Your heresy shall stay your feet – why you shouldn’t just invest in equities

The most popular approach to reaching FIRE here in Australia seems to be investing solely in equities, either Australian only or with some international shares as well. 

It’s a strategy expounded by some of the more prominent bloggers and any questions on Reddit or the like about how to invest to reach FIRE usually get a bunch of responses talking about various equities only portfolios.

Given the great returns that shares have had historically and especially over the last 10 years or so, it’s easy to see why this is a popular strategy.  Which is why I wanted to write about how it’s probably not actually going to be the best idea for most people. 

Quick disclaimer:  As is always the case you should not plan your finances around what some random person on the internet says. Everything which is written here is of a general nature at most and is certainly not specific professional advice for you and you should not be relying on it when making decisions. Whilst every endeavour is made to provide accurate information at the time of writing you should be talking to a licensed professional about any specific areas of your finances, taxes etc.  Also, it’s going to be really embarrassing if it all goes pear shaped and you have to explain that it did so because you read about something from a random blogger.  Moving on!

I live in Australia, why do I need to invest in equities in other countries?

There are certainly some very good reasons to invest in Australian shares.  You don’t have to worry about currency movements as much, there aren’t any annoying forms to have to fill out so that other countries don’t tax you more than they should, you’re supporting Australian companies and workers etc.

There are also a lot of problems with this though.  One of the problems that is frequently brought up is that in Australia the 10 biggest companies make up about 40% of the index.  The below is from Vanguard’s factsheet for VAS and it shows that the top ten companies make up 42.0% of the ASX 300 as of 31^st August.

Which is obviously a pretty big percentage, but isn’t actually that unusual globally as per the below chart.  Australia is really around the middle of the pack, although a lot of the countries where the top 10 make up smaller percentages of the index have much bigger markets.

What is more of a problem to my mind at least is that so much of the Australian market is focussed on just two sectors, Financials and Materials.

The Financials sector makes up 31% of the index, and in fact the big 4 banks are about 21% of the entire index.  Given that they’re almost entirely domestically focussed with few growth opportunities here and with a very large amount of their earnings coming from residential mortgages in what seems to me to be a very highly valued property market, I’m not super keen on having my money invested only in Australia.

Similarly with Materials making up about 17.5% and most of this being companies that dig stuff out of the ground and export it and are largely reliant on continued good relations with China, it doesn’t strike me as being a great growth sector either. 

I could be wrong on all of this of course (and have been wrong about all sorts of investment ideas in the past) but personally I would prefer a bit more in the way of diversification and growth prospects because otherwise you’re essentially taking a bet on housing staying strong and China continuing to buy our resources.

If I look at MSCI World ex-Australia (VGS), Financials and Materials are a much smaller part of the index so by buying international equities I have a lot more diversification and I get exposure to industries which have lower representations in Australia like IT, Health Care and the like and which are probably likely to see more growth in my opinion.  Again, I could be wrong about all of this but that’s part of my thinking here.

There is also some diversification benefit from investing in global equities, in that although the Australian sharemarket is likely to closely follow what global markets are doing ie if they go up or down so will the Australian market but the reverse doesn’t necessarily hold true.

So if the Australian share market has a fall due to overinflated property prices for example, stockmarkets areoudn the globe are unlikely to get hit on the back of this.  So to me it makes a lot of sense to invest not just in Australian equities but International ones as well. 

Why should people invest in anything other than equities?

I mentioned in my post explaining bonds that I actually have about 21% in investments other than equities.  That’s a mix of cash, fixed income, REITs, and infrastructure investments. 

I also talked about one of my favourite FIRE bloggers the FI Explorer having about 30% of his investments in assets like bonds, gold, and bitcoin as of his last update.  

The idea of investing in those other asset classes is that hopefully when equities fall or aren’t doing much, these other assets will go up in value.  Historically speaking bonds tend to go up in value when equities are falling significantly.  Likewise gold tends to rise when stocks go down.  I’m less convinced about Bitcoin as an investment but it’s worked as a hedge so far is my understanding, and it’s not as though it’s me who is invested in it.

As someone who has spent a lot of time studying finance for both formal qualifications and my own enjoyment (yes really) I’m very aware of the fact that equities are a pretty volatile asset class.

I’m not talking about the stupid stuff on the news about billions being wiped off or added on to the value of the sharemarket that the media loves to talk about, that’s irrelevant because what it actually means is the Australian share market went down or up 0.1% or something similar that I don’t care about.

What I do care about are the big falls in the value of the market, and thus my investments.  It doesn’t actually make much of a difference to me mathematically at this point in time because I’m still a long way from hitting my FIRE number, in fact it’s actually a net benefit because I can invest at a lower price.

