Let's keep this really, really simple. I know what happens when I get excited about money and investing. There's a... sedative effect on the audience. To counter this, I'm stripping out tons of neat stuff and just leaving the basics in. This means that I will be discussing aggressive, high-yield stock market investing, suitable for people who have a long (>10 year) period before retirement. I'll discuss money management, tax optimization and/or bond markets for another day. Or not.
What if I told you that I could tell you how to achieve the eightieth percentile of investment returns every year, GUARANTEED? In other words, if I randomly paired you with 100 other people, you'd do better than 80 and worse than 20. You'd never be the absolute best, but you'd always be right there, year after year.
You'd think I was trying to sell you something, right?
Fortunately, this is absolutely true and absolutely attainable for regular people. If there is a secret (and there really isn't), this is it:
Making money from investing is all about knowing what you can control and what you can't.
There are exactly four things you can control when you invest: (1) What you buy, (2) How much, (3) When you buy it, and (4) who you buy it with. In comparison, there are umpteen million things you can't. These include the price of oil, a dictator's heart condition, and a CEO sex scandal, among many others. Furthermore, as an individual investor, you are too small to meaningfully affect any large entity you invest in. You are, in effect, a twig that floats on ocean currents, subject to the whims of fortune.
Sounds daunting, eh? Maybe now you just want to buy a duplex or something?
Well, let's not hit the panic buttion yet. Even though the four factors you have control over seem very small and very simple, they have a lot bigger effect than you might imagine.
Investing In the Stock Market, Writ Simple
My strategy for dominating investing can be summed up in one phrase: Aspire to the average.
What is average for the stock market?
Over its hundred-plus year life, the S&P 500 (the 500 largest companies in the US*) has an average return of 10.47%. Thus, if I invested money on January first each year (and then lived an extremely long life), my average return would be 10.47% annually, assuming no other buying or selling. This is, in effect, the average return for this index. All you have to do is invest in the index regularly and hold it.
Wait a second - the average return on investment is WAY LESS than 10.47%! How does that jive?
While it's true that most people don't realize returns that match the market average, it's not the fault of the market. This is simple math. The truth is, most people manage to fuck this up on their own, primarily by not optimizing the four factors they can control.
Now that we know your major goal as an investor is to not fuck up a good thing, let's begin by learning how to use the four things we can control to get ourselves to the average:
Things You Control
(1) What you buy: In this case, we want to invest in the entire market (as opposed to individual companies). For this we can either buy Vanguard's S&P 500 index fund (ticker symbol: VFINX) or the "Spyder" ETFs (electronic traded funds), which are simply shares of the entire S&P 500 (S&P... SPyders... get it?). They're pretty much interchangeable; each one is a teeny tiny share of every company comprising the index. These are blue-chip stocks, like Coca-Cola and Apple. I prefer Spyders because the commission is slightly lower than purchasing mutual funds, but that's a tiny issue.
(2) How much: As much as you can afford to invest. I'm not going to bust your balls over saving rate (for now), but MINIMUM 10%, preferably 20% or more.
(3) When to buy: Regular intervals. It's obviously not feasible to split your contributions into daily investments (you pay each time you invest), but the more frequent your contributions, the more closely you'll track the market average. For real people, investing 3-4 times a year will get you close, especially over a number of years. Google "dollar cost averaging" if your curious about why.
(4) Who you buy from: This has two answers, who you physically purchase from (most likely the online brokerage platform you use) and who offers the financial product (Charles Schwab, JP Morgan, etc.). The answer to the first question is a low-cost brokerage like TD Ameritrade. The answer to the second is Vanguard, which is far and away the best, most efficient investment company on the planet. The only reason to not use Vanguard is if you have a 401k that doesn't offer their funds (fun detail: employers often take kickbacks from investment houses in exchange for running the employee 401k. These kickbacks are usually proportionate to the shittyness of the options they stock the 401k with).
Noah, you claimed I'd beat 80 out of 100 people with this strategy. Investing for the average means I should only beat 50 or so... right?
Good question! Hypothetically, average returns should be, well, average, but we're living in the real world. By carefully selecting the four factors we can control, we're going to do much better than the average retail investor. The reason is (are?) expenses, which are the main way the typical investor screws themself over.
Investing the wrong way will tear you apart.
Investing isn't free. In fact, you pay money three times on your investments (four if you count taxes on profits, but let's ignore that for now): The transaction fee (e.g., the fee Ameritrade charges you to make a purchase), the internal expenses of the fund (more on that in a second) and fees your investment advisor tacks on. Fortunately, these are all factors we can control.
To illustrate the importance of controlling investment expenses, let's go through the expenses associated with investing a modest amount (say $5,000) into Spyders versus investing the same amount into a typical investment option over a period of ten years.
Noah's way: Buy-it-yourself S&P 500 index shares:
As I mentioned earlier, the S&P average lifetime return is 10.47%. The expense ratio for Spyders is a paltry 0.09% (it doesn't cost much to invest using a computer formula), reducing my actual return to 10.38%. Since I'm doing this myself, there are no advisor fees and I paid Ameritrade 8 bucks to execute the trade after setting up an online brokerage. After ten years, we have $13,424. A nice, tidy profit. Simple. Average**.
Sadly, here's how most people do it:
They give their financial advisor five grand and tell them to invest it. Assuming he's not the next Bernie Madoff, your guy/girl invests the cash for you in an actively managed fund ("actively managed" generally means it's run by men in suits who actively try to beat the market average). For an investment outfit, I selected American Funds, which I previously mentioned are very popular with financial advisors due to their lucrative kickbacks. You'll also be charged $50 to purchase the shares.
