How I’m investing my savings in my 20s and 30s: A guide

Investing For The Long-term (Retirement)

How to Assess Investment Vehicles

16 min read.

Having chosen that you’re going to invest in the stock market through investment funds, there are several frameworks within which you can do it. In choosing which is right for you, you should take into consideration the following criteria:

• Expected return on investment.
• Commissions and fees.
• Degree of control over investment decisions.
• Degree of freedom to withdraw your savings.
• Taxes.
• Employer benefits towards retirement plans.

Many of the above criteria are interlinked, often acting as trade-offs where you will have to choose between benefiting less on one end to benefit more on another. I’ll cover them indirectly while discussion a few topics. At the end of this chapter, we’ll review these criteria with our acquired knowledge from these topics.

Active vs. Passive management

Let’s start by considering the most top-level decision you’ll make on how your money is going to be invested: will you hire someone to invest it for you, or will you invest it yourself?

“Actively managed” means that there’s a team of financial experts who decide on your behalf where your money is going to be invested, meaning which assets are going to be bought to include in your portfolio. These decisions are always made according to the fund’s stated investment strategy. For example, a fund may have a more aggressive strategy, allowing for a larger portion of its portfolio to be composed of stocks of companies in emerging markets (which are riskier) and another fund may be more conservative, limiting the weight of stocks as an asset class in the portfolio. There is a full array of funds being offered by financial institutions, to every liking.

I’ll use a quote from Ramit to explain “passively managed” funds, also called “tracker funds”.

[Tracker funds] work by replacing portfolio managers with computers. The computers don’t attempt to find the hottest stock. They simply and methodically pick the same stocks that an index holds—for example, the 350 stocks in the FTSE 350 index—in an attempt to match the market.

—Ramit Sethi, I Will Teach You To Be Rich

Putting your money in an actively managed fund has the advantage of being a hands-off approach. Your only concern should be to regularly put money on the fund, and the fund managers will take care of your investing. However, this service comes at a cost. You’ll pay annual fees that, in Portugal, from what I saw, tend to fall somewhere between 1 and 2% of our capital. This means that, if you have 50.000 € invested in an actively managed fund at the moment the fund managers are taking their fee, they’ll charge between 500 to 1.000 €. You’ll find passively managed funds with annual fees of 0,20% or even lower (I’ve invested in one with a 0,20% fee).

Are actively managed funds worth the higher fees? The answer is no.

Financial experts—in particular, fund managers and anyone who attempts to predict the market—are often no better than amateurs. They’re often worse. The vast majority of twentysomethings can earn more than the so-called “experts” by investing on their own. No financial adviser. No fund manager. Just automatic investments in low-cost funds. So, for the average investor, the value of financial expertise is a myth. (…)

Managers use fancy analysis and data, and trade frequently. Ironically, this results in lots of taxes and trading fees, which, when combined with the expense ratio [=annual fees plus other expenses], makes it virtually impossible for the average fund investor to beat—or even match—the market over time. (…)

A fund manager may be able to perform very well over the short term. But over the long term he will almost never beat the market—because of expenses, fees, and the growing mathematical difficulty of picking outperforming stocks.

—Ramit Sethi, I Will Teach You To Be Rich

In short, because actively managed funds are expensive and tend to fail to beat the market, you’ll probably be better off with a tracker (passively managed) fund.

Tracker funds are the financial equivalent of “If you can’t beat ’em, join ’em.” And they do so while also being low cost and tax-efficient, and requiring hardly any maintenance at all.

—Ramit Sethi, I Will Teach You To Be Rich

Asset Allocation and Diversification

Regardless of whether you’re hiring someone to invest your long-term savings for you, or whether you’re investing it yourself – and after reading the last section, I think you’ll want to invest it yourself – probably the key idea to investing is: you want to build a portfolio that is diversified across asset classes (broad asset allocation) and inside each class (diversification).

Before talking about asset allocation and diversification, let’s talk about returns and risk.

Retuns and Risk

In determining where to allocate your assets, one of the most important considerations is the returns each category offers. Of course, based on the different types of investments you make, you can expect different returns. Higher risk generally equals higher potential for reward.

—Ramit Sethi, I Will Teach You To Be Rich

To offer you a reference, Ramit presents the Average Annual Returns of 80 Years for 3 asset classes:

• Stocks: 10,5%
• Bonds: 5,2%
• Cash: 3,8% (when stored in an interest-generating money-market account)

Stocks clearly outperform bonds and cash. So should we only invest in stocks, to maximize our returns? Below we’ll see that it depends on for how long you’re intending to hold this investment (basically how young you are if you’re investing for retirement), but the general rule is no. We should diversify across multiple asset classes. And the reason is that higher returns mean higher risk. Stocks are riskier than bonds, which in turn is riskier than cash, and returns reflect that (it’s said that investors are rewarded with a risk premium when they invest in riskier assets).

