We’re running a series of articles on different asset classes, and will start with the most important one - Equity.
Shareholder’s equity, which is what we’re talking about(as opposed to say homeowner’s equity) represents fractional ownership in a company. Formally, equity is the money that would be returned to the shareholders, proportionally, once all debts are paid off.
We’re focusing on equity as it has proved to be the best performing asset class over the last century. This holds true over in just about every large economy on the planet. Unless you invested at the top of a bubble or just before a downturn, it holds true over most shorter periods as well.
Here’s a great chart from A Wealth of Commonsense that depicts the performance of asset classes over the last 200 years. There are very few periods where equities have underperformed other asset classes.
In my view, it is the single most important asset class to own for several reasons. What makes it so good?
Returns - Equities outperform just about every other asset class over the long term.
Liquidity - Equities allow you to invest small amounts at a time and pull as much money out as you need at short notice
Ease of Diversification - Equities allow for easy diversification through buying indices. This is an extremely powerful notion that allows even a completely uninformed investor to make good choices
Breadth of Diversification - Equities allow people to invest outside their domestic market pretty easily. Compare that to buying a house in another country!
Low Costs - Investing in a passively managed mutual fund is probably the most cost effective investment. Fees are a fraction of a percent annually. Depending on the market/fund, they’re less than 0.1% - e.g. the market pioneers and leaders Vanguard have several funds with an expense ratio of less than 0.05%.
Security - The stock market is regulated. Firms have rules around disclosures. Insider trading is a crime. While white collar crime such as fraud and front-running occur, and investments are subject to incompetence and mismanagement, there are more guard rails here than with some of the newer riskier asset classes such as crypto.
Ease of operation - Everything can be done digitally. Settlement cycles(the time between when you buy or sell something and see the stock/money in your account) is short - typically 1 to 3 days. You have access to the same opportunities in the smallest villages as in the largest cities.
So, when coming to equities, what does one invest in?
Every book on personal finance will tell you two things -
- Avoid investing directly in stocks.
- Invest in passively managed index funds.
Let’s break down why this logic holds true.
Investing directly in stocks requires a lot of time, effort, investment knowledge and patience. Note: We’re speaking of investing, not trading. Investing is putting money in for the medium to long term, while trading has a time horizon of minutes to weeks.
Individual investors are heavily handicapped in such a market where the professionals have better tools, more in-depth knowledge and access to direct interactions with company management and data sets that help them go far deeper into company performance. While a diligent investor can trawl through appendices and footnotes to glean a lot of data, it isn’t for everyone.
On the other extreme, passively managed indices give you exposure to an entire market (or a subsection of it such as large-cap shares) for a very small fee. The indices are maintained, self-balancing themselves when companies either grow or shrink. This provides excellent diversification, as a well-selected index is a barometer of the entire stock market.
So, is there no point in investing in anything other than a passively managed fund? The answer, like many, is ‘it depends’.
For the uninformed investor, or for someone starting out with a small amount of capital, the answer is unequivocally yes.
As you increase your investible capital, you can diversify amongst indices, tapping into different sectors, market segments, company sizes or geographies.
Over time, you’ll build enough understanding of accounting statements, market performance and have enough of a pulse on the economy that it might make sense to start thinking about investing directly in stocks. This is a reasonable strategy when looking at smaller or newer companies as they are typically not covered by the institutions(or sparsely covered) - small and micro caps for instance. It is also an extremely risky strategy as these companies might find it hard to meet their potential, weather a downturn. Another reason to be careful is that corporate governance standards fall when moving from large to mid and mid to small cap stocks.
If you don’t want to wait that long, you can always train yourself by investing a hypothetical portfolio, by starting out with some number - say a million - and investing it in the portfolio of your choice. Register in any portfolio tracking site - there are hundreds of free ones - and use it to track your decisions and performance, use it for managing your research and tracking news, and it’ll give you a good idea of how ready you are and how successful you are.