by Steve Forbes
We would like to help you navigate the treacherous rapids ahead. Our advice won’t put you on the Forbes World’s Billionaires list. In fact, there are only a relatively few investors on it. Most make fortunes through owning their own businesses or by financing the ventures of others. What the information and suggestions in this book will do, however, is help you preserve and build on your wealth.
Achieving this objective does not require access to sophisticated hedge funds, equity funds, or even venture capital funds. Nor do you have to strive to get in at the ground floor of red-hot initial public offerings. All you have to do is follow a few basic steps. If you are truly a long-term investor you will do very well indeed over time if you follow the advice we are about to give you. In fact, you will do better than the vast majority of professional money managers.
The Panic of 2008–2009 proved that you don’t have to be a survivalist in an underground bunker to be concerned about the potential for disaster in this era of unstable money. The devastating bear market that began in late 2007 and ended in early 2009 may not have been the apocalypse some had predicted. To many, however, it felt like something close to it: the two most prominent major stock indexes, the Dow Jones Industrial Average and the S&P 500, lost about 54% in value, and hundreds of individual stocks lost a lot more. Real estate investment trusts (REITs), a favorite income-producing vehicle for millions of investors, plunged 75% as many appeared headed for collapse. Bank equities overall dropped 80% as shareholders in many such institutions were wiped out altogether. All this havoc in a mere 17 months.
The financial crisis was a lot like Hurricane Katrina: most people didn’t recognize the full magnitude of what was coming. Just as it’s good to have a hurricane preparedness kit, it also makes sense to practice financial preparedness.
Some Questions and Answers
How do I protect myself?
Our recommendation: 5 to 10% of your money should be invested in Treasury Inflation Protected Securities (TIPS), another 5 to 10% should be in cash, 5 to 10% should be in gold coins or bullion, and the rest should be in stocks. A few comments on each follow.
Treasury Inflation Protected Securities. These low-risk bonds are decidedly unglamorous. But because their par value rises with inflation, TIPS are a prudent investment in inflationary times. They have a fixed interest rate and pay investors semiannually. You can purchase them from the government through TreasuryDirect.gov. TIPS require a small minimum investment of $100 and are sold in $100 increments with 5-, 10-, and 30-year maturities.
Cash. To be ready for emergencies, 5 to 10% of your money should be in cash. Typically, in bear markets you end up with too much cash and miss opportunities when the market turns around. In bull markets people will borrow too much on their credit cards and get in trouble when there’s a crunch.
Gold. When we say gold, we’re talking about gold coins or bars. You should not own gold as an investment but rather as an insurance policy. When governments misbehave and undermine the integrity of your money, the real value of your traditional investments and savings vehicles will be eroded. But you can take comfort in the fact that your gold will move up in nominal value.
As we discuss later on, the experience of the last several years underscores how treacherous it is to treat gold as an investment vehicle. Think of the losses suffered by all the people who bought gold in the last couple of years in response to all those TV ads. In 2010–2011 there was real fear that the Fed’s ballooning balance sheet would bring a repeat of the inflationary 1970s. When the Fed’s quantitative easing failed to make it into the economy, gold prices dropped dramatically from their highs.
Having a small percentage of your money in gold is a hedge against a weakening dollar. For example, during the inflationary period that began in the late 1960s and ended in the early 1980s, gold shot up from $35 an ounce to a brief peak of $850 in early 1980. Meanwhile the real value of stocks had gone down.
The reason you don’t want to treat gold like your traditional investments, though, is what happened afterward. The yellow metal crashed to under $300 in the summer of 1982 when the Fed was killing inflation. For the next two decades gold’s price remained around $350 an ounce. Only a nimble speculator could turn a profit in such an environment.
Stocks. Despite all its volatility, the stock market is your friend. Stocks are excellent long-term investments, and they are fine short term. This may seem counterintuitive, given recent events including the horrific plunge of 2008–2009, heinous frauds like those perpetrated by Bernard Madoff, an unending array of insider-trading scandals, flash crashes and technology glitches that can actually close down markets, and alleged (and untrue) market rigging by high frequency traders.
Now let’s look at this fact: for over 100 years, the average annual return on stocks is about 9½% a year—5% from price appreciation of shares and 4½% from dividends. This average includes the years of the Great Depression, the two world wars, numerous recessions, and countless stock market corrections.
Obviously the market doesn’t achieve that 9½% average appreciation in a straight line. The Dow Jones Industrial Average went nowhere from 1966 to 1982. When you factor in inflation, it lost considerable ground. Another widely used index, the S&P 500, did better, but it was still no bargain. But eventually things turn around. From 1982 to 2000, the Dow appreciated 15-fold.
Since 2000, stocks have been hit with two severe bear markets—2000–2001 and 2008–2009. The latter one was especially painful. Yet, by early 2014, stocks more than doubled from the lows of early 2009.
