Kicking Financial Ass

by Paul Christopher Dumont

  Historically speaking, the stock market generally goes up, and dividends increase. The total return varies each year, but over the past hundred years, the stock market has averaged about 10% a year before inflation, with 6% to 8% of that coming in the form of stock price increases and the other 2% from dividend payments. You can receive these payments in cash or have them reinvested to buy more stock, which I recommend.

  What About Leaving Money in My Savings Account?

  Because of inflation, you lose money every day your money is sitting in your savings account. A savings account typically has a 0.05% interest rate unless you own a high interest rate savings account, which pays around 1.5%. The average inflation rate in the U.S. and Canada over the past 20 years has hovered around 2% a year, which historically has been low. In 1990, inflation was as high as 6% in the U.S. (Canada 4.8%), and in 1980, it was 12.5% (Canada 10.1%)!

  For example, if you kept $1,000 in your savings account with 2% inflation, it would be worth about $980 of purchasing power after one year. Your account would still have $1,000, but the cost of goods you buy, like groceries, would have increased in price by 2% making your money worth less. Multiply that loss each year, and it adds up to a lot of money. How can you beat inflation? The answer is by investing in the stock market.

  What Stocks Should I Buy Then?

  The right question is not what stock you should buy but how can you buy all of them? Warren Buffett, the greatest investor of all time, recommends buying an S&P 500 index fund and doing it consistently. He is on record saying:

  “A low-cost fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.”

  “Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a lowcost S&P 500 index fund.”

  “Consistently buy an S&P 500 low-cost index fund. I think that’s the thing that makes the most sense practically all of the time.”

  As wealthy as Warren Buffett is, why not hire an investment advisor to manage his investments instead? The answer is that their fees are too high. Individual stocks cost more to manage, which means advisors take a larger chunk of your earnings. Your financial advisor may charge 2%, which may not seem like a lot, or does it?

  Let’s say you have $100,000 to invest. Are you willing to pay $2,000 a year plus any additional fees on top of that to your financial advisor? Over 20 years, that is $40,000, not to mention the lost income you could have made if you did not have to pay those fees.

  You Have Heard the Stock Market Is Too Risky

  You may have heard the stock market is too risky from either a friend or family member. The biggest risk is not investing in the stock market. You need your money to outpace the rate of inflation or else you are losing money every year. Think about what has happened since 1900:

  •First World War

  •Great Depression

  •Spanish Flu that killed over 100 million people

  •Second World War

  •Multiple recessions

  •Korean War

  •Vietnam War

  •Cold War

  •Gulf Wars

  •1990 Tech Bubble

  •9/11 Terrorist Attacks

  •Asian Tsunami

  •Great Recession of 2008-2009

  If you invested $500 in an S&P 500 index fund in 1901, held on during each major event until 2018, assuming you are still alive, you would have received $7,028,399 back!

  Keep Your Emotions Out of It

  The average investor makes bad investment decisions. When the stock market is rising, most people feel they need to buy. And then, when markets start falling, they sell. Making money investing is not accomplished by buying high and selling low. It is done by buying low and selling high. Why do we succumb to this instinct when we know better?

  Psychologists say that it is because our fear of losing money is greater than our hope for gain. So, when the market has a decline, we panic and sell, which is the worst thing you can do for your returns. I know what you are thinking, “I’m smarter than that! I’m not the average person.” I am not either, but guess what, it has happened to me before, and I guarantee that it will happen to you at some point in time unless you listen to this advice.

  One of the biggest fund managers, Blackrock, conducted a study on how most investors behaved between 1997 and 2016. The average return for the stock market during this period was 7.68% per year. The average return for the average investor during the same period? 2.29% per year.

  That is an underperformance of 5.39% per year. If $10,000 was invested, that is the equivalent of receiving $15,728 back on an investment versus $43,924 that the market returned over that same 20-year period.

  How did the average investor do compared to other investments?

  The average investor not only underperformed the stock market, but they also underperformed every single investment. The Dalbar study, one of the longest running and respected research studies in the financial world, determined the four worst times average investors sold:

  •1987 Black Monday Stock Market Crash

  •1997 Asian Financial Crisis

  •2000 Tech Bubble Crash

  •2008-2009 Financial Crisis

  In other words, the worst crashes in recent memory.

  Investor underperformance is one of the most important reasons to buy the index instead of individual stocks. It would not matter if the stock market is up or down if you are systematically investing. On the other hand, if you buy individual stocks, chances are you will be tempted to buy and sell at the wrong times and devastate your investment portfolio.

  INVESTING 101

  If you can take away three things about investing other than to invest in the index, remember compound interest, the rule of 72, and dollar-cost averaging.

  Compound Interest and The Rule of 72

  Albert Einstein called compound interest the Eighth Wonder of the World. What is compound interest? It is the result of reinvesting interest rather than spending it so that interest in the next period is then earned on the principal plus previously accumulated interest, meaning earning interest on interest.

