So, what happened? After the first round, with only the five pieces of information, the handicappers were 17 percent accurate, which is pretty good. They were more accurate than a blind guess. What is more fascinating is that their confidence was 19 percent, which almost matched their accuracy of 17 percent.
The second round introduced more information. For the second round, the handicappers were given up to ten pieces of information on anything they wanted to help them determine the winning horse. The third round they were given 20 pieces of information and in the fourth round 40 pieces of information. Logically, we would assume the more information they had, the more accurate they would be. However, their accuracy stalled at 17 percent. Having 40 pieces of information did not improve the odds of their winning over having five pieces.
What about the confidence in their predictions? Their confidence nearly doubled to 34 percent. The more information they had did not improve their accuracy, yet the handicappers felt they had an advantage that boosted their confidence.
Why is this the case? We typically make a decision and then try to justify it with information that confirms our original assessment. We tend to ignore or dismiss any information that conflicts with our conviction. Psychologists call this “confirmation bias,” and it is evidenced in multiple fields and studies.
Relating this back to investing, an almost limitless amount of information exists. Trying to keep on top of it all is a recipe for disaster. Who is to say that the reasons for the dollar continuing to go lower is a direct consequence of monetary policy or trade relations with China and so on? You hear it all the time that the financial experts cannot explain why stocks continue to go higher or lower. It is hard to make sense of so many moving pieces, and the harder we try, the more we can succumb to confirmation biases. It is better to ignore the noise and expert opinions on the stock market and invest on your own with your money in a stock market index.
More Information = Analysis Paralysis
Not only does having more information give us a false sense of confidence in the world of investing, but we are likely to become paralyzed by the information and make no choice, which is just as bad or worse than making the wrong choice. Barry Schwartz writes in his book The Paradox of Choice: Why More is Less:
“…As the number of mutual funds in a 401(k) plan offered to employees goes up, the likelihood that they will choose a fund – any fund – goes down. For every 10 funds added to the array of options, the rate of participation drops 2 percent. And for those who do invest, added fund options increase the chances that employees will invest in ultraconservative money-market funds.”
How often have you stood at the supermarket wondering which toothpaste to buy? Investing can be the same thing—overwhelming. There are so many choices that many people simply do not invest, or if they do, they make a hasty decision ending in lower returns. The same factor affects financial advisors and their stock picking ability.
Financial Advisors Are Human
Financial advisors are prone to the same behavior biases as regular people. Just like with anyone, the more confident someone is, the more they are prone to overconfidence, leading to disastrous results.
Do you need a financial advisor? If you follow my advice, then no you do not. But depending on your level of comfort with your finances, you may want a financial coach. A financial coach is a fee-only professional who charges you a flat fee. The fee-only system removes any potential conflict of interest. Someone on commission is incentivized to make you buy and sell to make money, which is how most financial advisors are compensated.
No One Can Predict the Future
The next time you hear an analyst talking on TV about what she or he thinks the stock market is going to do, change the channel. No one knows what the stock market is going to do.
“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
—Warren Buffett
The best thing you can do is to invest early, often, in stock indexes, and use dollar-cost averaging over time whether the market is moving up or down. Most likely, you will make more money over the long term. Otherwise, if you listen to analysts and financial advisors, chances are your portfolio is going to under-perform.
HOW DO I BUY?
You can open a brokerage account with your bank or use an online brokerage. Before you open an account, consider these factors:
•Commissions: Almost all online brokers charge a trade commission, normally between $5 to $10 per trade.
•Account fees: These include annual fees and inactivity fees.
•How often you plan to buy: If you are buying the index ETF monthly, as you should, you want a broker with low commissions.
•Support: Brokers offer various levels of educational resources and customer support.
•Minimums: A broker’s minimum can range between $0 and $2,500 or more.
Once you decide on a broker, signing up for an account will require:
•Social Security ID (U.S.) or Social Insurance Number (Canada)
•Driver’s license or other government-issued ID
•Address
•Employment status
•Annual income and net worth
•Date of birth. Note: Most require you to be over 18.
You need to send a deposit or funds transfer, which is often the minimum amount. The funds’ transfer can take between a few days and a week. Once the funds are transferred, you can begin investing. To invest, search for the ticker symbol for the index fund you want to buy, say VOO, which is the Vanguard S&P 500 ETF and has the lowest expense ratio, and decide how many shares to purchase. Once you hit buy, you are finished. Do this once a month or every paycheck for the rest of your working life, and you will have nothing to worry about in your retirement.
Personally, living in Canada, I like dealing with RBC with their online trading platform. I can easily transfer funds between accounts, often instantly, and I can set up automatic withdrawals to other accounts to make it easier to save. They also offer an account where you can practice buying and selling stocks. A lot of the other Canadian banks offer the same services.
