by Gary Laturno
They ignore the daily financial news and noise of Wall Street.
9. AVOID COMMON MISTAKES
a. Do Not Trust Your Financial Instincts
“Don’t join the herd. The public buys the most at the top and the least at the bottom”. Bob Farrell, founder, Farrell’s Ice Cream Parlor
“Our investing intuition is often wrong.” Daniel Kahneman, PhD in Psychology, Nobel Prize in Economics, 2002. Our biggest mistake—we buy stocks when prices go up, but when prices fall, we panic and sell.
As a result, the typical investor underperforms the market, getting between zero and three percent per year, not 10 percent per year.
Dr. Kahnenam’s advice: For most people, a passive approach is wise, that is, buy into low-cost index funds on a regular basis and leave them alone.
b. Read History to Become a Better Investor
“Opportunities abound in America. The gross domestic product on an inflation-adjusted basis has more than quadrupled over the last six decades. Throughout that period, every tomorrow has been uncertain. America’s destiny, however, has always been clear: ever-increasing abundance”. Warren Buffet
In a recent interview available on line, Mr. Buffett reminded us of the following: In the 20th century, the United States endured two World Wars, the Great Depression, twelve recessions, financial panics, and many other challenges.
Despite the above, over a one-hundred-year period, U.S. stock prices overall averaged about 10 percent per year. On January 1, 1900, the Dow was at 66; on December 31, 1999, at the end of the century, the Dow was at 11,500.
Bad things happen. The times are always uncertain. Stock prices go up and down, but over time, companies do well and stock prices follow.
Walter Updegrave, CNNMONEY also put the discussion into historical perspective. He wrote: “Since 1929, we’ve had 14 recessions and 13 bear (down) markets, an average of about one of each every six or so years. And each time stock prices eventually recovered from these setbacks and climbed to new highs. I see no reason for that dynamic to change.” “Market Timing: Not a Good Strategy,” CNN.MONEY.com, December 13, 2012.
The lesson: People who invest regularly and stay the course for the long-term achieve substantial wealth.
Recommended reading: “Market Rewarded Those Who Stuck It Out – A Tale of Three Investors” by Joe Light, Wall Street Journal, March 5, 2013 and “Reasons to Avoid Buying Stocks, and Why You Should Ignore Them” by Paul Sullivan, New York Times, February 22, 2013.
10. EIGHT GUIDELINES TO SUCCESSFUL INVESTING
a. One: Start Investing Early; Take Advantage of Compounding
“No one saves a million dollars at once; they save a hundred dollars over and over again”. Stuart Ritter, T. Rowe Price
“Compounding is mankind’s greatest invention. It allows for the huge accumulation of wealth”. Albert Einstein
“Compounding, also known as compound interest, is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.” (Investopedia.com.)
Start early! Here are a few examples to consider: “No matter how aggressive the portfolio, projected portfolio balances at age 65 are significantly higher for investors who started saving at an early age than for investors who began later in life.” Maria Bruno, Vanguard Group
“For an individual who invested 6% of their salary in a portfolio of 50% stocks and 50% bonds starting at age 25, the median portfolio balance at retirement was $360,000. The number fell to $237,000 for those who started at age 35 and to $128,000 for those who started at age 45.” Carolyn Geer, interviewing Maria Bruno, The Wall Street Journal, May 27, 2012
If you start at age five, you would need to invest $40 per month and average 10 percent a year to have $1.5 million at age 65. If you start at age forty, however, you would need to invest $2,208 per month and average 10% per year to have $1.5 million at age 65.
Here is another example of compounding: Recall our friends Marcy and Antoine. Based upon the math, they decided not to buy a $500,000 home, choosing instead to rent and invest both the $100,000 down payment and the $6,000 saved each year on a mortgage. How would they fare if they were to invest the funds into a small-cap index fund that averaged 12.7 percent per year, as opposed to a total U.S. stock market fund that averaged 10.4 percent per year?
