„The compount interest effect is the eighth wonder of the world. Who understands that, will profit. Who doesn’t understand that, will pay for it.” – Albert Einstein
Albert Einstein already detected the positive effects of investing and he understood the long term impact of the compound interest on your assets. Look at the following table to see the growth of a 10.000€ investment:
In the article „How to invest money?“ you have already learned that stocks offer the best balance between risk and return. Now it is important to understand the difference between individual stocks and a stock portfolio, e.g. investmend funds. This will make it clear why only few effort and reasonable risk taking are neccessary for great wealth bulding.
Problem of Individual Stocks
The problem of an investment in individual stocks is, that they are not diversified enough and therefore their risk is much higher. If you don’t extensively deal with every company you are invested in and if you don’t invest in several industries, your investment will be more a gambling game. Furthermore, especially small retail investors should consider that they need to pay fixed transaction fees for every buy and sell order, regardless of the amount of stocks they are trading. Let’s say you buy one stock for 100€ and you pay 5€ transaction fees, then you have already generated a loss of 5% on the first day. On the contrary, if you buy 1.000 stocks for 100.000€ you also pay 5€ which is only a deduction of 0,005%. Finally, there are certain stocks that you cannot afford for 100€ – for example an Amazon stock currently costs more than 1.000€.
Better: Investment funds
The diversification problem of individual stocks can be mitigated by investing in funds. Simply put, there is a financial instituion, that collects the investors’ money in a pot and buy securities on a larger scale. In that case, all investors pay the transaction fees just once and share it among each other.
In those active managed funds, the service provider (fund manager) decides in which stocks the capital is invested. According to his experience, he will buy and sell stocks at the best possible time to generate high returns.Sounds reasonable, right? However, fund manager ask for additional administration fees and provisions. If you have already been at a classic financial advisor, he probably demonstrated the best funds with the highest return. But he probably kept the negative impact of the high costs on your final return as a secret. At first, you pay a disagio up to 6% of your invested capital. So if you invest 10.000€ you already pay 600€ fees. It might take months or years until this loss is compensated by the return of the fund. Additionally, you pay an administration fee up to 3% of your assets yearly.
Calculation sample: You invest 10.000€ with a a return of 8% yearly. After 30 years you capital has increased to 142.000€. If you have paid additional 3% administration fee, this would reduce your interest to 5% so that your investment would be only 82.000€ worth, so 42% less.
To avoid those costs, you need to give up the fund manager. Therefore, you can use a different and modern investment opportunity instead, namely ETFs.
What are ETF funds?
Exchange Traded Funds are index funds that are traded on the stock market. They are not actively managed, but follow an index, e.g. the DAX or MSCI World, automatically. ETFs won’t make you rich in the short term. However, they are very qualified for wealth building in the long term – let’s say at least 10 years. You can use this money in the future for pension, buying a house, world trips, early retirement etc.
Advantage of ETF funds
Diversification
Leading scientiest detected that already 20 stocks of different companies in different countries and industries are sufficient for a diversification to significantly reduce risks. Especially ETFs provide this diversification as they replicate a bigger market. A DAX ETF for example is invested in the 30 biggest German companies. On a larger scale the MSCI World ETF replicates 1600 companies in 23 different industrial countries so that the risk of loss is massively mitigated.
ETF Low Cost
A big advantages of ETFs towards active managed funds are the low administration costs, so called TER (Total Expense Ratio). The yearly fees are only between 0.05% and 0.75%, which hardly affects your portfolio performance. In most cases you would also pay transaction fees about 1.5% or more. However, we will show you how to avoid the transaction costs by using a so called RoboAdvisor.
Passive Investing according to the Buy & Hold Principle
At first a passive investment strategy is much less time-consuming. You don’t need to watch your securities daily to decide whether you buy or sell anything. Instead you use the Buy & Hold Principle with a savings plan, in which you invest a fixed sum in ETFs monthly and let your capital rest on the account. With this strategy you prevent stress because you can rely on a long term market growth.
Active Investing vs Passive Investing
Now you might argue, that a professional fund manager must perform better, as he can generate more profit with more target-oriented trading – at least compared to a passive fund that doesn’t do anything. Fortunately, empirical studies have shown that the oppositive is true. Only 15% of active managed funds perform better than the benchmark after deducting the costs. Probably the amount of top performer is even less, as most of them only had luck in certain years, but cannot repeat their past success in the long term. If somebody shows you an actively managed fund that performed very well in year X, you should double check the data and see whether it was also a top performer in the last years and if the return was indeed better than the benchmark. 10 % return per year is not a great performance when the whole market has actually grown by 12%.