If you have the intestinal fortitude to ride the highs and lows, you will eventually be rewarded. Consider this: if in your mid-twenties you put $10,000 into stocks in a tax-deferred account such as an IRA, reinvested dividends and capital gains, and made no more direct deposits, you would have accumulated well over $350,000 by your mid-sixties. By the time you hit 70 you would have more than $500,000. Even with average inflation of, say, 3% a year, you come out ahead.
Let’s say when you start to work in your early twenties you set aside $100 a month into your account. By the time you’re 70, your nest egg would be worth almost $1 million. Albert Einstein supposedly said that compound interest is the greatest miracle. He was right.
Why are you still confident in the stock market with so much recent volatility, and with the economy so burdened by increasing regulation and constraints on enterprise?
Remember that the market has achieved 9%-plus annual average returns for more than a century. There was no greater disaster than the bear market of 1929–1932 that saw the Dow Jones Industrial Average go down almost 90%. Equities will take hits, but they always come back.
Stocks represent ownership of companies. In the United States, free enterprise always triumphs. The American people have exhibited an astonishing capacity to right the ship of state when it goes drastically off course. We’re seeing this with the dramatic attitudinal shift toward freer markets and away from central planning taking place right now in response to the Affordable Care Act, nicknamed Obamacare, which to date has been the greatest failure of a social experiment since Prohibition. One thing this freedom-loving practical nation has never tolerated is failure.
Could the U.S. government really do away with retirement accounts like 401(k)s—or seize people’s savings, as the government of Cyprus did in that country?
The Obama administration has made noises about restricting private retirement accounts like 401(k)s and IRAs as a prelude to laying its hands on some of that money. Washington may attempt this through new regulations that would be imposed by the new Bureau of Consumer Protection that was set up under the Dodd-Frank bill. Ensconced inside the Federal Reserve, this bureaucratic monstrosity has no accountability and no congressional oversight.
This agency will eventually be found unconstitutional. But in the meantime it can create plenty of mischief. The government could also renege on the promise of Roth IRAs, which right now let you save after-tax money and make later
tax-free withdrawals by decreeing such monies as taxable.
We have already witnessed brazen looting of people’s financial assets not only in Cyprus but also in Poland, Hungary, and Argentina. Chile, with a new hardcore socialist president, may make moves on individual social security accounts that were privatized 30 years ago.
In the United States, such an attempt to seize individual assets will give rise to a fierce reaction. Not convinced? Just look at what happens when attempts are made to suborn the Second Amendment, the right to bear arms.
Deciding on a Stock Investing Strategy
You should have two investing strategies. The first is a conservative strategy whose objective is preserving and building your wealth for retirement. You have the time to do this, even if you’re in your late fifties.
When investing your retirement funds, your goal should be to do as well as the market. Invest in the whole market and ride the ups and downs. The best way to do this is through index funds. They were invented by one of the great investing heroes of all time, John Bogle, founder of the Vanguard Group, now the second-largest mutual fund group in the world and a champion of low management expenses. As a Princeton University undergraduate, Bogle noticed the distressing tendency of individual investors to lose out in the investing game because of expenses and chronically bad timing.
His answer: the first index fund, launched by Vanguard in 1976. It was designed to mimic a broad stock market index, the S&P 500. Initially greeted with derision, index funds today are immensely popular. They exist for all the major market indexes, as well as for numerous sectors of industries such as banks, pharmaceutical companies, and technology firms. There are index funds that encompass the entire global universe of publicly traded stocks and for the markets of scores of individual nations. There are also bond index funds of all kinds: U.S. Treasuries; high-grade corporate bonds; junk bonds; short-term, intermediate, and long-term debt securities; and international versions.
The advantage of index funds is that the individual stocks aren’t being actively traded as they are in a traditional mutual fund. Because they don’t need an army of managers and analysts, costs are lower. The expenses of Vanguard’s S&P 500 Index Fund are only one-sixth of 1% (or 17 basis points) versus at least 1.5% for the typical mutual fund; for its Total Stock Market Index, which encompasses just about all traded stocks in the United States, the expense is also an ultralow 17 basis points. While compounding can give you miraculous returns over time, expenses compound as well.
Choosing an Index Fund
Go for broad-based index funds like the Vanguard 500, which has 500 equities based on the S&P 500 Index, or the Fidelity Spartan 500 Index Fund. The big question revolves around how index funds are put together, more specifically how one weighs each stock. Does a smallish stock count as much as, say, Apple? Vanguard and its followers did it by the market capitalization of each equity. The debates about index funds sound almost like medieval theology. No need to get caught up in them. Traditional index funds work just fine for our purposes.
Beating the Market
You can indeed beat the market by a strategy as simple as investing in an index fund: dollar cost averaging. With this strategy you buy a particular dollar amount of an investment on a regular schedule—typically every month—and stick to it. You do this regardless of what’s happening in the market. Yes, prices will go up and down. That’s precisely the point.