First a little background: Over a period of eighty years, small cap stocks (companies worth less than two billion) beat large-cap stocks by an average of 2.3 percent per year. From 1926 to 2006, the long-term return of the S&P 500 (large companies) was 10.4 percent, while the average annual return of small-cap stocks during the same period was 12.7 percent. Robert Brokamp, “Beginning Investing Strategies: Small-Cap Investing,” TheMotleyFool.com
So, if Marcy and Antoine were to invest in a small-cap index fund earning an average annual return of 12.7 percent per year, their $100,000 in principal could potentially grow to $3,612,000 in 30 years minus the fund’s expense ratio. Their $6,000 invested every year for 30 years could grow to $2,086,503.50 minus the expense ratio. Not bad! Historical returns are a guide but do not guarantee future results.
Important caveat: Compound interest can be your friend and work for you. Or, it can be your enemy and work against you. Do you have a high-interest credit card and make the minimum payment each month? Compound interest is now working for the credit card company not you.
Takeaway: (1) Start to invest today. Allow compounding to work for you. (2) Get rid of debt, especially high-interest credit card debt; do not let compounding work against you.
Recommended reading: “So You Think You’re A Financial Genius?” by Carolyn T. Geer, Wall Street Journal, June 23, 2013. Ms. Geer points out that many investors – one quarter in an education foundation survey – do not understand compound interest. Nor do many investors understand how Wall Street’s take cuts into earnings. “Investors end up paying all manner of fees . . . . The longer the investment period, the bigger Wall Street’s take”. See Part Four below “Invest Frugally”.
If you would like more information on compound interest, read “Albert Einstein’s Greatest Discovery: “The Rule of 72” by L. E. Duncan, http://voices.yahoo.com/albert-einsteins-greatest-discovery-rule-72, December 12, 2006; also see “Ten Facts about Compound Interest,” by Gary Foreman, U.S. News & World Report, November 19, 2012, http://money.msn.com/personal-finance/10-facts-about-compound-interest.
b. Two: Invest Regularly and Stay Invested
“Our favorite holding period is forever”. Warren Buffett
“Bad news is an investor’s dream; it lets you buy stocks at a marked-down price. Stocks always come out of crisis”. Warren Buffet
Systematic investing and dollar cost averaging are two approaches to maximize saving and investing. Systematic investing is setting up an automatic deposit from your checking account into an investment account on a regular basis. The reduction to your pay will not be noticed, and you will not be influenced by negative market news. Dollar cost average is a similar concept and means you buy into the market over a period at different price levels.
It is important that you invest regularly and that you stay invested. Reinvest the dividends; take advantage of compounding. You will build a nest egg over many years.
“The two levers an investor can control—savings time horizon and savings rate—will provide a higher probability of success rather than relying on the possibility for higher portfolio returns with more aggressive investments.” Maria Bruno, Vanguard
c. Three: Diversify Investments
“98 or 99 percent—maybe more than 99 percent - of the people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs”. Warren Buffet
Core Funds to Consider
Vanguard Total U.S. Stock Market Index Fund: This fund gives an investor ownership in the shares of virtually every publically-traded stock in the United States
. The Vanguard expense ratio for a $1,000 investment each year (ER) is .05/yr.
Vanguard Total U.S. Bond Market Index Fund: This fund gives an investor ownership in the shares of the entire taxable United States investment grade bond market, including government and corporate issues. Vanguard expense ratio is .11/yr.
Consider Global Investments
Profound changes are occurring in the global economy. Foreign markets led by China, India, and Brazil account for more than one-half of the world’s economy.
Emerging markets are growing three times faster than the United States, Japan, and European nations.
The United States is seldom among the top ten stock markets in the world. The top country changes every year. So, diversify by investing in foreign markets. Consider investing in a total international fund.
The lesson: Ignoring foreign markets may mean missing investment opportunities.