Psychologically though it can make a difference.  I talk a lot about the math behind FIRE, but in a lot of ways the behavioural aspects are more important. 

I can tell you from experience that it’s not a lot of fun seeing your net worth drop by $100k or more when the market decides to go down by double digit percentages as it did for the last quarter of 2018.  As much as you might assume it’s only temporary it doesn’t feel like that at the time and you start wondering if this time is going to be different.  

I would say that I’m actually far more relaxed about this stuff than most people because after 20 plus years in finance (mostly in equities/equity linked products) which includes the dot com crash, the GFC, the Greek debt crisis, the taper tantrum and all the other moves up and down over that time period I’ve got a fair idea what it feels like to see my net worth drop and be nervous about the state of the markets and my investments. 

Certainly from the number of conversations I’ve had with people who freak out about a 2% drop it seems like I’m a lot calmer about the volatility of shares.  Despite that I still want to reduce the chance of big falls in the overall value of my portfolio as much as possible, to have some investments which zig when equities zag so to speak. 

Investments like treasury bonds are great for this, because they tend to appreciate in value when the market falls as shown in the graph below taken from this excellent post showing what bonds have done when stocks crashed over the last 30 years or so.  The numbers are for the US but would likely be very similar for Oz.

The chart below from this post by one of my favourite finance bloggers (Ben Carlson at a Wealth of Common Sense) shows the performance of stocks and bonds during bear markets over the last 70 years or so, again this is for the US rather than Australia.

The same author wrote this amusing post after Bank of America declared the 60/40 (stocks/bonds) portfolio dead.  60/40 is the rule of thumb asset allocation for US investors, here in Australia your super fund will tell you they’re more like 70/30 even though they’re probably more like 90/10.  Again, that’s a post for another time.  In any case, as he says in the post a 60/40 portfolio gave you an 8.1% return vs 9.5% for stocks, but had 40% less volatility.  I’m happy to trade some return for a lot less volatility.

My point is that although having some money in bonds is not going to be enough to stop the value of my portfolio falling a bit especially given that most of my portfolio is still made up of equities, it will hopefully be enough to stop it from being cut in half as would have been the case for equity only portfolios in the GFC.  

So bonds to me are a safety net, both emotionally and financially.  Having that safety net in place means that I’m more likely to be able to stay the course.  However depending on the timing of any stock (or bond) market crashes they may actually help me reach my goal faster.  If there is a big stock market crash right before I would have hit FIRE and bonds haven’t been too much of a drag in performance along the way, then bonds will reduce my losses and help me get to my FIRE number faster than an equity only portfolio will.

What else can you invest in to diversify?

As I mentioned above another asset which can serve well as a diversifier is gold, although personally I don’t like it because even though it has worked historically there is no real reason why it should do so.  Warren Buffett has this great quote about gold.  “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”  So I don’t invest in gold personally, but if others want to I can see how it makes sense based off what has happened historically.

Similary with Bitcoin which I think of as being even sillier, yes it has worked as a diversifier in the short time it has been around but it has even less utility than gold and basically is worth something only because there are a bunch of people who are willing to keep believing it is worth something.  Maybe it’ll keep on working, maybe it won’t, I’m not planning on buying any either way.

As I said above I do have some other investments like property (REITs) and infrastructure as well, I don’t think these are necessarily great for helping me out if the stock market crashes but they may help a little, and in the meantime in years when the stock market goes up but not by much these may well do better for me.  In fact over the last 20 years for the US, both bonds and REITs have outperformed stocks.  

So maybe I should actually have more money in bonds and REITs than what I currently do!  

Does diversification help when you retire?

Dan at Ordinary Dollar has done some great work on optimal asset allocation and longer retirement lengths looking at a mix of Australian and US stocks and bonds.

Combining the findings of the two posts, if you have an 80/20 portfolio you get pretty close to the same probability of a succesful retirement as 100% equities but with a lot less volatility. Sounds like a pretty good deal to me!

It also shows that a 100% allocation to Australian equities (or to US equities for that matter) is not as effective as a more diversfied portfolio, particularly over longer time frames.

The benefits of diversification

What I’m aiming for in my portfolio is a mix of assets that will go well in most circumstances without too much volatilty, and when stock markets crash won’t fall by as much.  This will help me out psychologically by having smaller falls in net worth along the way so I don’t panic when markets are falling, and as I’ve said above might well get me to FIRE faster than an all equities portfolio anyway.

It will also help me when I have retired because as it turns out having some diversification actually gives me a higher likelihood of a successful retirement!

Are you all in on equities, or do you have other assets to diversify your portfolio?  Has this post changed your mind?  If you enjoyed this post and would like to read more like it please subscribe!