  In finance, the rule of 72 is a simplified way to determine how long an investment will take to double given a fixed annual rate of interest that compounds, or multiplies, over time. By dividing 72 by the annual rate of return, investors get a rough estimate of how many years it will take for the initial investment to double. For example, let’s say you buy an index that averages 10% growth per year. Expect your money to double every 7.2 years (7 years to keep the numbers easy). If you invest $2,000 when you are 18 years old and retire when you are 60, your money would double six times to become $109,527.

  You just turned $2,000 into $109,527 by buying the index? YES. It took 42 years, but you only had to invest once and forget about it. That is the magic of compound interest! You can easily turn an investment into multiples of itself over time. That is how people retire at younger ages. Invest early and often!

  Dollar-Cost Averaging

  Dollar-cost averaging is investing money continuously over your working years, ideally from every paycheck or at least once a month. This is a systematic approach to investing and eliminates the urge to try and time the market. If you try to time the market by either keeping money on the sidelines or selling at the wrong time, meaning missing the best 10 trading days between 1995 and 2014, your annualized returns would drop from 9.85% per year to 6.1%. Better to invest systematically and take your emotions out of the game.

  Applying the dollar-cost averaging concept and assuming you invest $2,000 each year instead of investing only that first year, your investment would grow to $1,292,329 over the same 42-year time frame.

  Your investments are worth almost $1,300,000 over the same 42 years, but you only invested $84,000
? YUP! That is the power of compound interest combined with dollar-cost averaging. Now, imagine the effects if you save over 30% of your income each year. This is how you can retire early.

  *Assuming 9.7% S&P 500 returns using a compound interest calculator.

  In another example, suppose you save $1,000 a year from the age of 25 to 65 in an investment account earning 9.7% a year, which is the average annualized S&P 500 return for the past 50 years, for a total of $40,000. By the time you turn 65, you will have close to $447,572. If you started when you were 35, this would only be worth $170,507. A difference of $277,065.

  Sarah Sharon

  When beginning to invest, the person is… 25 35

  Each person invests $1,000 a year for… 40 years 30 years

  With a 9.7% rate of return, at age 65, their accounts are worth… $447,572 $170,507

  The Most Important Retirement Chart You Will Ever See

  •This retirement chart will inspire you to start saving as much as you can for retirement as soon as you can.

  •It can help you decide how much you want to save each year to hit your retirement goal. Remember, you only need to save 25x your annual spending rate.

  •It can help you determine how on-track or off-track you are for your retirement goals.

  •It can help you set financial goals and make sound financial decisions.

  For example, let’s say your spending rate is $25,000 per year. According to the chart above, if you invested $20,000 per year, you could retire in about 15 years (25 years x $25,000 spending rate= $625,000) using simple index-based investing. Of course, market returns of 9.7% are not guaranteed for the future. However, the concept of compound interest remains the same. Save early and often in index funds, and you will be able to retire a lot sooner than you think.

  INDEX FUNDS

  Mutual funds and exchange-traded funds (ETFs) are two investment vehicles that allow you to buy a basket of stocks that track the stock index. They have one important difference, however: Fees. Mutual funds charge big fat fees, called expense ratios, that eat into your returns, costing investors the equivalent of tens of thousands of dollars over the lifetime of an investment. The justification for the fees is that mutual funds pay managers to pick investments trying to outperform the market. Moreover, some mutual funds charge fees on top of their expense ratio, whether a front-end load (paying a fee when you buy a mutual fund) or a back-end load (paying a fee when you sell a mutual fund). As a result, over 75% of mutual funds do not match the financial returns of the index they are tracking.

  ETFs, on the other hand, simply match the market return, keeping their costs low by being passively managed, meaning no managers actively pick the stocks. They are extremely low-cost, easy-to-maintain, and tax-efficient.

  In the U.S., a few ETFs seek to replicate the performance of the S&P 500 Index, giving investors several different options. Each has similar returns, so go with the one with the lowest fee structure if your investment account allows for it. I include a few ETFs that cover the Canadian stock market as well, although I recommend buying the U.S. ETFs since the S&P 500 has outperformed the TSX (the Canadian stock market) over time.

  Top U.S. Index Funds SPDR

  S&P 500 ETF (SPY)55

  The SPDR S&P 500 ETF (SPY) is the oldest U.S.-listed ETF, having begun trading in 1993 as an innovation in the financial world. Since then, SPY has become one of the largest and widely traded securities in the world with a 9.41% average return for the 10 years between 2008 and 2018 versus 9.52% for the S&P 500.

  iShares S&P 500 ETF (IVV)56

  If you want S&P 500 exposure with a low fee, the IVV is the fund for you. It is plenty liquid, meaning it can be bought or sold with a low transaction fee, with over 1.5 billion shares changing hands every day. Over the past 10 years between 2008 and 2018, it has returned on average 9.44%.

  Vanguard S&P 500 ETF (VOO)57

  The most recent addition to the S&P 500 ETF space came in 2010 with the release of Vanguard’s S&P 500 ETF (VOO). While it is only a fraction of the size of the other two ETFs, it has the lowest expense ratio charging just 0.04% per year. VOO only discloses its holdings monthly, not daily like the IVV, which is a slight ding in terms of transparency. And VOO, unlike SPY, reinvests its interim cash. Since its inception, it has a 15.30% average return per year.

