What equities do I invest in?

Edited: the title to change from "how do I invest" to "what equities to invest in" as I realised that this post only talks about equity investing and might not be suitable for investors of different risk profiles.

My Personal Finance professor once taught us that the best way to invest was to invest in a diversified pool of risky assets over the long run. I will look into the reason for doing so, and suggest the recommendations to implanting this.

1. Diversified
It has to be diversified. In the academic study of finance, there are two types of risk, systematic and unsystematic risk. Systematic risk are general risk that affects the entire economy, such as a global financial crisis, and cannot be removed.

Unsystematic risk are specific risk that affect specific entities, such as a company news, or local event. Since only general risks affect the entire economy, such specific risks can be eliminated by holding a diversified pool of assets.

To hold a diversified pool of assets, one can simply purchase an ETF, which already covers many stocks across many geographical locations, and across various industries. Look for ETF that are global.

2. Risky
The basis of the Security Market Line suggests that the more risk one takes, the more reward one will have. This is also know as the risk-reward trade-off. Do note that this risk refers to the systematic risk, and not the unsystematic risk.

To get higher reward, one should hold risky assets. Risky assets are usually equities. Large capitalisation stocks are less volatile and hence less risky than mid capitalisation stocks, which in turn are less risky the small capitalisation stocks. As a result, small capitalisation stocks rewards investors with the highest return.

An anomaly is that small capitalisation stocks reward more than proportionately than both mid and large capitalisation stocks. Thus, they make a valuable investment. Speaking of anomaly, there is another anomaly present in stocks. That is, value stocks always outperform growth stocks. Value stocks are stocks with low price-to-book ratio and growth stocks are stocks with high price-to-earnings ratio. Hence, one should invest in an ETF which has a small cap value investment strategy.

3. Long run
One cannot expect to simply buy today and sell tomorrow and earn spectacular returns. Equities are volatile and it is common, especially for small capitalisation stocks, for them to fall more than 20% in a single year. However, over the long run, there will be more years with positive returns than negative returns, and overall rate of return will be positive.

The best way to invest in the long run is to do a long-cost averaging. This means that you invest a fixed amount of money every month, or quarter, or year. By doing so, you buy more units when the price is low, and less units when the price is high. Thus, it reduces the average cost of your units.

Research has proven that market timing is impossible, and your best bet would be to use dollar-cost averaging. This is also beneficial in investing psychology. When the price of your investments drop, you will be happy to buy more units at a lower price; if their prices rise, you will be happy too.

On the basis of holding a diversified pool of risky assets, and to capitalise on the anomalies that value stocks outperform, I would suggest two ETFs that one can invest in. One is the Vanguard Rusell 2000 Value ETF (VTWV) and the other is the Vanguard All World ex-US Small-Cap (VSS). I would suggest putting an equal allocation into both.

The Vanguard Rusell 2000 Value ETF has a median market capitalisation of $1.6 billion, and price-to-book of 1.5x. The Vanguard All World ex-US Small-Cap has a median market capitalisation of $1.4 billion and price-to-book of 1.6x.

Just a side note not to invest in an ETF simply based on the name. For instance, the Vanguard Small-Cap Value (VBR) has a higher median market capitalisation of $3.1 billion, and higher price-to-book of 1.9x as compared to VTWV, which means it is less "small-cap", and has less "value".

Also, even though the Vanguard All World ex-US Small-Cap has no "value" in it's name, it's price-to-book is 1.6x, and could termed as a value ETF as well.

In sum, I would go full equities into both the Vanguard Rusell 2000 Value ETF (VTWV) and the Vanguard All World ex-US Small-Cap (VSS) equally, with dollar cost averaging, and yearly portfolio balancing to keep at 50-50 mix.

Post edit: small cap are expected to produce a return of around 12% per annum over the long run, and with the addition of value stocks, this portfolio will provide a return of more than 12% per annum.

Post post edit: this portfolio of VTWV and VSS might be too volatile for many to take. For majority of people, I would suggest a 3-fund portfolio. This portoglio comprises of the equity portion of the STI and Vanguard All-World UCITS ETF, and the bond portion is the Singapore ABF Bond ETF.
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