Good reads from around the Web.

One of the many reasons I love the Mr Money Mustache blog is the MacGyver-like way the Mustachioed one has welded an ecological message onto his financial freedom message.

(Well, that and and the swearing. We’re too tame to do it around here!)

Not surprisingly, I loved his latest post where he observes the weird spending habits of an alien race as seen from outer space, and then sees just the same thing back home on Earth:

In one incident, I traveled to a distant suburb with my son to attend a child’s birthday party […]

At the party, every food was an unrecognizable assembly of chemical compounds ripped out of a brightly-colored box, served on styrofoam plates which were promptly discarded into a black plastic bag.

Every gift was a plastic and metal recreation of a famous movie character or vehicle, ripped out of another plastic package. There was a television in the kitchen blaring news and advertisements.

The unhealthy parents drank beer and ate cake, and sighed about not having enough time or money to spend more time taking care of their home, or their kids, or themselves.

All of this took place in a neighborhood with beautiful walking paths and parks, and a modern utopia of a school just down the road. But every weekday at 2:45 PM, an ominous horror begins. An immense and powerful passenger vehicle will ease down the road and come to a halt at the prime spot of the school’s pickup loop.

And the engine will be left running.

As ever, Mr Money Mustache has a plan to deal with it – and to his credit he isn’t advocating the use of tactical nuclear warheads – so go read it.

[continue reading…]

There are savers and investors out there who do not religiously open an ISA (or top up an existing ISA) every year in order to use up as much of their annual ISA allowance as they can.

This is nuts.

ISAs are one of the best tax breaks going for the likes of you and me.

Everything you hold in an ISA is shielded from capital gains tax.

There’s no tax to pay on interest or on the dividend income from shares held in an ISA, either.1

Tax might not seem a big deal when you’re starting out with investing. But over the long-term, paying too much tax can dramatically cut your returns.

It’s true that there can be modest fees for holding an ISA on some platforms. But it doesn’t take much for the tax breaks to outweigh these tiny costs – maybe as little as £100 or so in dividend income if you’re a higher rate tax payer.

Even these platform fees can be avoided if you simply open an ISA directly with a fund provider and invest in, for example, one of their cheap tracker funds.

But there’s another good reason to get into the habit of investing in ISAs.

Whatever you buy in an ISA and whatever gains you make from your investment – capital gains or income – is your business. You don’t have to tell HMRC about it and it doesn’t want to know.

Using ISAs for all your investments therefore sidesteps the horrors of paperwork that can build up if you invest outside of their lovely HMRC-shielded protection

Avoiding self-assessment paperwork with an ISA

I can think of plenty of places I’d rather not be at two o’clock in the morning.

Delivering pizzas in Kabul, Afghanistan, for example.

But being in my home office filing through old share trade notes to calculate my CGT situation for the taxman – that’s right up there with the war zones.

You have to declare details of your capital gains and losses from share trading over the past financial year if:

• You made more than your CGT allowance in capital gains in the year

• You made total disposals of 4x that allowance

And you might be surprised to discover how easy it is to stumble into such a situation…

Let me take you back to 2009.

I sold quite a few holdings in the tax year to 5th April 2009, recycling the proceeds into what I guessed judged were safer harbors during the bear market.

As you’d expect back then, this meant I realised capital losses. Even if I wasn’t bound by law to detail them to HMRC, I’d have done so anyway to carry the losses forward to set against CGT in future years.

But as it happened I did have to detail them, because my total disposals were beyond the 4x threshold.

For example, I sold my remaining bank shares in summer 2008, which looking at the prices I got for them seems a lot cleverer/luckier in retrospect than it felt at the time.

Selling Lloyds shares for between £2 and £3 when I got cold feet about the merger with HBOS was hard, given they’d recently been over £6. But considering the share price approached 30p within 6 months, I thank whatever angel was sat on my shoulder that day.

Looking at other trades was equally painful; positions built up over years sold at less than cost, down from twice that level in 2007.

And I had to note it all down for the taxman. Talk about adding insult to injury!

(Note that I typically didn’t take the money raised out of the market. Selling low and missing the upturn is a classic bear market error; instead, the money my sales realised were recycled into other shares, trackers, and trusts. I was a net buyer during the bear market).

