This is perhaps an unusual book about investments. I will not tell you how to analyse company accounts, spot economic trends, identify great products, recognise the next hot stock or anything like that. Instead, I will try to convince you that you are probably among the vast majority of investors who are better off not trying any of that complicated analysis and then I’ll tell you what to do with your investments on the basis of that premise. In other words, this is a book for investors who have no ‘edge’ over the markets.

In reality, very few investors have the edge to outperform the financial markets, where many thousands of investors with access to the best and most timely information, analysis and financial models compete. Those investors speak to companies, research analysts, economists, traders, customers and so on. Then they read any report, web-chat, filing, news piece, etc. before they analyse the information using the most sophisticated systems and financial models. Only then do they buy or sell. Despite that level of insight, it is not clear that professional investment managers as a group outperform the markets. We as investors are probably unable to consistently pick the winning managers among them, just like we can’t consistently pick winning individual investments. But in both cases we can be sure that fees and expenses make the task of outperformance much harder. We are left with a realisation that we are far better off taking a step back and not competing in the financial market circus.

The absence of an edge does not mean that you should avoid investing. Doing so would exclude you from potentially exciting long-term returns in the equity markets, or benefiting from the security of highly rated government bonds. By embracing the fact that you do not have an edge or advantage to consistently outperform markets I will help you understand how to benefit from a simple and cheap portfolio construction that, despite its simplicity, is very close to the best both from a practical and a portfolio theory perspective. I call it the rational portfolio and those that implement it are rational investors because once you realise that you do not have the edge to beat the markets, I hope you will agree that what I suggest is the rational way of investing.

While most people would obviously rather have the magical ability to pick the market’s winning stock every year, and soon be richer than Bill Gates, reality is that a vanishingly small number of people can consistently beat the markets or know others who can do it for them, and most are far worse off for trying. It’s a huge positive step forward if you can embrace the fact that you do not have the edge to beat the markets. It will make you a better investor and leave you wealthier in the long run while spending less time worrying about your investments.

The rational portfolio that I’m going to propose is much simpler, yet more theoretical and practically robust than what most investors have today. On top of arguing that most investors have no chance of beating the markets, as the other major point of this book I will argue that the only equity investment you’ll ever need is one that cheaply tracks the world equity markets. This is a hugely important point, and perhaps quite different in its simplicity from what you normally hear from financial advisers, but one I hope you will come to embrace. Even before considering its massive fee advantage over more conventional investment portfolios, this portfolio offers investors a superior risk/return profile because of its greatly diversified and optimised investments. Other advantages include excellent liquidity, ease of tailoring risk to suit individual needs and tax efficiency. So you are getting something better at a far lower cost.

Lower costs are possible because the rational portfolio is implemented through cheap index-tracking products (investment products that try to mirror the performance of an index). Particularly in the equity part of the portfolio you can save about 2% a year in fees and expenses compared to many typical investment products that actively seek to outperform the market. To put this in perspective, if you have an income of £50,000 a year and save 10% a year from the age of 30 to 67 (so £5,000 at age 30, and every year thereafter going up with inflation at 2%), and the market gives you a return of 7% a year before fees, then at 67 the difference in your portfolio from the yearly 2% saving on fees is staggering (see Figure 1.1).

Figure 1.1 Fee-saving example

You are set to benefit from an increased wealth of £403,000 and retire as a millionaire! The money saved up every year amounted in total to about £281,000 at age 67, but the investment returns took your savings up to £1.06 million because you invested in the rational portfolio along the way.

You can re-run the example with other levels of savings or returns, or with just one investment. While you will be changing the numbers, the conclusion remains the same: unless you have an edge in the markets, the benefits from cheaply constructed rational portfolios are hugely significant over time. Remember this and act on it.

Where do we hope to end up?

By the end of the book I hope you will have become a rational investor. As part of the journey there are three main themes for you to understand and apply.

1 Embrace that we do not have an edge

Investors who embrace that they do not have an edge are not necessarily unknowledgeable or naïve about the world of finance. In fact they may be the smartest person in the room. But they know something much more important: they do not think that they have the informational, analytical or other advantage to outperform the markets. Edge may exist in the finance world; we are simply acknowledging that we neither have it nor know someone who does.

