also routinely convince themselves – and the rest of the world – of the opposite, which makes them even more dangerous. The finance world has been littered with mathematical models that pretend to tame the uncertainty and give the discipline a pretence of science, completely missing the point that science is based on testing hypotheses, not just formulating them.
If you’re still not convinced that so-called financial experts haven’t got the faintest idea of what is going to happen, check this awesome video interview which explains the sub-prime mortgage crisis.
So we’re on our own. Let’s start over. Shall we?
If we don’t trust financial experts, then why invest at all? That’s a fair question. You could spend all your money buying stuff. But buying stuff can give you a high that’s pretty short-lived. Then all you’re left with is crap that you have to find a place for, or try to sell, likely at a much lower price than you paid for it.
You could try spending it on fun things, like going to the Met Opera every weekend, or going to see Lady Gaga once. But, if you’re like me, you’ll do as many of those things as your time and energy permit, and then you’ll still have a bit of money left over.
Besides, you should have a bit of money left over anyway, for when you retire, or for emergencies (e.g. you fall in love with a girl who needs you to buy her a huge bouquet of flowers every single day).
You could let that money sit in your bank account, but then it’s going to be worth less and less every day, as inflation eats at it. Why do that when you can get its value to grow with a minimal effort?
Note that the minimal effort requirement excludes any investment that I can’t do from my couch with an iPad. Don’t even mention real estate.
So, for better or worse, we’re pretty much only left with financial stuff.
Following his hunch that economists are no better than blindfolded monkeys, Scott Adams concludes that there is no reason to use any of the managed mutual funds. Managed funds have never consistently outperformed indexes (fixed pools of stocks chosen to represent the whole market or market segment). So, he says (like many others before him): just put your money in an index fund. Since it’s not actively managed, it will have lower overhead costs, hence it will perform better.
ETFs (Exchange-Traded Funds) are funds traded on the stock market. They cost less than regular mutual funds. And there are no minimums. Anyone can put even tiny amounts of money in an ETF index fund. And you can do it quite easily through your bank’s brokerage account, or through one of the low-cost online brokers.
Which ETF funds? Scott argues for a simple, 50%–50% split between two ETFs from Vanguard: VTI (a good sample of US companies), and VWO (a sample of emerging market companies). This diversifies your money into basically every company on the planet. Except, say, European ones (as a European expat, let me say: how wise).
This is 100% stocks. To me, having recently witnessed not one, but two stock market crashes, and having just re-read The Black Swan, that seems awfully risky. Who is to say that the stock market is going to monotonically increase? Looking at past evidence, this seems to rarely be the case.
Betting on the stock market as a whole is too risky. And not risky enough. At the same time. Let me explain.
I’m not going to explain the whole philosophy behind the Black Swan book for you, because I want you to read it yourself. For the purpose of this article, though, the tl;dr is this: shit happens. And nobody can predict it.
The good news is that shit can be good and bad. The stock market might crash tomorrow. But a small company might triple its value overnight. Or the price of oil might skyrocket as supplies fail to meet demand.
You can be prepared for shit to happen. You can minimize the risk of the bad shit and maximize the returns from the good shit.
According to Nassim, to prepare for the bad shit, you should put most (say, 80%) of your money, the part that you are not prepared to lose, in the safest investment possible. To prepare for the good shit, you should put the rest of your money (20%) in a pool of investments with the highest potential return.
Personally, I’m young, my savings so far are small, and I’m prepared to lose a big chunk of them. So I’m inclined to go with a more aggressive split, say 60%–40%. Note that this is still 60% more of safe investments than Scott Adam’s portfolio. And a whopping 40% more of high-potential-return investments.
So where do I put the 60% safety net money? For fixed-return investments, the options seem to be:
Cash gives 0% per year. Or 0.5% if you have a generous bank. Good savings accounts can give up to 1.25%. Certificates of deposit can give as much as 2%, but require you to commit to the investment longer-term (what if I want to buy a new MacBook Air tomorrow?!?). Bonds, on the other hand, can give up to 3%. They are not 100% safe, as their value can plummet if the issuing institution goes bust. You can mitigate the risk by investing in bonds from a varied pool of ‘reliable’ institutions (such as governments). There are bond ETFs that let you do just that. The bonus of bond ETFs is you can buy and sell small amounts any time just as easily as any other stock.
After a bit of research, I picked Vanguard’s BND. It’s one of the top traded bond ETFs, and it has consistently yielded around 3% in the past years.
Edit: On second thought, I’d pick an even safer bond
ETF: VGSH. These are short-term government bonds.
In order to expose yourself as much as possible to the good shit, Nassim recommends a VC-type fund. Which would be great. As a startup guy, I’d love no better than to invest in startups. It’s what I know, and it’s where the fastest growing opportunities are. Unfortunately, mere mortals are not allowed to invest in startups. You have to have millions, you have to be an “accredited investor”, and you have to be part of the angel/VC community. There is no legal way for a regular Stefano to invest a small amount of money in a startup. A few projects (Profounder, Secondmarket, Venture Bonsai) are trying to exploit loopholes in the system, but they’re still too young to be practically useful.
