Learn About Simple Investments
One of the worst-kept secrets in the financial world is that simple investing behaviors which reduce risk, minimize tax liabilities, and keep costs relatively affordable tend to outperform overly complex approaches. If you follow a handful of guidelines over a long enough period of time, it isn't particularly difficult to get rich from your investment portfolio.
Regardless of such sage advice being repeated over and over again, generation after generation, there is something in human nature that makes people want to feel like they have somehow found a silver bullet. Warren Buffett once remarked that there would be no need for the priesthood if people figured out that the ten commandments were all you needed to live your life.
Some investors want complexity; crave it, even. There is something deep within their psyche that feels important, a member of the club when presented with secret symbols, fancy handshakes, unique codewords, and an element of sacredness. As a result, a lot of irrationality is unleashed into the world.
It is no accident that entire industries build up around complexity and confusion, providing the high priests of a particular discipline the opportunity to make a lot of money at the expense of others. In actuality, while the skill set necessary to make intelligent decisions can take years to acquire, the core matter is straightforward: Buy ownership of good businesses (stocks) or loan money to good credits (bonds), paying a price sufficient to reasonably assure you of a satisfactory return even if things don't work out particularly well (a margin of safety), and then give yourself a long enough stretch of time (at an absolute minimum, five years) to ride out the volatility.
That's it. That is the secret. That simple investing formula is all it takes to build the framework within which you should be able to accumulate wealth. Sure, the details might be complex, but the implementation should not be. The average investor has no business buying leveraged exchange-traded funds, shorting a stock, or speculating with derivatives such as stock options. The consequences of getting it wrong are too dire.
An excellent, if painful, illustration: Recently, on my personal blog, I did a case study of a 32-year-old small business owner in Arizona who had around $37,000 in a brokerage account at E-Trade. He took a position he neither understood nor the risks for which he fully appreciated and woke up to find he had generated losses of $144,405.31 in his account. After losing all of his equity, he now owes his brokerage firm $106,445.56 in a margin call. That is a real debt that could end up with him declaring bankruptcy if he can't find a way to satisfy the liability.
Even when investors stick to stock, bond, and mutual fund ownership, their rejection of simple investing basics such as low turnover results in pathetic returns on their money. According to one study I read from research giant Morningstar, during a period when the stock market returned 9% compounded annually, the average stock investor earned only 3%.
Part of this underperformance was due to selling during crashes and buying during booms, part of it had to do with frictional expenses such as brokerage commissions, capital gains taxes, and spreads, and part of it was the result of taking on too much risk by investing in assets that weren't understood.
Most of these behaviors are driven by investors trying to be above average rather than tailoring their securities holdings to their own personal goals and being happy with the results. Instead of being content with slowly growing richer each year as their dividends and interest compound, they try to hit a hole-in-one, damaging their capital with big losses.
When It Comes to Your Investments, Less Is More
This is a tragedy because, in many ways, investing is a place where the famous phrases, "Less is More" and "Keep It Simple, Stupid" ring particularly true. An investor who spent his entire career of 40 years regularly saving money and putting it to work split evenly between a low-cost stock index fund and a low-cost intermediate bond fund would have done very well for himself and his family.
Much of this performance would have been the result of almost non-existent fees such as mutual fund expense ratios that he would have paid, which most likely would have been less than 0.25% per annum. Alternatively, working with a high-quality asset management company that charged no more than 1.50% in per annum in management fees but who provided the white-glove service that made comprehensive tax, estate, and portfolio planning easier, might have made it possible to achieve financial independence and multi-generational wealth much more quickly.
Why don't more investors adapt either approach? Because these strategies can be boring. Let's consider the case of an investor that wanted an asset allocation of stocks, bonds, and real estate. His entire portfolio could consist of only three mutual funds even though indirectly, he'd own hundreds of investments. The S&P 500 fund alone holds Microsoft, ExxonMobil, Apple, Wells Fargo, Berkshire Hathaway, American Express, General Electric, Procter & Gamble, Colgate-Palmolive, McDonald's, and 490 other stocks!
- Vanguard S&P 500 Index Fund (Ticker Symbol: VFINX)
- Vanguard Intermediate-Term Tax-Exempt Bond Fund (Ticker Symbol: VWITX)
- Vanguard REIT Index (Ticker Symbol: VGSIX)
Running this portfolio would have all of the excitement of filling out insurance forms. You'd have $100, or $500, or $1,000 or whatever you wanted automatically withdrawn from the bank each month and divided evenly into the three mutual funds. By reinvesting dividends, interest income, and capital gains for an entire working career of 40+ years, it would be a virtual certainty, or as much as such a thing is possible in a non-certain world, that the portfolio owner would retire with millions of dollars in assets due to the power of compounding.
All that would be required would be ignoring the account statements so as not to get scared by the inevitable 50% drops in market value that happen from time to time.
Alternatively, had the investor gone the private client route, he or she could have worked with an expert to build an individually managed account; the sort of Rolls Royce of the wealth management industry, though not one that is available to many investors (the elite firms offering such a thing typically require opening balances ranging between $500,000 to $10,000,000 in investable assets). In the past, I've recounted a story about one such roadblock to achieving success when taking this approach that is germane to our current discussion so I'll repeat it here.
Many years ago, I was having lunch with an analyst at one of the best, most conservative, most well-respected asset management companies in the world. Its interior was like a library; a far cry from the typical Wall Street image you might imagine as only a few dozen people worked in an office managing tens of billions of dollars for clients, all of whom are multi-millionaires; executives, business owners, celebrities, heirs.
In exchange for their services, this firm charges a fee of around 1.5% per annum. It has made a lot of money for a lot of families, and in many cases, multiple generations of families; men, women, children, nieces, nephews, grandchildren, all of whom are living off the dividends, interest, and rents of the well-constructed portfolios the managing directors have built on their behalf. The odds are good you've never heard their name. This is by design.
One client, a man they had made tremendous amounts of money over long periods of time, had grown impatient with their conservatism during the dot-com boom. He watched his friends make 20%, 30%+ per year, year after year, gambling on Internet stocks that had no revenue, no customers, and no sustainable business plan. This particular firm refused to participate.
It had a long history stretching back to the days before the Great Depression. The firm culture was steeped in the idea that once a client was rich, the objective was to keep the client rich first and foremost; return was secondary.
As a result, while the S&P 500 index funds, active mutual funds, and individual investors of the world stuffed their portfolios with garbage, they did nothing. They sat on blue-chip stocks such as Johnson & Johnson, underperforming the index for several years as cash levels built, waiting to be deployed once an intelligent opportunity appeared on the horizon.
The client finally became exasperated. He called, angrily demanding to speak to a managing director. When he got one on the phone, he screamed something along the lines of, "What the hell am I paying you so much money each year to do over there? My portfolio has practically no turnover. You're not buying or selling anything. Everyone else is making money and you're waiting for the return of Elvis."
The managing director, having seen this sort of thing before during the 1960's go-go era, calmly responded along the lines of, "You hire us for our advice. Our advice: Go play golf. We will not buy something we know is overvalued simply because other people are doing it. We don't manage money on the basis of peer pressure but fundamentals. Sometimes, you pay us to keep you from your own worst instincts."
Of course, he was right. I have no idea if that particular client cashed out and left the firm (subsequent history would indicate it would have been an expensive mistake had he done so) but some people, for whatever reason, lack the willpower or fortitude to think long-term and behave intelligently. They feel the need to always be doing something. Simple investing is more profitable. Never forget that.