A Global Core Fund to Consider
Vanguard’s Total International Stock Market Index Fund: This fund offers investors a low-cost way to gain equity exposure to both developed and emerging international economies. The fund tracks stock markets all over the globe, with the exception of the United States.
Because it invests in non-U.S. stocks, including both developed and emerging markets, the fund can be more volatile than a domestic fund.
Long-term investors who want to add a diversified international equity position to their portfolio might want to consider this fund as an option. The expense ratio is 0.18 percent/yr.
Consider Real Estate Investment Trusts
“REITS deserve a small percentage in your portfolio.”
David Swenson, Fund Manager, Yale University
“Real Estate Investment Trusts (REITS) are mutual funds that buy stocks in companies that own real estate-related assets such as office buildings, shopping malls, apartments, storage facilities, and hotels.” Roger J. Brown, Ph.D., past Director of Research for the Real Estate & Land Use Institute, San Diego State University
Some REITs invest nationally, some are confined to a local geographic area and some invest throughout the world.
REITs pass nearly all their income as dividends to shareholders, but the dividends are taxed as ordinary income—not the long term capital gains dividends of stocks.
Advantage of REITs: They are not in lock step with the stock market. Bonds prices will fall if inflation and interest rates rise in an improving economy. REITS could thrive.
Disadvantage of REITS: They are stocks and thus subject to the ups and downs of the market. They are more “risky” than bonds but may deserve some percentage in your portfolio.
Recommended reading: “The Best Place to Hold REIT’s: An IRA or taxable Account?” Gregory Zuckerman, June 7, 2013, Wall Street Journal
d. Four: Invest Frugally
“Index funds have far outperformed the active manager and at a far lower cost to the investor”. Burton Malkiel, Princeton University*
Investment costs have a substantial impact on a portfolio’s performance. “Whether you’ll have enough money for retirement depends on more than how much you save and which investments you pick. The other powerful factor is how much you pay for those investments. . . . There is no evidence that paying more gets you better returns—quite the opposite. Small investors are far better off keeping costs to a minimum with low-cost investment options such as index funds.” Liz Weston, MSN.com
The U. S. Labor Department: “Assume that you are an employee with thirty-five years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7% and fees and expenses reduce your average returns by 0.5%, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5% your account balance will grow to only $163,000. The 1% difference in fees and expenses would reduce your account balance at retirement by 28%.”
Maria Bruno, Vanguard Group: “Take an investor, age 25, who contributes annually to a portfolio that is 50% stocks and 50% bonds. If the investor selects an actively managed fund with an expense ratio of 1.25% versus a low-cost index fund with an expense ratio of 0.25%, the difference in the median ending balance at retirement would be nearly $100,000.00 ($540,000 versus $456,000) or a loss of roughly 20% in the portfolio’s value.”
Also consider taxes and brokerage fees: The typical actively managed fund trades all stocks in the fund each year, triggering short-term capital gains and brokerage fees paid by investors who own the shares. In addition to high expense ratios, actively-managed funds can charge investors fees for sales and marketing costs. Some actively-managed funds charge sales commissions of 6 percent, either up front or at the time the investor sells their shares.
So, bottom line: You do not get what you pay for. Long-term, actively-managed funds do not give investors better returns than low-cost index funds that track he market.
*Recommended reading: “You’re Paying too Much for Investment Help”, Burton Malkiel, Wall Street Journal, May 28, 2013
e. Five: Do Not Try To Time the Market
“Ignore the guy who tells you he can beat the market”. Carl Richards, Certified Financial Planner, author and contributor to The New York Times
As an investor, you will undoubtedly be solicited by “advisers” in the financial services industry who will tell you they sell actively managed funds that perform better than the overall market. If you contact a large, brokerage company they may give you the same sales pitch. Ignore them! Some actively-managed funds do “beat the market” for a short period but not the long-term. So, if you are ever tempted to buy one of these funds, read Carl Richard’s article, “A Warning about That Guy Who Is Beating the Market,” in the December 11, 2012, issue of The New York Times.
