The investing landscape can be extremely volatile and change year after year, but there is a lot to be said for investing in what you really know and understand. Considering the enormous number of products on offer, as well as the nature of the industry, it is not that simple to be simple, but it can certainly be done.
Understanding the Investment 'Risk Ladder'
Cash: One could argue that the only asset that is fully understandable is cash in the bank or some form of fixed deposit. Here, you know exactly how much you will earn and that you will get your capital back. The problem is that you will be lucky to beat inflation, and simply leaving your money in cash is not the answer; it is just not a productive investment.
Bonds: Moving a bit up the risk ladder, we get to bonds. Given the variety of bonds and bond funds, understanding what you get is also not necessarily that simple. Government bonds are fairly straightforward, but, again, they don't pay much. Municipal bonds pay a little more and are usually tax-exempt, but are not going to satisfy the average investor's retirement needs. So to really earn anything, you need a variety of bonds, both corporate ones and, arguably, foreign. Yet, these start to become complex and riskier, depending on various factors relating to the issuing company or country. Likewise, bond funds may depend on a number of managerial and financial issues.
Stocks, Mutual Funds and Real Estate Funds: The same applies to stocks, mutual funds and so on. Even real estate funds have proved to be less reliable and straightforward than many people might think. Direct real estate purchases are more understandable in one sense—what you see is what you get. But then again, there can be unknowns relating to the market, taxation, the location, disclosure by the seller and so on.
Exchange Traded Funds (ETFs): ETFs have been getting more popular since they were introduced 20 years ago. Like stocks, ETFs can be bought or sold on an exchange at any time during the trading day. But similar to a mutual fund, an ETF holds a basket of assets, like tech stocks, or, more broadly, the U.S. stock market.
Alternative Investments and Hedge Funds: Similarly, alternative investments, such as hedge funds, can be extremely complex. Infrastructure, too, is, without doubt, a great idea in principle, but the nitty-gritty of investing in it is not such a sure thing. No matter how sound the principle of a particular investment, there is almost always someone or something out there that can make it go wrong.
Certificates of Deposit (CD): CDs are probably the hardest type of investment to understand. Given yield curves, expectations and potential early withdraw penalties, they may be the easiest to mis-sell.
Tracker Funds: Tracker funds are relatively simple to understand; you are indeed just "buying the market," but the markets themselves are not so easy to deal with and understand. Furthermore, the tracker market is becoming more sophisticated and complex. This all sounds very daunting. But, in fact, one can still invest simply and understandably, at low cost and with a good, diversified portfolio that is likely to perform well over time.
How to Invest Sensibly, Suitably and Simply
In general, we really know very little about a lot of asset classes and investments. Nonetheless, there are many ways of ensuring that you are investing in what you know. You can really invest in a straightforward manner, and understand what you're doing.
Many veteran investors have simple diversified portfolios and look more at asset allocation. Spending hours performing regression analysis is not an option for many part-time investors. For example, Steven Goldberg of Kiplinger has said in his "Value Added Web Column" that, "Most people wish they didn't have to be investors," and that they "lead busy enough lives without having to worry about stocks, bonds, and mutual funds." Goldberg, therefore, recommends sticking with index funds that simply mirror the market and only attempt to be average. He even argues that one only needs three index funds: one covering the U.S. equity market, another with international equities and the third tracking a bond index.
Trackers are sometimes better than actively managed funds. Lower fees, low turnover and a combination of available investor education make index investing extremely attractive. So, a really straightforward mix of these funds is transparent, cheap and does as good (or better) a job as more complex and expensive vehicles. Despite the above, to be fair, there are a lot of well-managed funds out there. With a bit of effort, you can find reliable and understandable equity and bond funds with which you can relax.
A good piece of advice is to start with simple investments and then expand and extend as you learn more. Specifically, mutual funds or exchange-traded funds are a good way to get going, and one can then move on to individual stocks, real estate and further down the line, even a sensible amount into resources or hedge funds.
It is interesting to note the book, How Buffett Does It: 24 Simple Investing Strategies from the World's Greatest Value Investor (James Pardoe, McGraw-Hill, 2005), about the world's greatest pro. Buffett himself says that Wall Street dislikes too much simplicity. The reason is that brokers make money out of complexity. But you do not have to fall for this.
The Bottom Line
The more you learn, the better. But above and beyond this, you can (and probably should) avoid investments that you do not understand in principle. A small number of index funds seems a very good solution.
Also, go on sound recommendations. If your parents-in-law have been investing for 20 years in a mixed fund, which has served them well, you may choose to take their advice and feel fairly good about it (although nothing is guaranteed). On the other hand, if you get a call from someone you met in a pub last week who wants to give you a hot tip as a "big favor," you should be more skeptical.
Likewise, there are many independent financial advisors around who get paid only for their time and not on commission. Their job is to understand what they recommend, without the pressure of having to sell to earn a commission. And make sure you diversify, not only into asset classes but possibly into different banks and fund providers. Then, if something goes wrong that neither you nor anyone else seemed to understand, the losses are not so disastrous.
Always bear in mind, though, that too many bits and pieces also creates complexity that can lead to errors.