Conclusion:
The best way to achieve high performance is not by trying to be better than the market, but by following the market. Of course, fund managers will still try to beat the market… well because it’s their job and nobody would pay them if they are lazy and use a passive strategy.
Which ETF to buy
What’s the best performing ETF in the long term? Nobody can answer this for sure since we don’t know what happens in the future. However, there are scientific principles that hold true: Due to the Modern Portfolio Theory, a higher return can only be achieved by taking a higher risk. The best practice to find a balance between risk and return is to reconstruct the whole market. By investing in a world portfolio of different stocks in different industries and countries you can mitigate the risk significantly and still earn the highest return in average. This world portfolio is given by the ETF – MSCI World (iShares Core MSCI World UCITS ETF USD (Acc), ISIN: IE00B4L5Y983, WKN: A0RPWH)
MSCI WORLD ETF
The MSCI World ETF is invested in 1.600 companies in 23 different industrial countries.The TER (Total Expense Ratio) which can be compared to a management fee for ETFs is only 0,2 % per year.In the last 5 years (2015-2019) it achieved a performance of 60 % return (=9,9 % per year). Based on long term data (1972-2019) you can expect a future return of about 8,3 % per year.
The MSCI World index fund is the most commonly used asset in an ETF savings plan. Just invest in this one asset for the rest of your life and you’ll most likely have higher returns than the average investor.
ETF – Where to buy?
It makes most sense to buy ETFs on the course of a savings plan so that you pay a fixed sum monthly. First you need to open a securities account at a bank. Almost every bank offers securities accounts, but only a few have fair conditions, without extra fees.One side note beforehand: Don’t worry about safety issues when dealing with online brokers. Your money is stored as so called “Sondervermögen”. Even in the very unlikely case that the broker gets bankrupts no creditor except you has access to your assets.
Best ETF-Broker 2020
Trade Republic:
Trade Republic is one of the youngest but probably the best broker on the market in 2020. The FinTech company developed a highly effective, secure and user-friendly mobile app on which you can trade about 280 different ETFs. The main advantage of Trade Republic is that you basically pay no fees at all, which is absolutely unique on the broker market.
Advantages:
- Open a securities account in 10 minutes via Video Identification
- English language support
- Savings rates from 25 € per month
- High developed and user-friendly mobile app
- No management fees
- No extra fees when buying ETFs on a monthly savings plan ( -> only provider on the market offering these condtions)Only 1€ order costs when buying individual costs (-> only provider on the market offering these condtions)
Disadvantage:
- No website banking, yet (trading only via mobile app).
- Only for people with tax residance in Germany or Austria
HERE you can open your account at Trade Republic in just 10 minutes.
Flatex:
Flatex is a more traditional online broker offering the unique advantage of an English web platform and about 400 free tradable ETFs. The provider was distinguished by “Stiftung Warentest”, “Handelsblatt” and “Focus Money” as the best Online Broker and best platform for trading ETFs in 2018 and 2019. Although Flatex is a German bank, you don’t have to live in Germany. The only thing you need is a bank account in the EU with a valid IBAN. Flatex can be recommended for those who prefer a non-Fintech company, thus traditional broker.
Advantages:
- English webpage
- Savings rates from 50 € per month
- No extra fees for selected ETFs (this includes all relevant ETFs for a long term investor)
- Fair conditions: 0,1 % management fee per year
- Order costs for individual stocks: 3,8 €
Disadvantages:
- Slightly higher fees compared to Trade Republic
- Less developed mobile platform compared to Trade Republic
HERE you can open a free account at Flatex.
OnVista:
Until 2018 OnVista was still No. 1 of the German brokers. However, in 2019 they changed the fee structure and ask for additional 1 € order costs when buying ETFs in a savings plan. If your monthly savings rate is 50 € this would already result in a loss of 2 % of your money. Don’t get me wrong – OnVista is still one of the most favourable brokers on the market, but cannot beat Trade Republic. The most common reason to choose Onvista instead is if you’re looking for a more traditional broker that offers a web platform (not only an app). Also keep in mind that the service is only in German and not as easy to comprehend as Trade Republic – your German language skill should be on a higher level.
Advantages:
- Savings rates from 50 € per monthOnly 1 € order costs for selected ETFs (this includes all relevant ETFs for a long term investor)
- No management fees
- Order costs for individual stocks: 5,99 €
Disadvantages:
- Only German language platform
- Slightly higher fees compared to Trade Republic
- Less developed mobile platform compared to Trade Republic
HERE you can open a free account at Onvista.
Conclusion:
ETFs are passively managed and therefore low cost index funds that reconstruct a diversified portfolio. Investing in a MSCI World ETF allows you to participate on the general stock market growth with return rates about 7–9% per year. In the long term this is the easiest and smartest way to increase wealth.
