How to invest money
This guide provides an in-depth analysis of how to invest money using the top down approach and other systematic processes used by professional fund managers.
Steady Wealth Growth & Winning by not losing
To build your wealth in a short time period requires huge risks and the odds of succeeding are minimal. Most successful investors build their wealth gradually, by selecting investments which generate good returns with low risk. Your partner in building wealth is compound interest.
“Compound interest is the eighth wonder of the world.” – Albert Einstein
Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit. Compound interest can be thought of as “interest on interest”.
Compounding needs two prerequisites to work:
- Investing for long periods of time
- Never lose big amounts of money
If you invest $10,000 at 20 with a 10% yearly average rate of return in 45 years you will have $728,904. The reason is that in first year your $10K would become $11K, while during second year your $11K would grow up by 10% and you will earn interest on the principal ($10K) and the interest ($1K) of the previous year. Additionally, If you save $10,000 every year for 45 years, then you will end up with $6,526,425.
When to Stay out of the Markets
The most important investment decision is when to stay out of the markets that is hold mostly cash or other safe investments like low-risk government bonds. The reason is, it is very difficult to recover from big losses during bear markets (the US Stock Market lost 38% on average).
Tip: A 50% loss requires a 100% gain to get back to even.
In the example below, experiencing three big annual losses adversely affected compounding and as a result the end value of the portfolio. More specifically, an investment of $10,000 grew to $1,8 million after 40 years instead of $24 million because of three 50% losses experienced in years 12, 24 and 36.
You should ignore stock tips, emotion, market headlines & economic forecasts. Instead, you should base your investment decisions on systematic flexible methods, build on scientific analysis and objective criteria, which adapt to the current market conditions.
Tip: Remain faithful to your investment strategy through good and bad times. Do not let your ego involved in market view.
The key investment principle to achieve good investment returns with low riskis Diversification.
Individual assets have hidden big risks that amateur investors won’t recognize (e.g. Enron, Lehman Brothers collapses, General Motors Bankruptcy).
A well-conceived diversified dynamic portfolio of assets has the potential to perform much better than investing individually in the assets themselves only.
Investors should select investments and strategies which control losses and cut them short while let profits run. If losses versus profits are small an investor can be 60% of time wrong and still be profitable.
KISS: Keep it Simple, Stupid
A simple strategy with fewer variables and rules (degrees of freedom) is preferred to another strategy with similar investment performance, more variables, and rules.
“Everything should be made as simple as possible, but not simpler.” – Albert Einstein
Assets & the 4 Economic Environments
There are four economic environments:
During this economic environment, the best performers are emerging market stocks, international real estate, emerging countries’ currencies, commodities, and TIPS (treasury inflation protected securities). The worst performers are US treasury bonds and cash since they are adversely affected by rising inflation.
High global growth with rising inflation expectations lifts commodities. Many emerging economies growth is linked to commodities. When commodities rise emerging market stocks, currencies and real estate rise as well.
The best asset performers protecting investors from inflation are Gold, Cash, Treasury Inflation Protected securities and the US Dollar. The worst performers are long-duration treasury bonds adversely affected by rising inflation.
The best performers are developed markets stocks, developed Real estate and US Treasury bonds.
Low inflation with moderate growth is a good environment for bonds and stocks and bad for the worst performs which are commodities and commodity related sectors.
During crashes and economic depressions bonds rise while stocks and commodities fall. Investors during these environments look for the safety of their asset rushing into the safety of US treasury bonds and the US dollar while selling stocks and commodities.
Stocks and low-risk government bonds like US 10-year treasuries or German bunds are the 2 main pillars of all professional portfolios. Each of the two assets perform wells during different economic conditions. When economic growth is high and inflation is rising stocks generate good consistent returns. At the same time, rising inflation is the worst possible economic environment for bonds.
However, when economic growth is slowing and/or inflation is falling or at the extreme cases economic recessions, depressions and market crashes are experienced long-term US bonds is the best performing asset by far, generating good returns with low volatility.
Since the Great depression in 1929, investors in the United States have experienced 24 years of negative stock market returns. During all periods, US Treasury Bonds protected investors from capital loss and served as a flight to safety. In 19 out of 24 years US Treasury bonds generated positive returns.
Discretionary vs Systematic Investing
There are two types of investment approaches: discretionary investing and systematic investing.
Discretionary investing relies on the subjective judgement of investors. It is in the investor’s discretion to decide which market to trade, when to trade, and how much to risk.
Systematic investing relies solely on signals produced by data analysis. Signals are generated from pattern recognition of market data and/or fundamental analysis of economic and corporate data.
If you are planning to invest in a specific mutual fund, index fund, ETF or any other investment check our investing for beginners guide to explore what to calculate for each investment to make sure you avoid excessive risks and generate stable good annualized returns.
If you are interested in becoming a trader yourself and learn how to trade stocks, bonds, commodities and currencies check our guides on portfolio management, stock trading, bonds investing, forex trading and options trading.
Alternatively, if you are interested in structuring your systematic low-risk investment strategy yourself without relying on financial advisors and investment firms check our asset allocation guide.
Lastly, MacroVar has created a database of profitable systematic investment strategies.