Quick basics

The most robust approach to investing is to build a globally diversified portfolio of stock funds, bond funds, inflation protected securities (TIPS), and some commodities. The returns of the investment should be higher than inflation, to generate wealth.

Diversification in the investment portfolio should ideally be performed across:

• Geography: Invest in US, Europe, China, India, etc.
• Asset Classes: Buy Stock Markets, Bond Markets, TIPS and some Commodities (Gold, etc.)
• Strategies: Index tracking funds following different methodologies (equal weighted, capitalization weighted, etc.), active strategies, etc.

Let’s start with a simple example. The simplest diversified portfolio is the “60/40” portfolio with 60% US stocks and 40% bonds.

The concept is that stocks and bonds move differently, so one market can compensate for the losses from the other market over time. This provides a “smoother ride” in the investment. Let’s plot the performance of US stocks, US bonds, and our 60/40 portfolio.

Note the stock market has a higher return than the bond markets, but also has higher volatility. There were large downturns in the stock market in 2000-2003 (44% drop) and in 2007-2008 (51% drop), but bonds behaved well in those periods. Investing in both stocks and bonds with the 60/40 portfolio produces smoother returns, at lower volatility. However, the behavior of the portfolio still looks a lot like the stocks, and there are long periods of under performance.

Knowing that each market has a different natural volatility, let’s see what percentage of the volatility in our portfolio is caused by stocks, and what percentage is caused by bonds.

In our example, stocks have an annual volatility of 16%. Bonds have an annual volatility of 4%. Therefore the volatility of stocks dominate. The stocks account for ~86% of the fluctuations in the portfolio components, which is huge.

I believe there are better ways to invest in the long term, like the Risk Parity approach, which holds a portfolio where each asset approximately contributes equally to the portfolio overall volatility. There are multiple ways to do this. The simplest approach is to make the volatility of each asset equal. This does not mean that the contribution to the portfolio will be equal, as this depends on how each asset moves with respect to the others, but it is a simplification that works well in practice. For a stock/bond portfolio, it would look like this:

That looks like a lot of bonds!. But it makes sense somewhat, as the stocks move more than twice than the bonds. Having most of the portfolio in bonds would reduce the volatility, but will also reduce the overall returns. The portfolio has to be leveraged a bit to target a volatility in between stock and bond volatility. Here is the Risk Parity portfolio performance leveraging by 50%:

That looks a lot better than the 60/40 portfolio!. The return is higher and the performance looks a lot smoother, so it’s more realistic that people will stick to the investment over the long term.

Don’t get excited yet: This is a simplified example with a few assumptions, and is exposed to a single country. The final strategy should be diversified internationally, and include other asset classes (commodities, TIPS, etc.). I’ll explain further and show an example later in this article. But first, let’s get something important out of the way…

Beware of the sharks!

Once you settle in your new location, you will start getting calls from well-spoken gentlemen from a local or international firms, offering free financial advice. They contact you based on a recommendation from someone you know.

You agree to meet with the adviser. He presents a compelling case of why you should to invest in funds that offer diversified exposure to stocks and bonds, to grow your money over the years. So far so good…

Then there comes the proposal to invest through Offshore Pensions / Investment-Linked Assurance Scheme (ILAS) offered by Zurich, Generali, Friends Provident, or others.

These are serious companies, but the investment products they offer to expats are some of the most expensive that exist. The fee structure is difficult to understand. The aggregated costs can be higher than ~4% of the investment value per year. This will eat away most of the returns you get in the long term.

The adviser receives a large upfront commission from the investment scheme provider on the first day you start the policy (can be in excess of 10K USD), so there is little incentive for the adviser to continue a quality relationship with you over time. You can find more detailed analysis here

Most of my colleagues got locked into these schemes. I believe you can do much better, armed with better knowledge.

How much better?

Let’s say you have an investment horizon of 15 years, and an expected compound return of 10%. The graph below shows how much the investment would grow over time, assuming we start the investment in 2021-01-01.

After 15 years, the final investment value with 4% fees would be 43% lower. That is a massive opportunity cost, so it’s better to steer clear from these schemes.

Reducing total costs to ~1% is actually easy and will pay off massively over time. Just need to learn a few things around brokers and financial securities.

Now that we got that one out of the way… let’s dig into how you can do it yourself to save a lot of money.

Brokers

You will need a broker to be able to invest in the stock and bond funds by yourself. There are many brokers that provide access to international markets. Common choices among international investors / traders are:

• Interactive Brokers
• Saxo Bank
• Internaxx, DBS Vickers, Swissquote, etc

I use Interactive Brokers and Saxo Bank. Both are great brokers with access to many international markets. Interactive Brokers has the lowest cost, and Saxo Bank is easier to use.

Account opening is easy: you mainly need your ID and utility bill as proof of residence. All the process is online and can be completed in a couple of hours. Account approval can take a few days.