Think of risk as the degree of uncertainty of how your portfolio will perform in the future. Higher risk means that you’re less able to have a grounded expectation on how much your portfolio will be worth 6 months from now, or 1 year from now, or 5 years from now. And this is because a high-risk portfolio’s value will suffer from higher volatility, from higher variability, will be more susceptible to market conditions (all synonyms in this context).

So definitely we want to keep risk to a minimum, although also not hampering our returns too much. This is where finding the right balance between higher-risk-and-higher-return assets and lower-risk-and-lower-return assets, known as ‘asset allocation’, comes into play.

Asset Allocation

If you bought all different kinds of stocks or stock funds, you’d be diversified—but still only within stocks. (…) It is important to diversify within stocks, but it’s even more important to allocate across the different asset classes—like stocks and bonds. Investing in only one category is dangerous over the long term. This is where the all-important concept of asset allocation comes into play. (…)

The little-known but true fact is that the major predictor of your portfolio’s volatility is not due, as most people think, to the individual stocks you pick, but instead your mix of stocks and bonds. (…) 90 percent of your portfolio’s volatility is a result of your asset allocation. (…) In other words, by diversifying your investments across different asset classes (like stocks and bonds, or, better yet, stock funds and bond funds), you could control the risk in your portfolio— and therefore control how much money, on average, you’d lose due to volatility. It turns out that the amounts you buy—whether it’s 100 percent stocks or 90 percent stocks and 10 percent bonds— make a profound difference on your returns. (..) Suffice it to say that asset allocation is the most significant part of your portfolio that you can control.

Think about that remarkable fact: Your investment plan is more important than your actual investments. (…)

As we discussed earlier, the key to constructing a portfolio is not picking killer stocks! It’s figuring out a balanced asset allocation that will let you ride out storms and slowly grow, over time, to gargantuan proportions.

—Ramit Sethi, I Will Teach You To Be Rich

So how does a balanced portfolio look like? How much weight should I attribute to each asset class? Just as a reference, Ramit included in his book David Swensen’s model of a balanced portfolio, and I’ll include it here as well.

The Swensen Model of Asset Allocation

Swensen is pretty much the Warren G of money management. He runs Yale’s fabled endowment, and for more than twenty years he has generated an astonishing 16.3 percent annualized return, whereas most managers can’t even beat 8 percent. That means he has doubled Yale’s money every 4.5 years from 1985 to today. Best of all, Swensen is a genuinely good guy.

—Ramit Sethi, I Will Teach You To Be Rich

Stocks
30%	Domestic equities	UK equity funds, including small-, mid-, and large-cap stocks.
15%	Developed-world international equities	Funds from developed foreign countries, including the United States, Germany, and France.
5%	Emerging-market equities	Funds from developing foreign countries such as China, India, and Brazil. These are riskier than developed-world equities.
Real Estate
20%	Real estate funds (REITs)	REITs are funds that invest in residential and commercial property, both in the UK and overseas.
Bonds
15%	Government bonds	These provide predictable income and balance risk in your portfolio.
15%	Index-linked bonds	To protect you against inflation. These should be the last ones you get after investing in all the better-returning options first.

Note that this is only provided as a reference, and you probably won’t build such a complex portfolio from the start. Actually, if you’re starting investing early, you should feel comfortable to start with a more aggressive portfolio, more heavily focused on stocks.

It Depends on Your Age

Timing matters. If you’re twenty-five years old and have dozens of years to grow your money, a portfolio made up of stock-based funds probably makes sense. But if you’re older retirement is coming up within a few decades and you’ll want to tamp down your risk. I heard from tons of people in their forties, fifties, and sixties who were rocked by the stock market’s decline in 2008. I can’t help but feel sorry for them, but you should learn from their mistakes. Even if the market tanks, you have control over your asset allocation. If you’re older—especially if you’re in your sixties, for god’s sake—a sizeable portion of your portfolio should be in stable bonds.

Bonds act as a counterweight to stocks, rising when stocks fall and reducing the overall risk of your portfolio. By investing part of your money in bonds, you reduce some of your overall risk. (…)

“But Ramit,” you might say, “I’m young and I want to invest aggressively. I don’t need bonds.” I agree. Bonds aren’t really for young people in their twenties. If you’re in your twenties or early thirties, and you don’t necessarily need to reduce your risk, you can simply invest in share-only funds and let time mitigate any risk. But in your thirties and older, you’ll want to begin balancing your portfolio with bonds to reduce risk. (…)

Over time, you can manage your asset allocation to reduce risk and get a fairly predictable return on investments. Thirty years from now, you’re going to need to invest very differently from how you do today. That’s just natural: You invest much more aggressively in your twenties than in your fifties, as you get older and tell long-winded stories about yourself.