If you are in the U.S., it might be worth checking if your bank offers the same services. Otherwise, open an account at E-Trade, TD Ameritrade, Merrill Edge, or Robinhood to name a few. You can also open an account with a robo-advisor, which I go into later in the chapter.
ALTERNATIVE INVESTMENTS
But what about your friend who made a 50% gain on cannabis stocks or the friend of a friend who keeps talking about cryptocurrencies and tripled his money? These are the two biggest investment topics when writing this book, but replace them with whatever is being talked about now. The fact is that it is very hard to beat the market year after year. Your friend may beat the market this year, next year, and the year after that, but because all his or her eggs are in one basket, it just takes one problem with the industry or company, and they could underperform the market or even lose it all. Just like flipping a coin, someone can flip heads five times in a row but then have the sixth flip come up tails.
Gold
Gold is another popular investment for those people fearing the end of fiat currency or for those seeking a safe investment. A quote from Warren Buffett on gold:
“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Gold has no utility. It is used in very limited quantities in the world for jewelry, coins, dental fillings, and decorative items, and that is about it. Should you buy gold? Wharton Finance Professor Jeremy Siegel keeps track of various asset class’ returns from 1802. Siegel calculated that if you bought $1 worth of gold in 1802, it would be worth $3.11 today. In comparison, if you bought $1 of the stock market index in 1802, it would be worth $1,033,487. I would not recommend buying gold and neither would Wa
rren Buffett.
Alternative investments, in general, tend to be subject to trends, fads, manias, and erratic investing behavior, so be careful.
Real Estate
Real estate is not a very good investment for most investors. Why? Because returns are poor, and over time the average return on property has been 0% after taking into account inflation. The exception to this is that if you receive more rental income than your payments and have positive cash flow, then it can be a good investment. I discuss real estate at length in Chapter 12: The Perils & Benefits of Real Estate.
Penny Stocks
Penny stocks are typically shares of a company that trade for under $1 per share, hence the name. Often people are drawn to penny stocks because they fluctuate in value in very short periods of time. You could see a penny stock rise from $0.10 to $1.00 overnight, with many thinking, “Wow, if only I put in $10,000, it could be worth $100,000.” Little do they know that penny stocks are akin to gambling. Most companies trading for those prices have little to no earnings, most investors lose money, and the stocks are purely speculative with many susceptible to pump and dump scams, and furthermore, they often have poor management teams. The stock of the company is trading at low prices for a reason, and if something sounds too good to be true, it often is. It is better to wait and see if the company can prove itself before investing, or better yet, buy the index and avoid penny stocks altogether.
WHAT ABOUT ROBO-ADVISORS?
A robo-advisor is a service that uses highly specialized software to do the job of wealth managers or investment advisors—people who decide what investments you should be making and then tinker with those investments over time. You typically fill out a questionnaire to determine your appetite for risk and then, through proprietary algorithms, spread your money into various investments, adjusting over time as your situation and the market changes. They primarily invest in ETFs and typically collect under 1% in annual fees, which is less than a professional investment advisor who can charge as high as 3%.
Should You Invest with a Robo-Advisor?
They are completely safe, and there are ways to ask questions through their customer service support. Overall, however, I recommend you open your own investment account(s) at your bank, set up automatic withdrawals, and invest in a single ETF that tracks the entire S&P 500 index as mentioned earlier. The reason why I recommend you invest on your own is again the fees. While robo-advisors charge less than mutual funds, on average, they still do what you could do for less.
For example, Betterment’s lowest fee option is 0.38% per year versus the Vanguard S&P 500 ETF 0.05% fee. Moreover, the lack of control you have and the variety of ETFs offered can hinder your returns. Why invest in an alternative investment ETF when you can invest in the S&P 500 index with a proven track record over time of nearly 10% a year in returns? Furthermore, many robo-advisors do not offer financial advice other than investing and will not help you with tax planning, budgeting, or other financial planning.
Lastly, some robo-advisors might not consider your outside accounts. For example, if you have a 401(k) or RRSP where your employer matches, this is the best place to invest first. Many robo-advisors, however, do not include those assets in their planning, which can skew and unbalance your portfolio.
I only recommend investing with a robo-advisor if you do not want to deal with the small hassle of investing in an index fund yourself or will otherwise be checking your investment account every day and be tempted to day trade the market, which is one of the best ways to destroy your returns. Compared to human financial advisors, robo-advisors can be a good deal with advisory fees between 0.25% and 0.50%, which is less than half of what human financial advisors charge, and an investment fee of 0.08% to 0.13%, for a total of 0.33% to 0.63% of your portfolio per year.
If you choose to go the robo-advisor route, do your research. I recommend Wealthfront simply because it offers the lowest fees. For Canadians, Wealthsimple ranks near the top of the list and typically in the top three. Use the online calculator at autoinvest. ca to see which robo-advisor is recommended based on what you consider important criteria.
WHAT ABOUT BONDS?