Into your retirement accounts, put in a certain amount systematically, say $100 a month. When the market turns down, console yourself with the knowledge that you’re getting more shares for your money. Inevitably the market rebounds, usually when you least expect it. Your bonus: your gain is bigger.
Take this simple example: You put $100 in and buy 4 shares at $25. The next month, the market is down and shares are $20, netting you 5 shares. The month after, the market is horribly bearish and shares are selling at $10, giving you 10 shares. Now the market turns bullish with shares back at $25 and you buy 4 shares. After four months, with dollar cost averaging you own 23 shares worth $575. If the market had been stable, you would own 16 shares worth $400. Extreme? Of course, but the point is valid.
Now let’s go to a real-world example. Say you started your monthly retirement program of $100 a month in early 2000 when the Dow peaked at 11,722 and stayed with it through 2012 (we leave out 2013, when the Dow surged 27%, to underscore our thesis). With dividends and capital gains reinvested, your investment would have appreciated 48% thanks to dollar cost averaging.
You might want your retirement money to be divided in half between stocks and bonds. Each year—and only once a year—you would recalibrate your portfolio to bring it back to that 50/50 balance. Say stocks that year surged and bonds bombed, so your portfolio is now 65% in your equity index fund and only 35% in your bond index fund. You would sell equity shares and buy bond shares to restore the ratio you want. You would do the same if you have divided your portfolio between U.S. and international stocks and bonds. The key here, as in all of investing, is discipline and consistency.
To sum up, index funds let you do what few money managers do—they let you do as well as the market. Dollar cost averaging enables you to beat it.
That’s why you should take full advantage of every retirement vehicle you can, such as 401(k)s, including maximizing employer contributions, IRAs, and Keogh plans, which are available if you have self-employment income and can be utilized even if you also have a regular salary.
Indulging Your Inner Buffett
Your second strategy can be to indulge your “inner Warren Buffett.” You might take some additional risk to see if, like the famous Forbes World Billionaire investor, you can beat the market—or achieve the more modest objective of meeting your own particular needs and wants. Put aside a percentage of your money that you don’t need in the near term—or, in the worst case, that you could afford to lose—for investments with a little more risk.
This is where you can focus more on individual stocks. But indulging your inner Buffett doesn’t require getting esoteric. Remember that very few succeed in beating the market. Charles Ellis, a noted money manager with an excellent long-term record, recommends that people approach investing the way they should play tennis: get over the fact that you are not going to make it to Wimbledon or the U.S. Open—except as a spectator. Just focus on getting the ball over the net and within the lines, period. Leave the fancy shots for others and you will do far better than if you try to act like the pros.
If you want to invest in individual stocks, then go for blue chips like Coca-Cola, which has raised dividends every year since it went public. These days “stodgy” blue chips also include the likes of Amazon, Google, and Apple. In general, you should aim for stocks with good dividends (high-growth, large-cap stocks like Amazon are an exception) and ride them up and down.
Industries to Focus on During Times of Inflation
Good places to look during inflationary times, at least initially, are in industries related to commodities and construction and other hard assets. One example: companies that make farm or construction equipment, such as John Deere and Caterpillar. Both did well in 2011–2012 and then faltered a bit. Caterpillar has since come back but has trailed the stock market.
Keep in mind that investments that do well in times of inflation are always part of the next bubble. As we’ve discussed, inflation misdirects capital to hard assets and commodities. In the early 2000s, housing did well—until it didn’t. Mining companies did well but then were clobbered, especially gold mines. Steel companies blossomed and then took a hit. The same thing happened during the inflation of the 1970s. Those who did well with gold, oil, other commodities, forest products, farmland, and tax shelters took a beating in the 1980s.
If we do end up getting truly high inflation, you need to take an especially hard look at earnings. Remember, rising prices distort market signals. A company can appear to be doing well while the real reason for the “soaring” revenues may be inflation.
Do we really need to be protecting against inflation when the annual CPI increase was under 2% in 2013?
Remember what we said: if you started with $100,000 in 2000 and did nothing, your money would have declined in value by 26%. According to the CPI, inflation got as high as 4% in the past decade. Independent estimates put the rate significantly higher. Also it’s not the annual rate but the total rate over time that eats away at your savings. It’s like the reverse of compounded interest.
Investments for When the Fed Tightens
There’s no simple investment solution when the Federal Reserve tightens, because the Fed can tighten in several different ways. One scenario is typified when the Fed deliberately tightens up on credit, as in the early 1980s when Paul Volcker’s attempt to wring inflation out of the economy was successful, but it sent both the bond and the stock markets reeling. Another scenario is the inadvertent tightening that occurs when the Fed does not meet monetary demand, as happened in the booming economy of the late 1990s. This gradually hurt traditional manufacturers and commodities; when there’s a shortage of cash, people sell commodities to raise it. We noted in Chapter 4 on inflation that the Fed’s actions ended up adding fuel to the high-tech boom because investors, looking for opportunities in the United States, turned to high tech.