In short, share trading outside of an ISA was a lot of hassle and paperwork for a pretty uncertain return that year.

(Remember, it’s better to use a tracker folks!)

There’s hassle, and then there’s Sharebuilder

What made this tax accounting exercise even more tedious was that most of the shares I sold were located in a so-called Sharebuilder account where I had held my high-yield portfolio.

Sharebuilder accounts seem a great idea, because they enable you to buy small bundles of shares at a much lower cost per trade (£1.50 a trade back then, since raised to £2).

You can even set them to automatically re-invest dividends, which at the time I was doing it incurred no commission fees at all.

The trouble comes when you have to calculate a taxable gain or loss on disposal. Then the Sharebuilder is an instrument of torture.

I had some positions built up from half a dozen more purchases or more over the years, including reinvested dividends.

This meant I had to tediously go through and collect all the transactions to calculate my total purchase costs.

With Sharebuilder, I also frequently ended up buying fractions of shares. This seems a lot less cool at two in the morning when you’re staring at something like:

BT.A
23-Jan-04  BUY    269.3072    184.18
5-Mar-04   BUY    274.524021  180.68
20-Aug-04  BUY    136.464485  181.19
7-Sep-04   BUY    15.566294   184.18
14-Nov-04  BUY    249.38911   198.89
29-Nov-04  BUY    253.557919  195.62
8-Feb-05   BUY    22.261045   208.93
27-Oct-05  BUY    219.669073  203.67

Believe it or not, it got even worse.

The ultimate nightmare is when some shares were bought and sold multiple times over say a five-year period.

Back in those days, the rules said you had to work out how a pool of expenditure on the shares changed over time, in order to work out the capital gains or losses due. (Thankfully this element of CGT accounting has since been simplified).

In short, paperwork like this is fiddly and boring, and if you’re lucky you’ll never have to do it. (If you’re unlucky and you’re stuck, check out the UK government page on tax arising from share transactions for more details.)

I spent a weekend digging through old trades and working out my gains and losses on disposal that year.

What idiot said share trading was fun?

ISAs and SIPPs avoid all this hassle

Avoiding tax on gains and dividends is the big benefit of ISAs and SIPPs.

But being free of this paperwork is another great reason for using a tax-exempt trading account to hold your shares.

ISAs and SIPPs (Self-Invested Personal Pensions) enable you to shelter your holdings free from income and capital gains tax – and also from paperwork.

The tax advantages are obviously worth having. But the thing is, many people will take a few years to reach the stage where their investment will be generating serious dividend income. Or else they’ll invest in a tracker or other fund and allow it to grow without selling it.

They therefore wonder why they should bother setting up an ISA, especially if they have to pay a fee for it, since they’re not getting much income or seeing capital gains in the early days.

But eventually through regular saving and reinvesting, dividend income will grow to be meaningful. When it does you’ll curse the unnecessary tax you’ll pay on your hard-earned investments.

Equally, deferring capital gains by not selling is a fine strategy – right up until you do need to sell2, and then you discover you owe the taxman a big slug for two decades worth of growth.

Yet even if these tax benefits take a while to show, avoiding paperwork is a bonus you get straight away when you open an ISA or a SIPP for share trading.

You aren’t expected to tell the taxman what you hold in an ISA. He doesn’t want to know. You can make gains and losses in your own perfect little ISA kingdom, free of the toll of the taxman.

I have about half my portfolio in ISAs and a little more in a SIPP. I started using tax shelters too late, and so will forever be playing catch up by moving my money into them (likely by harvesting capital gains on unsheltered holdings).

I see little chance of me ever sheltering all my money within them, unless I stop earning and saving altogether.

But just maybe you can do things differently.

If you have only recently started investing, you can avoid this sorry fate by thinking about tax shelters from day one.

Or if you’re an old hand who is yet to open an ISA – yes, they exist, I’ve met a few – then bite the bullet and start sheltering your funds from tax today.

Remember the deadline for opening an ISA is April 5th.

Note: This article on reasons to open an ISA was updated in 2015 to reflect the current tax situation.

1. I don’t want to hear a peep in the comments about the hoary old 10% dividend credit you used to get a trillion years ago in an ISA but don’t any more. The old situation is irrelevant and anyway in almost all situations the 10% ‘tax’ is not a tax you pay as such. [↩]
2. It’s not always your choice – companies get taken over for cash surprisingly often, for instance. [↩]

Making the case for world equity index trackers is former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. His book, Investing Demystified, is focused on index fund investing.

