Millionaire Teacher
Page 6
Before getting to that, remember that you can invest half of what your neighbors invest over your lifetime and still end up with twice as much money—if you start early enough. For patient investors, the aggregate returns of the world’s stock markets have dished out fabulous profits.
For example, the US stock market averaged 10.16 percent annually from 1920 to 2016. There were periods where it grew faster than that, while it dropped back at other times. But that 10.16 percent average return has provided some impressive long-term profits.
Of course, the stock market doesn’t grow each and every year. Some years between 1920 and 2016, US stocks exceeded a growth rate of 10.16 percent. Other years, stocks fell. But patient investors get rewarded.
Here’s an example. Assume you had invested $1,600 in the US stock market at the beginning of 1978. If you had added $100 per month, come hell or high water, you would have practiced something called dollar-cost averaging. Instead of speculating whether it was a “good time” or “bad time” to invest, you would have put your money on autopilot. Here’s how that money would have grown in a tax-free account, if you had added $100 per month to the initial $1,600 investment between 1978 and August 2016 (the time of this writing).
Table 2.1 Dollar Cost Averaging with US Stocks Starting with $1,600 and Adding $100 Per Month
Year Ending Total Cost of Cumulative Investments Total Value after Growth
1978 $1,600 $1,699
1979 $2,800 $3,273
1980 $4000 $5,755
1981 $5,200 $6,630
1982 $6,400 $9,487
1983 $7,600 $12,783
1984 $8,800 $14,863
1985 $10,000 $20,905
1986 $11,200 $25,934
1987 $12,400 $28,221
1988 $13,600 $34,079
1989 $14,800 $46,126
1990 $16,000 $45,803
1991 $17,200 $61,009
1992 $18,400 $66,816
1993 $19,600 $74,687
1994 $20,800 $76,779
1995 $22,000 $106,944
1996 $23,200 $132,767
1997 $24,400 $178,217
1998 $25,600 $230,619
1999 $26,800 $280,564
2000 $28,000 $256,271
2001 $29,200 $226,622
2002 $30,400 $177,503
2003 $31,600 $229,523
2004 $32,800 $255,479
2005 $34,000 $268,932
2006 $35,200 $312,317
2007 $36,400 $330,350
2008 $37,600 $208,940
2009 $38,800 $265,756
2010 $40,000 $301,098
2011 $41,200 $302,298
2012 $42,400 $344,459
2013 $43,600 $403,514
2014 $44,800 $458,028
2015 $46,000 $463,754
August 2016 $46,800 $498,904
Source: A Random Walk Down Wall Street (11th edition); Morningstar.com, using returns from the S&P 500.
Between 1978 and August 23, 2016, the investor would have added just $46,800. But the money would have grown to $498,904. To build such massive wealth, it’s best to start early. Let me show you how.
Notes
1Jay Steele, Warren Buffett, Master of the Market (New York: Avon Books, 1999), 17.
2Andrew Kilpatrick, Of Permanent Value, The Story of Warren Buffett (Birmingham, AL: Andy Kilpatrick Publishing Empire, 2006), 226.
3The Value Line Investment Survey—A Long-Term Perspective Chart 1920–2005 and Morningstar Performance Tracking of the S&P 500 from 2005 to 2016, www.morningstar.com.
4Jeremy Siegel, Stocks for the Long Run, 3rd ed. (New York: McGraw-Hill, 2002), 18.
RULE 3
Small Fees Pack Big Punches
An out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said,
“Look, those are the bankers’ and brokers’ yachts.”
“Where are the customers’ yachts?” asked the naïve visitor.1
—Fred Schwed, Where Are the Customer’s Yachts?
In 1971, when the great boxer Muhammad Ali was still undefeated, US basketball star Wilt Chamberlain suggested publicly that he stood a chance of beating Ali in the boxing ring. Promoters scrambled to organize a fight that Ali considered a joke. Whenever the ultra-confident Ali walked into a room with the towering Chamberlain within earshot, he would cup his hands and holler through them: “Timber-r-r-r-r!”
Chamberlain felt that one lucky punch could knock Ali out. He thought he had a chance. But the rest of the sporting world knew better. Chamberlain’s odds of winning were ridiculously low, and his bravado could only lead to significant pain for the great basketball player.
As legend has it, Ali’s “Timber-r-r-r-r!” taunts eventually rattled Chamberlain’s nerves enough to put a stop to the pending fight.2
Most people don’t like losing. For that reason there are certain things most of us won’t do. If we’re smart (sorry Wilt) we won’t bet a professional boxer that we can beat him or her in the ring. We won’t bet a prosecuting lawyer that we can defend ourselves in a court of law and win. We won’t put our money down on the odds of beating a chess master at chess.
But would we dare challenge a professional financial adviser in a long-term investing contest? Common sense initially suggests that we shouldn’t. However, this may be the only exception to the rule of challenging someone in their given profession—and beating them easily.
