How should I invest? Have a look at the Universal Investment Equation!
After my last post on switching to an evidence-based investment strategy, I continued thinking about what we could consider to be the ‘truth’ of investing, and I’ve had a sudden epiphany.
What you can see above is a very simple equation that describes what investing is about. In other words:
Capital x Time x Rate of Return = Wealth.
If you increase one of these three first factors, you increase the product, i.e. the end result. So your wealth increases if you:
- invest more capital, or
- invest for a longer period of time, or
- get a higher investment return.
All of what I have written on this blog, and pretty much all of the academic / semi-academic literature on investing that I’ve read so far has focused exclusively on point 3, which only represents one of three factors. That third factor, the rate of return, is also arguably not very important.
Because getting a return of 10% in one year does not matter if it’s just one year and you only invest 100 EUR.
But getting a return of just 5% can be absolutely sufficient if you invest for longer – let’s say 40 years – and you have a nice stack of cash – let’s say 50.000 EUR – to invest, because the end result will be a sevenfold increase in your capital to 352.000 EUR!
So you could say that the length of the time during which you invest, and the amount of capital you invest, are much more important than the investment return you get, because you actually have a direct influence on those aspects.
Points 1 and 2 can be changed by simple decision on your part. Point 3 is what everybody gets excited about, with new strategies and smart beta and what not, but nobody can guarantee that their advertised strategy is better than simply holding a stock and a bond index fund. I can, however, guarantee that if you invest at age 25 and keep on doing it until you’re 65, you will have invested for 40 years. And I can also guarantee that if you invest 10.000 EUR for 10 years in a row, you will have invested 100.000 EUR.
Let’s compare these two scenarios:
- Person A invests 10.000 EUR for 5 years and gets a return of 7%.
- Person B invests 20.000 EUR for 5 years and gets a return of 5%.
- Person C invests 20.000 EUR for 10 years and gets a return of 3%.
Which one would you like to be? The sexy option A? Well, tough luck. Here’s the final capital accumulated for every scenario:
- A gets 14.000 EUR (+ 4.000).
- B gets 25.500 EUR (+ 5.500).
- C gets 26.900 EUR (+ 6.900).
A could have earned the same 6.900 EUR as C on her investment if this person had achieved an 11% annual rate of return for the 5 years during which she invested, but how likely is it that you average 11% return for a 5-year period? It’s much more likely that you’d average 3% or more for 10 years, than to get 11% or more for 5 years.
So what does this tell us?
Since we can’t directly set the rate of return we’re getting, let’s focus on what we do control: the amount invested and the time during which we invest.
So invest as much as you can (without risking your financial stability!), as early as you can (to get those compound returns!) and don’t worry about the return you get, i.e. just use a simple index fund portfolio that you can actually stick with for a long time.
That will be the best strategy for the vast majority of us, including myself.
It has taken 3+ years of reading about investing strategies for me to realise that the simplest strategy – a few index funds held forever and rebalanced regularly – actually seems to be the most intelligent for me.
If you’re not yet convinced that simple is best, I think the likelihood that you’ll be convinced at some point in the future increases the more time you spent trying to optimise your portfolio. Because when the average market return in a year is 5%, as the low-growth scenarios and current valuations seem to predict for the EU and US markets, there is no amount of optimisation that can reliably give you 8% or even more per year. So it’s best to accept the market return you can actually reliably achieve, and focus on optimising the other two factors of the equation.
Investing is really simple, once you’ve done all the complicated bits and you learn that taking the shortcut is actually the smartest approach! 🙂