For this example, I've used a "target date" fund. These are very popular of late. You simply select the year you want to retire; the fund is more aggressive as you're younger, then shifts to a more conservative investment allocation as you approach retirement. I'll be 65 in 2045, so I picked that as the target date.
As you can see from the chart, we immediately see several worrisome things: First, the 2045 retirement fund's rate of return is lower than the S&P index. You may be thinking I picked an underperforming fund deliberately to fudge the numbers in support my arguement. In fact, 22 of the 57 funds offered by American perform at this level or worse (count them yourself if you like), suggesting this rate of return is somewhat typical.
You also see that the expense ratio of the fund is 0.75%. This doesn't sound like a lot, but it's more than eight times that of my index fund. Remember - how much you pay in investment expenses is one of the only things you can control as an investor. Remember also that your annual expenses are really 1.75% (you're also paying your financial advisor 1% for the privilege of underperforming the stock market). This erodes your expected annual return to 2.28%, which may or may not keep up with inflation.
You can really see effect of high fees on the low rate of return after ten years. Instead of nearly tripling, your $5,000 investment is only worth $6,500 or so. Terrible.
Now let's say you notice you're getting fucked over and decide to cash out in search of greener pastures. You call your advisor and tell him you want to sell this terrible investment.
"Sure thing," they reply. But before you do that, it's time to pay one more bullshit fee: American Funds charges something called a back-end load. In easier to understand terms, a back-end load is essentially a cover charge you pay to leave the bar. American levies a whopping 5.75% for all their target date retirement funds. Your meager return is further eroded by another $374, a final kick in the nuts on the way out the door.
Let's assume you skimmed the previous paragraphs and have no idea what you just read. In the simplest possible terms: When you invest in a way that incurs high expenses, your investments have to do quite a bit better than average just to break even with the guaranteed return of investing in the entire market.
Remember the beginning of this post where I said I could guarantee returns that beat 80% of all investors? This is how it's done. By keeping expenses to a minimum, your relative performance improves by virtue of those around you being dragged down by higher fees. In reality, your net returns (what you actually get) moves from the fiftieth percentile to the eightieth. Thirty percent improvement each and every year - that's how powerful disciplined, low-cost investing can be.
But Noah, there are millions of people with trillions of dollars invested this way. Doesn't that prove that financial advisors do better than the market?
Absolutely not. The financial services industry has brainwashed the public into believing that investing is complicated and that they've somehow figured it all out. This is why financial services companies and banks barrage us with abstract television commercials of whales breaching every time we watch tennis. You can read every terrible thing about the 2045 Target Date fund I used as an example right there on the company's own website, but people either don't know or don't care; this fund alone has 2.33 BILLION dollars invested in it ($7 per American).
What about Warren Buffett? He makes bank.
Buffett is an anomaly that has become a self-fulfilling prophecy; he's a trendsetter in investment circles who's immediately emulated when he makes a major move. This subsequent flood of interest pumps up his investment and makes him look like more of a genius.
If investment managers really are so adept at investing, why don't they agree to work on commission and take a largish percentage of the gains they achieve for you (fun note: most hedge funds actually DO take 20% of the profits, although they don't absorb any of the losses)? Not even Buffett does that (to the best of my knowledge). Back to American Funds: only 8 of their 57 fund offerings beat the S&P 500 average. And that's before they charge you a dime in expenses.
This post covers investing in the stock market. There are other options, of course, but this is historically the best for achieving the highest returns over time. I won't go into detail about the basics here (don't invest money you need soon, no guarantee of profits every year/be ready for volatility, etc.). However, I should mention the most important rule for investing (other than "always do it yourself" and "shoot for the average"): Never buy and sell based on panic. Timing the market is a fool's game.
Ironically, the steady-eddy approach negates the risk of market peaks and valleys. By investing a regular intervals (shown in chart), you'll eventually hit a roughly equal number of investments where the market is relatively cheap or expensive. This makes you hit the - wait for it - average over the long term.
And average is awesome.
Last thing: Ego. Terrible enemy of any investor. So many poor, irrational investment strategies are based on ego. Entire industries are based on separating fools from their money. It's true; somewhere in Tulsa, there's a guy in a cube farm who honestly believes he can predict the flow of global currencies. Why else would retail ForEx (foreign currency exchange, which is basically gambling) exist?
You have no idea what the market is going to do. You cannot pick stocks. Your advisor cannot pick stocks. Men on Wall Street in fancy suits cannot pick stocks. Equities markets are irrational beasts. To logically predict the action of an illogical entity is impossible. Anyone who tells you they can is trying to sell you something.
I, on the other hand, lack the sophistication to post an affiliate link to Ameritrade.
Yeah, so I'm not the first person to write about this stuff. Unfortunately, there are so many sharks out there it's sometimes hard to tell chicken salad from chicken shit. For further reading, I recommend this post by Jim Collins, who more or less follows the same line of thinking I do. He is wise.
*I use the term "stock market" and "S&P 500" interchangeably in this article. Astute readers will note that there are many stock markets, of which the S&P 500 is one. You can use any large market (Dow Jones and/or total stock market (ticker VTSAX) if you prefer, so long as it essentially reflects the entirety of the US economy.
**Technically 0.09% less than average, but close enough.
Noah's Inner Monologue
Scribblings of a man who can barely operate an idiotproof website.