The truth is that stock markets are irrational. No one can know the best days before they occur. Its time in the market that matters. As Ramit Sethi says, in I Will Teach You to be Rich, “No one can time the market.” From 1983 to 2003, the S&P index averaged 10 percent per year. During this twenty-year period, if you missed the best twenty days, your return fell to 5.03 percent per year. If you missed the best fifty days, your return fell to 1.6 percent per year.
f. Six: Control Risk
“Your investment plan should include an allocation among stocks, bonds and other assets”. Andrea Coombes, Wall Street Journal
“Asset allocation is the most important investment decision you will make”. Brendan Erne, “Seven Deadly Investor Sins,” Forbes
Risk can be controlled in a portfolio by asset allocation. Do not put all your money into stocks. Do not put all your money into bonds. Hold stocks for growth and income. Hold bonds as a hedge or defense against the short-term volatility of stocks. Thus, bonds play an important role in portfolio diversification.
For example, if you were to invest $100,000 in a 100 percent stock portfolio and stock prices fell by 20 percent, you would have a significant loss. On the other hand, if you invest $100,000 in a 50/50 stock/bond portfolio and stock prices fell by 20 percent, the bonds would serve as a buffer. In fact, the bonds in your portfolio would probably go up in value, offsetting some of the losses with stocks. In addition, you are now in a position to take some of the money invested in bonds and buy stocks at a lower price.
But note the counsel of Maria Bruno at Vanguard: “The amount one ended up with at retirement was influenced more by how much one saved than by how the money was invested. Saving 9 percent of ones salary in a 50/50 stock bond portfolio, starting at age 25, resulted in a higher median ending balance—about $540,000—than saving 6 percent at age 25 in a more aggressive account of 80 percent stock and 20 percent bonds—about $470,000.”
What is the Right Balance of Stocks and Bonds?
“Bonds are your portfolio’s shock absorbers”. Allan S. Roth, author “How a Second Grader Beats Wall Street,” and financial writer for CBS Moneywatch.com
“You should own more
stocks than bonds”. Bill Gross, financial manager who runs PIMCO’s $270.0 billion Total Return Fund.
“Bonds are a terrible investment at the moment (May 2013). Owners of long- term bonds may see big losses when interest rates eventually rise”. Warren Buffet
Investor guideline: The percentage of stocks in your portfolio could equal 120 minus your age. If you want to be more conservative, your percentage could be 100 minus your age. The right balance of stocks and bonds in your portfolio, however, depends on your financial goals and tolerance for risk.
For example, Warren Buffet, in his eighties, is reportedly 100 percent invested in stocks. Few, if any, eighty-year-olds, however, will want to follow Mr. Buffett’s lead. The short-term returns in stocks can be disappointing. In 2008, when the market fell, many investors were caught with substantially all their money in stocks. So, at least five years before retirement, you may want to start to move your money to more conservative investments.
John Bogle, founder of Vanguard, also in his eighties, is reportedly 80 percent invested in bonds and 20 percent in stocks.
Mark Laturno, age nineteen, Gary’s son, is 90 percent invested in stocks and 10 percent in bonds.
A typical corporate pension fund is invested 60 percent in stocks and 40 percent in bonds. Vanguard’s Balanced Index Fund matches this 60/40 split, stocks vs. bonds, by tracking two indexes that represent broad barometers for the U.S. equity and U. S. taxable bond markets. Expense ratio on for this fund is 0.10 percent/yr.
Life cycle or target date funds are another option to consider. They match the stock/bond mix with your age. Both TR Price and Vanguard offer target date funds. They may work for hands-off investors because they periodically rebalance without the investor owner taking any action. Recommended: “Missing the Target”, Liam Pleven & Joe Light, June 14, 2013, Wall Street Journal.