With Training, the Average Fifth Grader Can Take on Wall Street
Yes, it’s easy for a fifth grader to take on Wall Street. The kid doesn’t have to be smart. He just needs to learn that when following financial advice from most professional advisers, he won’t be steered toward the best investments. The game is rigged against the average investor because most advisers make money for themselves—at their clients’ expense.
The Selfish Reality of the Financial Service Industry
The vast majority of financial advisers are salespeople who will put their own financial interests ahead of yours. They sell investment products that pay them (or their employers) well, while you’re a distant second on their priority list. Many of us know people who work as financial planners. They’re fun to talk to at parties or on the golf course. But if they’re buying actively managed mutual funds for their clients, they’re doing their clients a disservice.
Instead of recommending actively managed mutual funds (which the vast number of advisers do), they should direct their clients toward index funds.
Index Funds—What Experts Love but Advisers Hate
Every nonfiction book has an index. Go ahead, flip to the back of this one. Scan all those referenced words representing this book’s content. A book’s index is a representation of everything that’s inside it.
Now think of the stock market as a book. If you went to the back pages (the index) you could see a representation of everything that was inside that “book.” For example, if you went to the back pages of the US stock market, you would see the names of companies such as Walmart, The Gap, Exxon Mobil, Procter & Gamble, and Colgate-Palmolive. The directory would go on and on until several thousand businesses were named.
In the world of investing, if you buy a US total stock market index fund, you’re buying a single product that has thousands of stocks within it. It represents the entire US stock market.
With just three index funds, your money can be spread over nearly every available global money basket:
A home country stock market index (for Americans, this would be a US index; for Canadians, a Canadian stock index)
An international stock market index (holding the widest array of international stocks from around the world)
A government bond market index (made up of government bonds that guarantee an interest rate)
I’ll explain the bond index in Chapter 5. In Chapter 6, I’ll introduce you to four real people from across the globe. They created indexed investment por
tfolios. It was easy for them (as you’ll see) and it will be easy for you.
That’s it. With just three index funds, you’ll beat the pants (and the shirts, socks, underwear, and shoes) off most financial professionals.
Financial Experts Backing the Irrefutable
Full-time professionals in other fields, let’s say dentists, bring a lot to the layman. But in aggregate, people get nothing for their money from professional money managers. . . . The best way to own common stocks is through an index fund.3
—Warren Buffett, Berkshire Hathaway Chairman
If you were to ask Warren Buffett what you should invest in, he would suggest that you buy index funds. He has also instructed his estate’s trustees to put his heirs’ proceeds into index funds when he dies. He shared this information in Berkshire Hathaway’s 2014 annual report. “My advice to the trustee could not be more simple: put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)”4
As the world’s greatest investor, you might think that Warren Buffett could find a great stock picker or mutual fund manager to invest his wife’s money. But he’s a smart man. The odds are against him finding anyone who can beat the market index after fees. That’s why his wife’s money will go into index funds.
I don’t believe I would have amassed a million dollars on a teacher’s salary while still in my 30s if I were unknowingly paying hidden fees to a typical financial adviser. Don’t think I’m not a generous guy. I just don’t want to be giving away hundreds of thousands of dollars during my investment lifetime to a slick talker in a salesperson’s cloak. And I don’t think you should either.
What Would a Nobel Prize-Winning Economist Suggest?
The most efficient way to diversify a stock portfolio is with a low fee index fund.5
—Paul Samuelson, 1970 Nobel Prize in Economics
Arguably the most famous economist of our time, the late Paul Samuelson, was the first American to win a Nobel Prize in Economics. It’s fair to say that he knew a heck of a lot more about money than the brokers who suffer from conflicts of interest at your neighborhood Merrill Lynch, Edward Jones, or Raymond James offices.
The typical financial planner won’t want you to know this. But a dream team of Economic Nobel Laureates want you to know the truth. Investors aren’t likely to find a professional money manager who can beat the stock market index.
They’re just not going to do it. It’s just not going to happen.6
—Daniel Kahneman, 2002 Nobel Prize in Economics, when asked about investors’ long-term chances of beating a broad-based index fund
Kahneman won the Nobel Prize for his work on how natural human behaviors negatively affect investment decisions. Too many people, in his view, think they can find fund managers who can beat the market index, long term. But such thinking is wrong.
Any pension fund manager who doesn’t have the vast majority—and I mean 70 percent or 80 percent of his or her portfolio—in passive investments [index funds] is guilty of malfeasance, nonfeasance, or some other kind of bad feasance! There’s just no sense for most of them to have anything but a passive [indexed] investment policy.7
—Merton Miller, 1990 Nobel Prize in Economics
Pension fund managers are trusted to invest billions of dollars for governments and corporations. In the United States, more than half of them use indexed approaches. Those who don’t are, according to Miller, setting an irresponsible policy.