  “Great,” you are probably thinking to yourself, “You just complicated my life with having to choose between three ETF index funds.”

  I personally recommend investing in the Vanguard S&P 500 ETF (VOO) because it has the lowest fees. You will see later in this chapter how much small fractions of a fee add up over time. I included the other funds just in case some readers want alternatives, or VOO is not available on your platform, although it should be.

  Top Canadian Index Funds

  FTSE Canada All Cap Index ETF (VCN)58

  In Canada, the FTSE Canada All Cap Index ETF (VCN) tracks the Canadian market. With an expense ratio of 0.05%, it is cheaper than most mutual funds. Since its inception in 2013, it has a 7.31% average return per year.

  iShares S&P/TSX 60 Index Fund (XIU)59

  iShares S&P/TSX 60 Index Fund (XIU) has exposure to the large, established Canadian companies, is the largest and most liquid ETF in Canada, and started trading in 1990, making it the first ETF in the world. Since inception in 1990, it has returned on average 6.88% per year. The expense ratio is high at 0.18%, however.

  iShares CDN Composite Index Fund (XIC)60

  With iShares CDN Composite Index Fund (XIC), you get to own the entire Canadian stock market and not just the top 60 companies like with XIU. And, it is low-cost with a 0.06% expense ratio versus 0.18% with XIU. Since its founding in 2001, it has returned on average 6.23% per year.

  Of the three Canadian market ETFs, I recommend VCN because it tracks the entire market and has the lowest expense ratio. However, if you have a choice, and you certainly do, I recommend the U.S. S&P 500 ETFs over the Canadian market ETFs as over time the U.S. market, which is a more diversified market and home to some of the largest companies in the world, has traditionally outperformed the Canadian market, which is more natural resource-driven. Keep in mind that Americans and Canadians can own any ETF. An American can buy VCN, and a Canadian can buy VOO.

  While it is possible to invest in more than one ETF, I do not recommend it because you can be overly diversified with multiple index funds. The upside is that you may add a layer of safety, but that may come with sacrificing returns. I recommend buying the lowest-cost U.S. index fund for the greatest return.

  Watch Out for Fees

  The average mutual fund fee, called an annual expense ratio, is 0.89%. While this may not sound like a lot, it will erode gains in your investment portfolio compounded over time.

  For example, if you invest in a mutual fund that earns a 7% annual return but has a 2% expense ratio, your investment would only grow by 5%.

  In comparison, the average fee for an index fund is 0.12%. Say want to invest $1,000 per year in a market index growing at the market average of 9.7% a year for 30 years. Should you choose an account with a 0.89% or 0.12% fee? While the fee differential looks small, it adds up.

  Management Fee Amount in Your Account 30 Years from Now

  0.12% fee $166,514

  0.89% fee $143,159

  Of the $23,355 difference, $9,958 was due to fees, but the biggest impact was the compounding effect on your return. Over $14,000 was lost in compounding potential! Since your money is growing at a slower rate because of the fees, your money will grow slower and slower compared to a fund with lower fees. And this example looks at two relatively low-fee funds. Some funds have an expense ratio that is over 1%, which will eat into your returns quickly. When deciding which index fund to invest in, look at the fees.

  ADVICE ON FINANCIAL ADVISORS

  The common conception is that because financial advisors and stock-picking fund managers invest for a living that they are better at it than the average person. This assumption c
ould not be further from the truth.

  According to a 2016 research report from Standard & Poor’s, over the past 15 years, 92.2% of large-cap funds lagged a simple S&P 500 index fund. The percentages of mid-cap and small-cap funds lagging their benchmarks were even higher: 95.4% and 93.2%, respectively. In other words, you have a 1 in 20 chance, or 5%, of beating the market when investing outside of an index, and this includes financial advisors.

  In 2005, Warren Buffett made a wager of $500,000 that no professional could select a portfolio of at least five hedge funds, meaning funds that actively manage money, that would match the S&P 500 index over a 10-year period. Only one investment manager decided to take him up on the challenge. The results were not even close. The five hedge funds as a group managed only a 2.2% annualized return, compared with a 7.1% average return for the S&P 500 index fund. Buffett estimated that 60% of fund gains went to the management fees even though they dramatically underperformed the market.

  A study in 1973 by Paul Slovic, a world-class psychologist and peer of Nobel prize winner Daniel Kahneman, demonstrated that the more information we have, the worse decisions we make. This is counter-intuitive to the common belief that the “better informed” we are, the better our decisions. Accumulating information is believed to give an advantage in most fields if not all. In his study, he found the opposite can be true.

  Slovic gathered eight professional horse handicappers and asked them to predict the winners of horse races. These handicappers made their living using their gambling skills and as such were highly experienced. Slovic told them they needed to make predictions on 40 horse races in four consecutive rounds. For the first round, each gambler received five pieces of information on whatever they wanted to place their bet. This could be anything from how old the horse was, to years of experience of the jockey, and so on.

  As another facet to the study, Slovic also had the handicappers say how confident they were in their predictions. There was an average of 10 horses per race, so each handicapper should be correct about 10 percent of the time, and so their confidence with a blind guess should also be 10 percent.