I believe the only equity exposure you should buy is the broadest, cheapest, and most tax efficient – which is a total world equity index tracker.

Most Monevator readers are probably already willing to accept the following points, which in my view will massively improve your returns over time:

1. You accept that like most investors you don’t have an ability to outperform the financial markets (a so-called ‘edge’) and as a result you agree that you should invest in index tracking products. In other words you’re what I call a ‘rational investor’.

2. You agree that keeping trading to a minimum and investing tax efficiently with the lowest fees will boost your returns in the long run.

3. You accept that to have a hope of decent long-term returns you should have some equity exposure, as the dull returns that safer bonds or cash in the bank provide (which may not currently even beat inflation) mean those assets are very unlikely to do the job alone.

So having agreed to all that, the question is which equities should you own?

Investing without edge

From the perspective of the rational investor – an investor accepting and embracing the fact they don’t have an edge in the market – each dollar, pound, or euro invested in the various stock markets around the world is presumed to be equally smart.

If the markets say a share in Apple is worth $125 and a share in Microsoft is worth $40, then we as rational investors don’t have a preference for owning one of those shares over the other, at those prices.

If we did have a preference, then we would effectively be saying that we know more about the future movements in share prices than the aggregate market does.

As rational investors, we don’t believe that’s true.

We believe that the money/person buying Apple is no more or less clever or informed than the money that’s invested in Microsoft.

And so we follow the money.

The case for market capitalisation weighting

Extrapolating this logic to the whole market means we should own shares in all the market’s stocks, weighted according to their fraction of the overall value of the market.

Let’s assume for a moment that ‘the market’ refers only to the US stock market, and that right now Apple shares represent 3.5% of the total US market value.

This implies that 3.5% of our US equity holdings should be in Apple shares.

If we do anything other than this, then we are effectively saying that we are cleverer or more informed than we really are – that we have an edge over the other investors in the market.

But we don’t believe that’s true.

So 3.5% in Apple it is.

Follow the global money trail

Buying hundreds of shares in a stock market in proportion to their overall market capitalizations is much simpler today than it was even a generation ago.

It is pretty much what most index tracking products offer, assuming they are so-called market capitalisation trackers. (There are other sorts of trackers, which I believe we should reject as rational investors. I’ll explain more in a future article).

In our example above, Apple would constitute 3.5% of the value of a US index tracker.

But why stop at the US market?

There is no reason to think that the UK market is any less informed or efficient than the US one, for instance.

So if there is $15 trillion dollars invested in the US stock market and $2 trillion invested in the UK market, that’s what our portfolio should mirror if we’re to track each dollar, pound, or euro of global capital.

Likewise with any other market in the world investors can get access to.

We should invest in them all, in proportion to their share of the world equity markets, as best we can in practical terms.

No home advantage

Some of you may be nervously twitching at this point. You know you’ve got a lot more money in the UK stock market than in other markets around the world.

This is illogical for rational investors, although it is not unusual.

Many investors around the world overweight their ‘home’ equities.

For instance, the UK represents less than 3% of the world equity markets, but the proportion of UK equities in a typical UK investor’s portfolio is often 40% or more.

Why does this happen?

Investors feel they know and understand their home market. And perhaps active investors think they would be better able to spot opportunities before the wider market at home. (A fanciful notion for us rational investors!)

In fairness, the concentration in home equities can also be because of investment restrictions or perhaps because investors wrongly are matching their investment with liabilities connected to the local market.

Another factor that’s cited is currency risk.

While I think there is some merit in currency matching specific and perhaps shorter-term liabilities via your investment portfolio, I think such matching is better done through the purchase of government bonds in your home currency.

If you worry that major currencies fluctuate too much for you, then I would ask if you’re taking too much equity market risk in the first place?

Broader investment and currency exposure is in my view favourable not only from an additional diversifying perspective, but also as a protection against bad things happening in your home country.

Typically whenever a currency has been an outlier against a broad basket of currencies, it has been a poorly performing one because of problems in that country (though there are exceptions to this rule of thumb).