I have a global index fund with all-in expenses at eight basis points.8
—Robert Merton, 1997 Nobel Prize in Economics
In 1994, Robert Merton, Professor Emeritus at Harvard Business School, probably thought he could beat the market. After all, he was a director of Long Term Capital Management, a US hedge fund (a type of mutual fund I will explain later) that reportedly earned 40 percent annual returns from 1994 to 1998. That was before the fund imploded. It lost most of its shareholders’ money and shut down in 2000.9
Naturally, a Nobel Prize winner such as Merton is a brilliant man—and he’s brilliant enough to learn from his mistakes. When asked to share his investment holdings in an interview with PBS News Hour in 2009, the first thing out of Merton’s mouth was the global index fund that he owns. It charges eight basis points. That’s just a fancy way of saying that the hidden annual fee for his index is 0.08 percent.
The average retail investor working with a financial adviser pays between 12 to 30 times more than that in fees. These fees can cost hundreds of thousands of dollars over an investment lifetime. I’ll show you how to get your investment fees down very close to what Robert Merton pays. By doing so, you’ll be able to learn from his mistakes.
More often (alas) the conclusions (supporting active management) can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.10
—William F. Sharpe, 1990 Nobel Prize in Economics
If you were lucky enough to have William Sharpe living across the street, he would tell you that he’s a huge proponent of index funds and suggest that financial advisers and mutual fund managers who pursue other forms of stock market investing are deluding themselves.11
If a financial adviser tries to tell you not to invest in index funds, they’re essentially suggesting that they’re smarter than Warren Buffett and more brilliant than a Nobel Prize Laureate in Economics. What do you think?
What Causes Experts to Shake Their Heads
Advisers get paid well when you buy actively managed mutual funds (or unit trusts, as they’re known outside of North America) so they love buying them for their clients’ accounts. Advisers rarely get paid anything (if at all) when you buy stock market indexes. That’s why they desperately try to steer their clients in another (more profitable) direction.
An actively managed mutual fund works like this:
Your adviser takes your money and sends it to a fund company.
That fund company combines your money with those of other investors into an active mutual fund.
The fund company has a fund manager who buys and sells stocks within that fund hoping that their buying and selling will result in profits for investors.
While a total US stock market index owns nearly all the stocks in the US market all of the time, an active mutual fund manager buys and sells selected stocks repeatedly.
For example, an active mutual fund manager might buy Coca-Cola Company shares today, sell Microsoft shares tomorrow, buy the stock back next week, and buy and sell General Electric Company shares two or three times within a 12-month period.
It sounds strategic. But academic evidence suggests that, statistically, buying an actively managed mutual fund is a loser’s game when comparing it with buying index funds. Despite the strategic buying and selling of stocks by fund managers, the vast majority of actively managed mutual funds will lose to the indexes over the long term.
Economic Nobel Prize winner William F. Sharpe explained this in his Stanford published paper “The Arithmetic of Active Management.”12 Here’s his explanation in a nutshell.
When the US stock market moves up by, say, 8 percent in a given year, it means the average dollar invested in the stock market increased by 8 percent that year. When the US stock market drops by, say, 8 percent in a given year, it means the average dollar invested in the stock market dropped in value by 8 percent that year.
But does it mean that if the stock market made (hypothetically speaking) 8 percent last year, every investor in US stocks made an 8 percent return on their investments that year? Of course not. Some made more, some made less. In a year where the markets made 8 percent, half of the money that was invested in the market that year would have made more than 8 percent and half of the money invested in the markets would have made less than 8 percent. When averaging all the “successes” and “losses” (in terms of individual stocks moving up or down that year), the average return
would have been 8 percent.
Most of the money that’s in the stock market comes from mutual funds (and index funds), pension funds, hedge funds and endowment money.
So if the markets made 8 percent this year, what do you think the average mutual fund, pension fund, hedge fund and college endowment fund would have made on their stock market assets during that year?
The answer, of course, is going to be very close to 8 percent. Before fees.
We know that a broad-based index fund would have made roughly 8 percent during this hypothetical year because it would own every stock in the market—giving it the “average” return of the market. There’s no mathematical possibility that a total stock market index can ever beat the return of the stock market. If the stock market makes 25 percent in a given year, a total stock market index fund would make about 24.8 percent after factoring in the small cost (about 0.2 percent) of running the index. If the stock market made 13 percent the following year, a total stock market index would make about 12.8 percent.
A financial adviser selling mutual funds seems, at first glance, to have a high prospect of getting his or her hand on your wallet right now. The adviser might suggest that earning the same return that the stock market makes (and not more) would represent an “average” return—and that he or she could beat the average return through purchasing superior actively managed mutual funds.
If actively managed mutual funds didn’t cost money to run, and if advisers worked for free, investors’ odds of finding funds that would beat the broad-based index would be close to 50–50. In a 15-year-long US study published in the Journal of Portfolio Management, actively managed stock market mutual funds were compared with the Standard & Poor’s 500 stock market index. The study concluded that 96 percent of actively managed mutual funds underperformed the US market index after fees, taxes, and survivorship bias.13