Summary of “The Elements of Investing” by Burton Malkiel and Charles Ellis

This is a very informative and compact book for individual investors, especially for beginner investors. I wish I had read it much earlier, when I first started my journey of learning about personal finance. But the appreciation I have of it now might be the result of reading the other investment books, because this book is a summary of the key big messages on personal investments that one needs to know and apply.

The authors are two of the greatest thinkers in the investment world. This book gives you the key Elements to achieving financial success. Here are the key Elements:

1. SAVE:

• Saving is the foundation of any investment plan.
• Dissaving is spending more than you earn. One absolute rule in saving and investment: Never, never, never take on credit card debt.
• Start saving early because Time is Money. Time is Money because of the powerful effect of compound interest, “the eighth wonder of the world” as what Albert Einstein said.
• The Rule of 72: this rule helps you determine the number of years to double your investment, given an investment return rate, and the other way round. For instance, if your investment return is 8% per year, how many years does it take for your investment to double? The answer is 9 years (72/8). The other way round will give you the rate of return required to double your investment after a certain period of time. Say an advisor says your investment will double in four years, that means your rate of return he is promising you is 18% (72/4)!
• Savvy saving: to be a successful saver, we need discipline and the right framing, where we focus on the benefit of saving — the inner satisfaction of being in control of our finances and ensuring our future financial independence and happiness. Discuss the topic of saving openly to your spouse or someone close to you. Every month or two go over your expenditures to see if they give you the worthwhile value for money. Avoid impulse purchases, by for example making a shopping list before you go to the store.

2. DIVERSIFY

• Diversify across securities, across asset classes, across markets and across time.Diversification will bring about the benefit in the form of a better risk-adjusted return to an investor.
• Most economic events do not affect all companies the same way, hence hold a variety of stocks. Invest in a “total stock market”, instead of concentrating on a few individual stocks or sectors.
• Asset allocation is a very important, if not the most important, consideration, when constructing your portfolio. A mix of stocks and bonds is highly recommended, if not a must, in your portfolio. John Bogle, father of index mutual funds, recommended as a rule of thumb your age as your allocation to bonds. Allocations do not need to be precise and the authors posit that a deviation of 10% does not make a difference.
• Different markets such as US, Europe and Asia can also provide diversification benefits. Globalisation, which results in higher integration among markets, does not mean stock markets move in lockstep. For example, in the 2000s when the US dollar was falling, the euro was rising, giving an added boost to European stocks. Even when equity markets around the world move in unison, there have been vast differences in the performance of different stock markets. E.g., during the first decade of the 2000s, developed markets were basically flat, but emerging markets produced an overall return of 10% per year compounded.

Diversify over time:

• Dollar Cost Averaging (DCA), where an amount of money is put into investment on a regular basis, if applied, ensures investors to stay the course through thick and think of the market. Most individual investors end up being losers because we chase after the “hot” stocks, buying at the peak of the market, and sell off when stocks go down, missing the opportunity to buy at a bargain.
• With DCA, investors can come out better in a market where prices are volatile and end up exactly where they started than in a market where prices rise steadily year after year.
• DCA is not optimal if the market does go straight up (you would have been better putting all your money into the market at the beginning of the period). But it provides you a reasonable insurance policy against poor future stock markets and minimises the regret if you put all your money into the stock market during a peak period before a market crash. (*My note: like many things else in life, stock markets are unpredictable. Hence, this approach makes total sense to me.)

3. REBALANCE:

• Rebalance is to bring your asset class allocations back to your target. The authors suggest it be done on an annual basis.
• Rebalance helps you realise some profits, buy at a lower price, can potentially enhance your return and always reduces your volatility. For example, your asset allocation target is 30:70 for bonds and stocks. At the end of the year, as the stock market has had a stellar performance, stocks now make up 80% of your portfolio. You will sell some stocks to bring its allocation down to 70%, and buy more bonds to bring its allocation up to 30%. You will have reaped in some profit from selling the stocks because stocks are rising, while bonds, which tend to underperform stocks in such a market, provide you with a bargain opportunity to buy at a lower price.

4. INDEX:

• Nobody knows better than the market, which most financial professionals still do not accept perhaps because they earn lucrative fees and believe they can pick and choose the best stocks and beat the market.
• Indexing i.e. following broad-based indices provides individual investors a mechanism to execute all the ideas mentioned above in a cost-efficient way.
• Index mutual funds such as those provided by Vanguard offer much lower management fees than active mutual funds. John Bogle says that in investment “you get what you don’t pay for”, so minimising your costs is very important.
• Indexing allows you to access a broad market without having to buy individual securities and incurring costs due to those transactions.
• Moreover, broad-based index funds have proved over time to outperform the majority of actively managed funds. Over 10-year periods, they have regularly outperformed two-thirds or more of the actively managed funds.
• ETFs offer even lower fees than index funds and give you broad-based exposures like index funds.
• Note to understand the composition of an ETF before you buy it, because not all ETFs are created equal.
• Buying ETFs incurs brokerage fees from your broker, so check out the fees before you buy.
• If you delight in buying individual securities because it can be a lot of fun, you can do so but only before you keep your serious retirement money in index funds.

5. TIMELESS LESSONS for TROUBLED TIME

1. DCA proves its benefits in a volatile market, which is expected to continue in the future. To illustrate this, the authors came up with an example of an investor investing diligently $1,000 every year in the first decade of the 2000s. This period is coined the “lost decade” because of the two major crises: the Internet bubble in the early 2000s and the global financial crisis in 2008. Despite this, the investor enjoyed a moderate positive return and was able to enhance her retirement nest egg.
2. Diversification is still a time-honoured strategy to reduce risk.
3. Index at least the core of your portfolio.
4. Fine-tuning a bond diversification strategy:

• Bonds have been an excellent diversifier over the 2000s, providing stability to portfolios when stock markets declined.
• But today, bond yields are extremely low and are not able to provide adequate returns to investors. E.g.: the 10-year US Treasury bond yields well under 2%, below the headline rate of inflation (as of 2012–2013 of the writing). With rising inflation and rising interest rate causing bond prices to fall, bond investors will suffer from negative returns.

How to structure your income-producing portfolios:

• Look for bonds with moderate credit risk, but with higher yields than US Treasuries. If you are a US based investor, you can consider investing in tax-exempt municipal bonds, many of which provide attractive yield spreads and are free of taxes. Or you can look at investing in foreign bonds such as Australia high-yield bonds.
• Substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality US bond portfolio. Many excellent US common stocks have dividend yields that compare very favourably with the bonds issued by the same companies, and their dividends are likely to rise steadily in the future. One example is AT&T, which provides a dividend yield of 5%, almost double the yield on 10 year AT&T bonds.

What I also like about this book is that the authors share their personal investment anecdotes. For example, one of them is obsessive with the Berkshire Hathaway stock, so much so that he checks its price everyday although he knows it’s nuts. The other one invests heavily in China. That is to show that we are all human and not saints. Even when one is regarded to be among the greatest thinkers in a particular field and fervently advocates a certain approach, he still has his own penchants and disposition, but we have to bear in mind that he adheres to and is very disciplined about applying the principles he advocates.