And it is exactly in those cases that the protection of diversified geographic exposure is of greatest benefit to you.1

Whatever the reason, various studies have suggested that this supposed home field investment portfolio advantage is not real, but many of us still continue to allow our portfolios to be dominated by our home market.

If you are overweight or underweight one country compared to its fraction of the world equity markets, then you are effectively saying that a dollar invested in the underweight country is less clever/informed than a dollar invested in the country that you allocate more to.

You would therefore be claiming to see an advantage from allocating differently from how the multi-trillion dollar international financial markets have allocated.

But you are not in a position to do that unless you have edge.

And we agreed we don’t have edge…

Since the millions of investors who make up the global markets have already moved capital between various international markets efficiently, the international equity portfolio is the best one for anyone without edge.

That’s on top of the other advantages of added diversification, simplicity, and cost.

Do you know better than all the world’s other investors?

Take me as an example. As a Danish citizen who has lived in the US and UK for more than 20 years, I might instinctively over-allocate to the US and Europe because I am more familiar with those markets than, say, Thailand or Japan.

But in doing that I would implicitly be claiming that Europe and the US would have a better risk/return profile than the rest of the world.

It might or might not turn out that way, but the point is that we rational investors don’t know ahead of time.

Similarly, you’ll often hear investors say things like: “I believe Brazil, Russia, India, and China are set to dominate growth over the next decades and are cheap”.

Perhaps you’d be right to say so, but you would also be saying that you know something the rest of the world has not yet discovered.

This is not possible unless you have edge.

Rational investors who accept they don’t have edge should therefore simply buy the global equity market.

The advantage of diversification

The world equity portfolio is the most diversified equity portfolio we can find.

And the benefits of diversification are great.

Consider the following chart showing how diversification impacts risk in a home market, such as the UK stock market:

As you can see from the chart, the additional risk reducing benefit of diversification tails off as we add ever more securities to a home market portfolio.

This makes sense. Shares trading in the same market will tend to correlate, since they are exposed to the same economy, legal system, and so on.

This means that after picking a relatively small number, you have diversified away a great deal of the market risk of holding any individual company.

But by further expanding our portfolio beyond the home market we can achieve much greater diversification in our investments.

This is not just because we spread our investments over a larger number of stocks, but more importantly because those stocks are based in different geographies and economies.2

So we could have similar chart to the one above, but one where “securities” was replaced with “countries” in the x-axis.

Only a few decades ago, we did not have the opportunity to invest easily across the world like this.

But with the range of index funds and ETFs now available, investing in a geographically diversified way is a lot easier than it used to be.

One fund to do it all

In fact today you can invest across the global equity market by putting your all your equity money into a single world equity tracking fund or ETF.

To summarize the benefits:

• Your portfolio will be as diversified as possible and each dollar invested in the market is presumed equally clever; consistent with what a rational investor believes. (I bet a lot of Japanese investors wished they had diversified geographically after their domestic market declined as much as 75% from its peak during the past 20 years.)

• Since we are simply buying ‘the market’ as broadly as we can, it’s a very simple portfolio to construct and thus very cheap to run – and of course we don’t have to pay anyone to be smart about beating the market. Over time this cost benefit can make a huge difference. Don’t ignore it!

• This kind of broad based portfolio is now available to most investors, whereas only a couple of decades ago it was not. (Most people then thought ‘the market’ meant only their domestic market.)

Even if you are already an index tracking investor, for some of you getting an internationally diversified portfolio may have involved combining multiple products in a bit of an ad hoc way to gain international exposure (perhaps based on gut feel of which markets will outperform).

Don’t bother. The market has already done all the work of allocating between countries and regions for you.

Instead, focus only on how much you want in equities overall compared to less risky asset classes and on collecting the equity premium.

The bottom line is you should buy the broadest based index tracking products you can.

By definition, that’s a total world equity market tracker.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

1. Currency hedged investment products do exist, but in my view their on-going hedging expense adds significant costs without clear benefits, and on occasion further fails to provide an accurate hedge. Besides, many companies have hedging programs themselves meaning that a market may already be partially protected against currency moves, or have natural hedges via ownership of assets or operations that trade in foreign currency (like Petrobras owning oil trading in USD). [↩]
2. I believe this is still true, despite international correlations having gone up as the world has become more inter-related and large companies increasingly global. [↩]