For a while, I’ve toyed with the idea of putting my money on promising Kickstarter projects, hoping that one day my generosity will pay off somehow. But I couldn’t find any promising enough projects, and still all the top donation spots were already taken, making it pretty unlikely that my contribution would ever stand out enough for it to pay off.
So I went scouring the internet, and my brain, for high-risk opportunites that are more readily available. I came up with three of my own. These are very personal, and very time-sensitive. I’ll tell you my choices, but you should trust your instincts and come up with your own. A good place to start is this ETF screener.
One thing to keep in mind as you evaluate funds and stocks is… the past doesn’t matter. Don’t fall for what Nassim calls the turkey fallacy. A turkey gets fed every day, so he is increasingly certain that he will get fed tomorrow. Until Thanksgiving comes, and the turkey is not fed. It’s killed. Don’t look at the past as a predictor for the future. Just don’t.
ARMThe startup I work for is in the hosting business. And I own an iPhone and an iPad. What do these things have in common? iOS devices run on ARM processors. And our servers will likely run on ARM processors in the near future. Microsoft annouced ARM support for the next Windows. Calxeda is a startup betting on ARM-powered servers. Can you connect the dots yet?
For CPUs, low-power requirements are more important now than raw speed. Both for servers, and for mobile devices, if the CPUs consume less, you can cram more of them in. Space is no longer an issue (you can make them smaller), but power consumption (and corresponding heat generation) is.
ARM are simply the masters at designing low-powered CPUs. Designing, not making. They let other companies make the products they design. Sounds familiar? That’s right, that’s how Apple does it. Watch ARM kick ass in the future, the same way Apple did in the past years. I’m willing to bet 20% of my savings that they’re going to make it big.
Some might say that this is nothing new, investors know it, therefore the price of ARM already takes that into account. Perhaps. But you could have said the same about AAPL two years ago.
The US stock ticker for ARM is ARMH.
Edit: a few people rightly pointed out that it’s inconsistent to discourage individual stock picking, and then pick a stock to invest in. In fact, as I mention elsewhere, I’m not recommending you do the same. I revised the portfolio not to include
ARM, though I might still keep this as my own personal bet, even if just for the thrill of it. I am fully aware of the risk.
People still argue whether peak oil is a myth or not. Fact is, behind closed doors, even industry insiders admit that the oil peak likely already happened. The only reason oil prices haven’t skyrocketed yet is because we’ve had multiple recessions.
I’ve heard the counterarguments. “There is plenty of oil.” Perhaps, but if so, then it must be hella hard and expensive to extract, how else would you explain the fact that production has plateaued for years despite increasing demands? “We’re going to switch to renewables.” Right. Let’s see us go from 4% renewable energy to 50% in 2 years. Let’s see the 97% of people who still don’t own an electric car go buy one tomorrow. Not gonna happen.
I’m not saying that oil is going to run out next week. I’m saying that supply is going to have an increasingly hard time meeting demand, and that is going to drive prices up. I’ve been convinced of this for a long time, but somehow I’ve failed to put the money where my mouth us. Until now.
I’ve investigated the possibility for a regular person to buy oil. Buying physical oil is possible, but, shall we say, impractical? Watch me store 2000 barrels of oil in my living room. A more practical solution is to buy “futures”, or the promise to receive oil at some date in the future. The problem with this is that you have to sell before the delivery time comes. Otherwise, again, you’re stuck with 2000 barrels of oil in your living room.
The solution is, again, ETFs. This time, though, there is a catch. Since oil ETFs are based on futures, not physical oil, something weird happens when there is a difference between the value of oil delivered today and the value of oil delivered tomorrow.
You see, oil funds own futures that expire on June 1st. Before June 1st comes, they have to sell them, and buy futures that expire July 1st, otherwise they have to accept the delivery of oil and figure out in which living room to place it. If you’re lucky, the July 1st futures will be cheaper (market in “backwardation”). If you’re unlucky, the July 1st futures will be more expensive (market in “contango”).
In the scenario that I envision, where oil prices start to go up, and finally everybody agrees they will keep going up, futures dated further in the… future will be more expensive. Each time the fund has to roll over, it has to pay extra to switch to futurer futures. These costs can significantly eat at your returns.
To mitigate that, one option is to go with an oil fund that tries to be smart about rolling over at the most convenient time. One such fund is DBO. If you trust Deutsche Bank to be able to accurately predict the future, go for it.
Personally, I trust no one with forecasting, so I’m not going for that. Instead, I found an option that’s more ballsy.