Far too many people think that they have an edge, and far too few people have an incentive to tell them otherwise. Certainly not many you meet in the finance industry will do so. People working in banks, insurance firms, brokerage firms, media outlets, etc. get paid in many direct and indirect ways as a result of the fees paid to the finance industry. They have the backing of all sorts of marketing professionals who persuade investors that giving them money is the right thing to do, and the forceful backing of conventional wisdom that they are probably right. They are not.

Most of us are rational investors, and it’s actually a pretty tall order to claim an investing edge. I hope that your reaction as we proceed will be, ‘OK. Got it. I see why it’s important. What’s next?’

An immodest claim

A large majority of investors will make more money over the long term by investing as suggested in this book and by embracing the fact that they do not have an edge in the financial markets.

2 Understand the components of a rational portfolio

The rational portfolio consists of the lowest possible risk investment combined with a portfolio of world equities, and potentially other government and corporate bonds. Adjusted for a few individual elements like risk and taxes, over the long term it will be very hard to outperform.

‘If I don’t have an edge, why invest at all?’ That’s a fair question that may be best answered by asking what the alternative is. Is it to put your cash under your mattress or buy jewellery that you can hide in the garden? What does ‘not investing’ actually mean? Leaving your money in the bank will yield little interest income and may mean taking credit risk with that bank. To put it simply, your money will not grow and its value will be eroded by inflation. In the example above, ‘doing nothing’ meant savings of £281,000 while the same savings invested with pretty reasonable assumptions in the rational portfolio meant savings of £1.06 million.

I hope to convince you that the rational portfolio suggested in this book is as close to theoretically and practically optimal as you will find and is how you will make more money from your investments over time. So the ‘rational investing philosophy’ is not the brainchild of yet another investment professional you may never have heard about (me), but instead is a practical and cost-efficient implementation of decades of work in portfolio theory by the sharpest minds in finance. While the benefits from the rational portfolio start accruing immediately, this is a long-term investment philosophy with a strategy and individual securities that you can hopefully keep for years or even decades.

Combining highly rated government bonds in the right currency, broad index-tracking products of world equities and possibly other government and corporate bonds in the right proportions through the best and cheapest products is core to rational investing (see Figure 1.2). I will quantify the risk/return profile of this portfolio and explain why low fees and expenses are core to long-term investment success. You may get bored with me talking about fees, but if you get expenses right you’ll have come a long way.

A major point of this book: Only world equities

The only equity investment you probably ever need to own is a world equity index-tracking investment. Accepting this fact will most likely make your life much easier and wealthier.

Figure 1.2 The core of rational investing

The combination of the three asset classes that is best for you depends on your specific circumstances, particularly your attitude towards risk. I will give you the simple building blocks and help you to combine them. I will also discuss why some asset classes do not fit in the rational portfolio, including popular ones like property and commodities.

3 Tailor your portfolio to your specific needs and circumstances

To get the full benefit of your rational portfolio, you must start by thinking about the risks of investing in the financial markets, and how that risk dovetails with your personal circumstances and attitude towards risk. You need to consider your investment portfolio in the context of all your assets and liabilities, and how all of those interact, also with our tax situation. I will touch on what investing looks like in complete calamity situations, and also on the role that pensions and insurance play in the rational portfolio. Getting all this right is no small task.

Finally you need to implement all this. I’m wary of suggesting specific products to buy as the development in index tracking moves so fast, but I will discuss a couple of offerings with the characteristics discussed above. These pass the ‘what should I tell my broker’ test; or, more likely these days, the ‘what should I tell my internet browser’ test.

The 60-second version

There are four things to take away from this book:

1. You almost certainly do not have an edge in the financial markets. That’s OK. Most people don’t, but you should plan and act accordingly.
2. There is an easy and cheaply constructed portfolio which is close to optimal. It combines the highest-rated government bonds with a world equity portfolio. You don’t have to, but you could add other government and corporate bonds if you have the appetite for a bit more complexity. Get close to that in the proportions that suit your circumstances, stick to it, and you should do very well.
3. Your specific circumstances do matter a great deal. Think hard about your risk appetite and optimising your tax situation, but also pay attention to your non-investment assets and liabilities.
4. Be a huge stickler for costs, don’t trade a lot and keep your investments for the very long run. Over time you will be far better off for having implemented the rational portfolio.