A bond is an IOU either issued by a company, government, or some other institution. When you buy a bond, you essentially lend money to the organization, your “principal,” in return for an interest payment that you receive either monthly or quarterly. The term of the bond varies from one day to over 30 years. The interest you receive is called a “coupon.”61 At the end of the term, you receive your principal back. Bonds are generally minimal risk because you only lose your money if the company or government goes bankrupt. If you buy a government bond, they can always print more money, so this is often referred to as the risk-free rate of return.
Generally, rich people and old people like bonds because they are such a safe, low-risk investment, and typically, your funds are locked away for the term of the bond. You may have heard that you should subtract your age from 100 and that is the percentage of your investment money that should be in stocks, and the rest should be in bonds. I do not necessarily agree with this advice, but it depends on your risk tolerance and how many years away you are from retirement. In almost all circumstances, the stock market has outperformed bonds over time. Bonds, on average over the past 80 years, have given a 5.2% return on average versus close to 10% for stocks. If you are in your 20s or 30s, I highly recommend having a 100% stock index portfolio. If you are older, I still recommend a stock index portfolio, but depending on your risk tolerance, you may want to consider mixing your portfolio with bonds.
If you are having a hard time deciding on your asset allocation, remember the 4% withdrawal rate and the Trinity Study in Chapter 3: Save 25X Your Annual Spending Rate. It showed that if you have an investment portfolio consisting of 50% stocks and 50% bonds, then you could withdraw 4% of your investment portfolio each year in retirement without fear of running out of money. If you have a 100% stock portfolio, you could withdraw 5% of your portfolio without drawing down your savings over 70% of the time, and a 6% withdrawal rate without drawing on your savings 55% of the time. If you have $1 million saved up in retirement and a 50/50 portfolio split, you could withdraw $40,000 per year safely. With a 100% stock portfolio, you could withdraw up to $60,000 per year.
SUMMARY
Avoid keeping money in savings accounts. Inflation will eat away the value of the cash. Instead, invest in ETFs that match the stock market return to keep your money from becoming devalued over time and allow you to grow your retirement nest egg.
•Remember the power of compound interest, the rule of 72, and dollar-cost averaging. These concepts allow you to retire early when applied properly.
•Avoid financial advisors because they are human just like you and are susceptible to confirmation biases like everyone else.
•Complexity is the enemy of execution, so keep it simple. Invest in one index fund ETF.
•Keep your emotions out of investing and invest for the long term. Directly trading stocks will harm your returns.
•Watch out for the fees when investing in ETFs. Every 0.01% difference will save you thousands of dollars over the years.
•Avoid alternative investments that are fads and/or high risk and real estate.
•If you are rich or older, bonds can be good to incorporate into your investment portfolio. Otherwise, if you are young and have time on your side, a 100% stock portfolio will provide greater returns with compound interest.
•If you choose to use a robo-advisor, do your research and remember you are paying for the convenience.
CHAPTER ELEVEN
USE YOUR RETIREMENT ACCOUNTS
WHY RETIREMENT ACCOUNTS ARE IMPORTANT
Picture this. You are on the first day of your new job, fresh out of undergrad, filling out forms when you come across the 401(k) section. You think to yourself, “I can always start saving later. Besides, I have a lot of bills and could use the money.” Ten years later, you start a family an
d think, “I’ll start saving when I have fewer bills or when I get the next raise or promotion.” Flash forward to age 40. Your kids are grown, you are making a lot of money, and have few bills to pay. FINALLY, you can save.
If you start saving now, by some estimates, you need to save more than a third of your salary just to catch up. When you were 22, the Dow Jones Industrial Index was at 1,800. As I write this, it is at 23,000. You could have made over 15x your money over that time. The right thing to do, then, is to sign up to your 401(k) or equivalent on the very first day you start your new job! And consider, some companies match 401(k) contributions, so you lost out on free money.
These accounts, called retirement accounts, are used to save and invest money for retirement. They offer benefits that include acting as a tax shelter to minimize taxes owed on investments and tax-deferred growth, meaning investments continue to grow taxfree and compound over time. Every country is different, but the concept remains the same, using specifically designed accounts to help you with your retirement savings. They are important because government-sponsored plans can no longer be relied upon as a sufficient sole source of retirement income.
In the U.S., social security is no longer enough to retire on. In the 1980s, Social Security could make up about half of people’s pre-retirement income. For someone retiring now, it covers only about 40%, and over time, that percentage will continue falling.
The Canadian Pension Plan (CPP) is not much better. If you retire at the age of 65 in Canada, expect to receive between $641 and $1,134 a month, or $7,692 and $13,60862 per year from the Canadian Pension Plan. It is better to apply for CPP later and receive more, depending on if you have the savings in the meantime. If you wait until you are 70, you receive 42% more per year than if you start taking CPP at 65. The average life expectancy is increasing every year. On average, Americans who reach the age of 65 can now expect to reach age 84.
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