Some ETF funds are labeled 2X. This means that the guy managing the fund takes your 10 bucks, and instead of investing them directly in the underlying commodity, he asks his grandma to give him another 10 bucks, and invests 20 for you. If the stock goes up, you get twice the profit! (Grandma only gets back her 10, plus a hug.) If the stock goes down however, you have to pay back grandma for what she lost as well, so you lose double.
I’m willing to bet big on the price of oil going up. I don’t care if, due to overheads, 2X funds don’t actually make two times as much, or even if they lose to a regular 1X fund in a plain up-down market. If the price does go up as I imagine it will, the 1.5X returns of a ‘2X’ fund are going to compensate for any losses, and any costs incurred if the market is in contango. The 2X oil ETF is UCO.
Edit: thanks to the great feedback, I decided it’s not wise to use leveraged funds for long term investing. I’ll stick with DBO instead.
This third option is for those of you who are less imaginative. Small-cap funds, as the name implies, simply hold shares of a bunch of small companies. They are interesting based on the idea that small companies, like startups (but to a lesser degree), are the ones with the highest potential for growth (and risk). These are funds composed of a large number of stocks, so the potential returns by one black swan in the bunch will be diluted by all the other small companies struggling. And one stock market crash will slash your value. So I’m not a big fan of this option. But if you can’t come up with any other ideas, go with a small-cap ETF, like VB.
This is sort of a different category as the other three, because I don’t feel that the potential returns are as big. The only reason I mention precious metals is because I see them as an insurance against stock market collapses. People tend to rush to gold whenever they suddenly remember that, oh shit, the stock market is not as safe as we thought!
There are precious metals ETFs. Choose wisely. Some ETFs are backed by real metal in a vault somewhere. If the issuing company fails, you get the real gold. Other ETFs are backed solely by a pinky promise from Goldman Sachs. Personally, I have no prejudice against any of the precious metals, so I’d pick an ETF which is representative of all four (gold, silver, platinum and palladium), backed by physical stuff. There is one fund that matches these requirements: GLTR.
I’m not quite sure whether this is a good enough use of my money. For now I’ll stick with a more simple 60% safe, 40% high-return split, without the more complex (and unpredictable) interdependencies.
Edit: following advice from Nassim himself, I’m now considering using GLTR as insurance against hyperinflation.
I agree with Scott that ETFs are a great option. However, I think it’s a bad idea to invest solely in stock ETFs.
I’m going with a Black Swan inspired ETF portfolio, where I put the portion of my money I’m not prepared to lose (in this case, 55%) in a safe ETF, and the rest I spread over a bunch of opportunities with a high return potential, as follows:
This gives me keeps me relatively safe in case all the other stuff crashes. (I originally recommended BND here, but VGSH is safer and thus truer to Nassim’s approach.)
In case the stock market stays healthy and a bunch of the small companies make it big.
As insurance against inflation and stock market collapses. (Swapped for ARMH.)
In case I’m right suspecting that peak oil will drive oil prices up. (My original pick was a leveraged 2X oil fund – changed thanks to feedback.)
These are my current choices, but keep in mind that, at least for the risky portion, you should probably make your own. Don’t trust me, what do I know? For that matter, what does anyone know? Trust no one. Your choices are as good as anyone else’s.
I think it’s important for you to have fun with your selections of the risky stuff. Think of the 60% of safe investments as a way to free yourself from having to make ‘reasonable’ and ‘educated’ decisions on the rest. After all, no amount of research and preparation can help you accurately spot the positive black swans lurking under some investment (or avoid a big loss), so just think of it as gambling, except with a higher likelihood of positive returns.
Who knows, if you have fun with it, maybe next time you have some money lying around you’ll decide to try out your next interesting investment, rather than spend it on something you might regret buying later. I think that’s a healthier use of your money.
Don’t get carried away though. Don’t spend time looking at day-to-day, or week-to-week, or even month-to-month changes. They don’t matter.
A couple of years ago I noticed that all my friends were considering switching to Macs, and everybody and their mothers was planning to buy iPhones. I convinced a friend to buy AAPL stock. He bought it at $60, then a few days later got antsy and sold it at $70, thinking that was all the profit he could possibly get. AAPL is now worth $340. I did end up buying AAPL for myself and make a healthy profit on it, despite a recession that annihilated many years of growth on all the managed funds that my family owned.
You’re in it for the long haul. You can withraw money any time you like if you need it for something else, but don’t expect to catch the right wave if you don’t wait for a while. Black swans don’t happen every day.
Needless to say, I’d like to hear your opinions on the topic.
ETFs?Comment on Hacker News, or hit me at steadicat.
3:23pm
EST: Revised my pick for the oil fund from a leveraged fund to a regular one. Thanks for the feedback!
10:20pm
EST: Following recent advice from Nassim Taleb himself, I swapped short-term bonds for mixed bonds, and re-introduced precious metals in the portfolio.