—Ramit Sethi, I Will Teach You To Be Rich

I, for example, at this stage, am going to only invest in stocks, but I’ll detail on my portfolio in another section.

Diversification

Now let’s move on to diversification. As already hinted before, it’s not only relevant to diversify across asset classes – although asset allocation should be the most important diversification tactic you’ll make – it’s also relevant to diversify inside each asset class. The Swensen Model above is a good example because it not only suggests investing in different asset classes, it also suggests investing in different regions and different kinds of an asset.

The broad category of “stocks” actually includes many different kinds of stock, including large-company stocks (“large-cap”), mid-cap stocks, small-cap stocks, and international stocks. (…) None of them performs consistently. In the same year, small-cap stocks might gain huge percentages, but international stocks might tank—and this performance can vary from year to year. (…) Similarly, different types of bonds offer different benefits, including rates of return and tax advantages. (…)

The fact that performance varies so much in each asset class means (…) you should own different categories of stocks (and maybe bonds) to balance out your portfolio. You don’t want to own only U.S. small-cap stocks, for example, or funds that own only small-cap stocks. If they didn’t perform well for ten years, that would really suck. If, however, you own small-cap stocks, plus large-cap stocks, plus international stocks, and more, you’re effectively insured against any one area dragging you down. So, if you were to invest in stocks, you’d want to diversify, buying all different types of stocks or stock funds to have a balanced portfolio.

—Ramit Sethi, I Will Teach You To Be Rich

So, the bottom line is: we’re seeking to maximize our returns, but assets that provide higher returns suffer from higher risk. To not be too exposed to one (risky) segment of the market, we’re going to build a portfolio that is diversified both across asset classes and within each asset class. Still, remember that if you’re in your 20s or early 30s, you can just let time mitigate the risk and build a portfolio that is more aggressive (meaning more weighted in stocks, if not fully composed of stocks) and easier to start with.

Taxes

This section will depend greatly on where you live. Here I’ll make a summary of the tax implications in Portugal for my Portuguese fellows, but you can also benefit from it to have a reference to what to search for in your country. I learned most of what I know about investing from reading about investing in the US and the UK.

In Portugal, the major taxes to consider when calculating the total cost of different investment solutions are the following.

Pretty heavy right? However, there’s a possible solution to decrease the tax burden. States typically give tax breaks to long-term savings plans, to encourage this type of savings. In Portugal, a special type of long-term savings plan benefits from a more-friendly tax regime: Plano Poupança Reforma, or PPR for short. We’ll talk in depth about PPRs later.

Employer Benefits for Long-Term Savings

From what I know, depending on the country it can be common practice for employers to offer such long-term savings plans like PPRs as part of their compensation package. To motivate investment in these savings plans, employers have schemes where they match, in total or partially, your investment in the plan. So for example, if your employer matches your investment by 50%, for every 100€ you invest in your PPR, you’re actually putting in 150€. Again, that’s free money, and it can dramatically improve your expected rate of return.

To Recap

Let’s take what we’ve discussed in this chapter and see how it affects the criteria by which you’ll choose an investment vehicle.

Criteria	Considerations
Expected return on investment. Comissions and fees.	Actively managed funds tend to fail to outperform the market, and they are more expensive than tracker funds that simply follow the market, so you’re better off picking a tracker. Different asset classes have different expected returns. Riskier assets, namely stocks, tend to show higher returns than safer assets, like bonds. So the investor needs to strike a balance between risk and return, noting that a lower variability may actually lead to a higher total return.
Degree of control over investment decisions.	It is crucial to invest across asset classes (asset allocation) and to diversify within each class (diversification). Now, most funds offered by financial institutions already incorporate this idea into their investment strategies. Still, funds managed by others will never really match your ideal investment strategy. Your target asset allocation depends on your age (on how long you’re intending to hold your investments). Some funds already accommodate for this fact, having in their strategy declaration the intention to shift their allocation towards less risky assets when closing in on the withdrawal date. Still, once again, when other people manage your investments it will never entirely match your preferences.
Taxes. Degree of freedom to withdraw your savings.	Taxes are heavy, but if they were the same for all investment options they wouldn’t impact your decision on how you’re going to invest. However, there is, in fact, one investment vehicle that has a beneficial tax regime, which we’ll cover in the next chapter. They are called PPRs. For now, we already know which taxes apply to all investment situations. This relates to the degree of freedom to withdraw your savings because PPR’s more-friendly tax regime acts as compensation for its rigid limitations on withdrawals. But again, we’ll cover this in-depth when discussing PPRs in the next chapter.
Employer benefits towards retirement plans.	Your employer may incentivize you to save for your retirement by matching, in total or partially, your contributions to your savings plan. If this is the case, it can have a big impact on your expected return on investment if you take advantage of this benefit.