Invest Outside the Box

Before even beginning to look at buying a stock, bond, or building, an investor is likely to start by depositing money in a bank account. Bank deposits are not so much an investment themselves but rather a convenient place to store money and a platform for using the bank’s services to transfer some of that money to other accounts. Usually, a depositor would have to pay a company for storage and other services to take care of personal belongings and valuables, but banks are allowed to invest the money deposited with them into bonds and loans (described in the next chapter), passing on part of the interest from those investments to the customer and keeping the rest as their service fee (rather having to charge direct fees for all of their services). As of 2017, banks and bank deposits are still the main way money moves around from business to business worldwide, and in fast-growing, recently poor countries like China, many first-generation bank customers are switching from banknotes and paper checks to paperless payment systems that move money electronically between bank accounts (like Alipay and WeChat Pay). Over the next decade, there is likely to be a rise in “e-cash” transactions using cryptocurrencies and blockchain technology (described in Chap. 9) and replacing the need for banks to serve as fee-taking and risk-taking intermediaries for the basic functions of storing and transferring money.

Bonds are easily the simplest investment instrument most people claim to not understand. A typical bond is simply a written promise to pay the owner of the bond (the bondholder) fixed amounts of money on fixed future dates, which is why this asset class is also called “fixed income securities”. Where bonds begin to differ from bank deposits is that a customer depositing $100 at a bank generally expects to be able to withdraw $100 (plus any interest) no matter what happens in the market, while a bond with $100 face value might be trading in the market at $99, $101, or even at $50 or $150 depending on how far in the future the fixed payments are scheduled and who the issuer promising to pay them is. In other words, although the income is fixed, the value is not.

Real estate is perhaps the most fundamental and tangible investment asset class most investors encounter one way or another. Humans need space to live, land to grow food on, and commit a fair percentage of their incomes to pay for office, storage, retail, and industrial square footage somewhere, whether directly or indirectly. Part of the American dream may be to own a home, but Asians have become known in many top cities around the world for their love of property investment. In some markets like London, Toronto, or Vancouver, Chinese buyers have a reputation of buying several homes at a time for cash, simply as a way of keeping money safely outside of China.

Ask 100 laypeople what first comes to mind when they think of investing, and chances are “stocks” and a “stock market” will be in a plurality of answers. Stocks occupy many of the headlines of financial newspapers and much of the airtime of financial radio and TV shows, and the ups and downs of “the market” seem to get more popular attention than daily moves in interest rates or the price per square foot of office space. Part of this is simply due to the availability of information: stock prices, like interest rates but unlike real estate, are quoted and traded on many times every second during business hours, and unlike most bond trades, stocks provide at least the widespread expectation of being able to double one’s investment relatively quickly. Beyond their “excitement” and volatility, stock do play an important role as one of the key asset classes both individual and institutional investors allocate money to for long-term real returns, alongside stocks and real estate.

Currencies are not really an asset class of their own but rather the medium through which almost all other current consumption and capital asset investments are denominated. Just as many individuals are familiar with the Australian dollars in their wallet or bank account they use for day-to-day purchases or investments in Australia, they understand that they will need British pounds in their wallet or bank accounts to buy groceries, properties, or stocks in Britain. In Sect. 1.​3, cash and currency was described as the liability of a bank, ultimately the central bank or monetary authority in many countries or monetary unions. Cryptocurrencies like Bitcoin and Ethereum, which have been increasingly developed and used in the mid-2010s, are covered separately in Chap. 9, though some of the mechanics described here will also apply to digital currencies.

“Alternative investments” generally refer to the “everything else” boxes of investments that are left out of one of the traditional boxes of stocks, bonds, and real estate purchased by “mainstream” mutual funds. Perhaps contrary to the name, many of the investments twenty-first-century advisors commonly consider “alternatives” are actually far older than the modern form of listed stocks or traded bonds. Consider the ancient history of investing in gold coins or art, private investments in shipping ventures, or Lloyd’s early insurance contracts.

Part 1 looked at different boxes of investment types individually, almost as though an investor would expect to find their one ideal investment in one of those boxes. This first chapter in Part 2 looks at how indices combine assets within a box to most efficiently earn returns from that box. Often, investors can expect better return and risk metrics by combining different assets with low or negative correlation with one another (i.e. ones that are at least as likely to move in opposite directions as they are to move up and down together). This chapter may be one of the most computationally intensive and technical in trying to provide one of the most accessible introductions to mean-variance analysis and optimization, but walks through the essential calculation in stock vs bond allocation that so many asset allocations get wrong. This chapter then finishes with the execution question by explaining the difference between implementing asset allocation through a top-down or bottom-up manner.

Stock market indices are widely known as benchmarks whose values are reported on TV, newspapers, and fund fact sheets, and whose returns most professional managers have not been able to consistently beat. In many asset classes, there is at least one index meant to track what an average investment would make or lose over time investing in that asset class. This chapter introduces some of the major types of investment benchmark indices, mostly focusing on stock indices, and describes their role in both passive and active portfolio management.

Blockchain technology is likely to transform the world of banking and signed documents in the coming decades, similar to how e-mail and mobile messaging transformed post offices, telephones, and photography over the past few decades. Blockchain applications development in the 2010s has so far been comparable to how web pages evolved in the 1990s. By 2017, markets in Bitcoin and other cryptocurrencies and tokens have grown to a value of over US$100 billion to levels many consider a manic bubble. This chapter aims to explain the essentials of blockchain, cryptocurrencies, and the example case of Bitcoin to hopefully help these technologies understood for some of their many excellent potential applications rather than as simplistic vehicles of speculation. In other words, the “outside the box” idea is not to simply try and by an ICO with the blind hope of making money, but rather in understanding how blockchain applications work and should be valued.

For many investors, the hardest boxes to think outside of are the geographic ones. American investors still mostly invest in American assets, Chinese investors still focus on Greater China, and even Australian investors keep a majority of their assets in the 2% of the world’s market that is Australia. Even many advisers who do highlight the importance of international diversification often suggest only a small fraction of one’s portfolio (often up to one-third) be invested internationally, while this author argues for higher international allocations (often more than half) for many investors.

Chapters 1 through 10 defined many of the boxes different investments are often categorized in, and hopefully helped readers familiar with investing in one box learn to diversify into one or more of the other boxes. This chapter steps outside these “textbook” investment boxes and discusses one of the most important differences between investment theory and investment practice affecting all these boxes: the fact that people don’t always act rationally. A good understanding of the principles and pitfalls in behavioral investing can both help investors better avoid such mistakes themselves and find ways to profit from irrational opportunities created by other investors. While these behavioral anomalies may cover some of the most obvious ways for investors to outperform the benchmarks using 100% public information, it is important to remember the John Maynard Keynes quote that “Markets can remain irrational longer than you can remain solvent.”