Taxes

Taxes are complicated, and what you pay depends on many factors like:

• Which country you are citizen from
• Which country you live in
• Which country you are investing in
• Security Domicile: Which country provides the securities you invest in
• Your income
• Many other things…

Here are some good news for expats:

• USA does not levy capital gains tax on stock and funds for non resident alien investors (non-resident and non-citizen). Dividends and Interests on US assets are taxed however. See IRS.
• Other countries have similar rules as USA (no capital gains tax for foreign investors), but make sure to read the fine print.

Note that if you invest in US assets (stocks, funds, real estate, etc.) as a foreigner, you are liable to US Estate Tax of up to 40% for assets larger than 60K USD in case you die (see IRS). You can avoid the US death tax if you invest in funds domiciled outside the US.

There is a good overview on international taxation in Wikipedia. In general, you are better off tax-wise if the country you are living in has a territorial taxation system. You may need to consult a tax advisor to understand your specific circumstances.

The impact of capital gains taxes can be huge, so being an expat can offer a massive advantage.

Let’s assume you get a compound return of 10% over 15 years, with an annual volatility of ~15%, and you get hit with a capital gains tax of 30% every year.

The impact of capital gains taxes can be huge over time. Note this assumes you are buying and selling the full portfolio value each year, more akin to what traders do. Long term strategies like risk parity or the 60/40 portfolio require less buying and selling to maintain, so the burden is lower, but still significant.

There is an important benefit for expats willing to get started in trading (market speculation). Not having to pay capital gains tax will increase the profit potential.

Financial Securities and Funds

By far the most effective and cheapest way to invest for the long term is by using Exchange Traded Funds (ETF). An ETF is a basket of securities like stocks or bonds. The ETF is listed in an exchange, and its price fluctuates during the day, as the underlying securities move in price.

Stock ETFs invest automatically in a basket of stocks so that the aggregate performance tracks a specific index. An index is the expected portfolio performance of holding a set of stocks following a given algorithm.

For example, the SPY ETF tracks the S&P 500 index. The index computes the performance of holding stock on the 500 largest companies in the US stock market, and weighting them by market capitalization. The list of stock holdings is updated once a quarter. The ETF is essentially a simple automated investment strategy, which follows the same rules as the index.

There are also bond ETFs, like AGG, which holds bonds and tracks the US Aggregate Bond index. Several example ETFs are listed in the sections below.

The idea is to buy several of these ETFs, to diversify internationally and across asset classes. Note historical international portfolio performance was not as good as US-only investment. USA markets have provided the highest returns historically, but there is no guarantee they will continue to do so in the future. The same is true for inflation. Inflation has been dropping over the last 40 years, but is likely to rise again this decade, so we should invest in inflation protected securities and commodities, as these asset classes behave better in inflationary environments.

An example portfolio with US-domiciled ETFs (most liquid and cheapest) can be this one:

Let’s examine a portfolio where we give 25% risk weight to each category: Stocks, Inflation Protected Securities (TIPS), Commodities and Bonds:

This looks like a more realistic performance, with some areas for improvement. I will dig deeper into asset allocation strategies in other blog posts, as there are many different ways to set up a portfolio. Since 2019 it is even possible to access a full diversified strategy like the one above, through the RPAR ETF, for example. Note the chart starts in 2009 because several ETFs only have data since 2009.

Does all this stuff sound risky to you? Let’s do one last chart, comparing our basic diversified portfolio historical performance, against keeping the money in the bank.

If you kept your money in a savings account paying 0.5% annual interest over the past 19 years, you would have lost 25% of your money due to inflation. If you had invested the money instead, the real wealth after inflation would have multiplied by 4.7X.

Of course, you would have lived though scary, unpleasant times of under-performance, where you lose money. There is no escape from this, except reducing the leverage of the portfolio, which reduces the return. The sweet spot of risk ultimately depends on your personality.

The year 2008 was a bad year for most investors. This portfolio also suffered, but the dip was smaller and the recovery was quicker. Note our model portfolio assumes the volatility of each asset is constant over time. There are several improvements that can be made. I’ll dig into this topic in other blog posts.

Putting it all together

The fundamental point of this article is that everyone should learn the basics of investing, regardless if you do it yourself, or hire someone to do it. There is a large opportunity cost in ignoring this stuff.

Confused? Here are some useful resources to learn investing:

• Web tools: Google, Portfolio Visualizer to experiment with ETF portfolios, List of liquid ETFs not domiciled in USA for non-US domiciled ETFs
• Books: Adaptive Asset Allocation , Balanced Asset Allocation , Smart Portfolios

And here’s a good sequence to get started:

1. Learn investing.
2. Open an account in a broker.
3. Buy a small diversified portfolio with ETFs. Rebalance periodically. Learn by exposing real money.
4. Decide if you want to manage the money yourself (needs discipline, but cheaper), or if you want it managed by a third party (hands-off, but more expensive).

Depending on how you set up your strategy, doing it yourself requires between 2 hours per year to 2 hours per month time commitment to maintain a diversified portfolio.

If you liked this article, you can follow me on Twitter, where I keep documenting my work and ideas.

Disclaimer: The information and analysis on this site is provided for informational purposes only. Nothing herein should be interpreted as personalized investment advice.