So far we have talked about a lot of ideas that I think are really important to your financial life. Now one thing I believe is that learning the "theory" so to speak is incredible important, but the real value comes when you can turn it into a practical and actionable solution. That is what I intend to do here. This post will be some theory, but it will mostly be about setting up a solid investment plan that you can implement immediately and do better than the 85 to 95% of people who lose money in the market.
First, you need to define what kind of investor you are.
Passive Vs. Enterprising Investor
This is an idea I am taking from Benjamin Graham's book "The Intelligent Investor". This is truly a must read for anyone who even wants to begin to go down the road of investment analysis. Ben splits investors into two groups. The first is the Passive Investor. The Passive Investor is one who really doesn't want to mess with their investments every day. They just want to put it in there and let it grow over time and focus on whatever it is they do in life. Now generally people have two thoughts about passive investing. It is either "OMG, that is exactly what I am looking for please tell me more!" or "Wow, how non intellectual is that. I am a math wiz and I can for sure do better on my own." If you are having some version of the second thought then you are probably what he classified as an Enterprising Investor. This is a person that is in love with the analysis. They want to run the spreadsheets every day and will consider annual reports as light spring reading. Deciding which type of investor you are is the first step in setting up a investment plan. So, are you a Passive Investor or an Enterprising Investor? Decide this now and write it down somewhere. Internalize it.
Expectations Of Each Type Of Investor
Now that you have decided what type of investor you are, we need to establish some parameters around what some realistic expectations are.
For passive investing the expectations are fairly easy to line out. Your goal is to pretty much match the market. Now what do I mean by "the market". The market is typically defined by the index called the S&P 500. It is a list of the 500 largest stocks on the New York Stock Exchange at any time based on the size of the company also known as the market capitalization. Your goal as a passive investor is to match the return this index, or another index that matches you portfolio mix, with a very low amount of fees and little work. A good number to use as an average return you can achieve over long periods of time is around 7 to 10% depending on the source you look at. Realize this is with little work. The set it and forget it type.
Now you guys are a much bigger beast. Once we decide we want to get into the weeds there are an endless amount of "strategies" out there. The vast majority of them are bullshit. There are also some good ones. Think of being an enterprising investor as playing the most complicated game of chess ever imaginable with essentially an endless amount of variables. In this vast sea there is no one silver bullet. If anyone claims they have it then you need to run. Here are a couple of warnings I have for you. First, your return is not likely to be THAT much larger than that in passive investing. Some of the best investors on the planet have achieved a rate of return of around 20% to 30%. Which is no doubt amazing, but you are not these people. I would say IF you are a successful enterprising investor (and that is the biggest if ever imaginable) you could stand to see average returns of 12 to 15%. These are the best of the best. Moreover you have a good chance of averaging a negative return which can be very devastating (See this post on market cycles). There are ways to lower this risk, but you must first understand that it is very possible to lose money (See this post on why humans suck at investing). The second thing is that good investing can take A LOT of time and a lot of money saved in order to have a diversified portfolio. You will essentially need to learn more about the businesses you invest in than you know about yourself. If you do it very well, you can stand to see that 12 to 15% return. If you just do well and not very well then you will probably match the passive investor's return with A LOT of time wasted. If you do average then you will lose money. So the question is "is the time you spend worth it to you". Your time is very valuable. I would say if you just love to analyze businesses and run calculations and look at financial ratios regardless of the money then it is probably for you. If you are doing it just for the money then it might not be. Your time might be better spent somewhere else.
Okay, so now you know what type of investor you are and you have some realistic expectations of what can come of each of them. Now we get to the meat. The rest of this post will be aimed at the passive investor, but you enterprising peeps should definitely take some notes.
The Simplest Investment Plan On The Planet
For the Passive Investors, this can be your playbook. This can be the one thing you can put your money into and leave it and stand to make a good return with little work. Are you ready? Here it is: buy the Vanguard Total Stock Market Index Fund (VTSAX) and invest in it continuously every month regardless of performance over time. Literally that is it. Now I can't just tell you this and not explain why. So let's dive in.
First lets talk about why I like Vanguard (I am in no way affiliated with Vanguard other than I invest in their funds). One of the things I think is VERY important to think about when purchasing or paying attention to anything is to understand how that entity is paid and therefore what they are incentivized to do. Let's take this blog for example. At the time of this writing I currently have no products to sell. Therefore my goal is really to help as many people as I can. Since I have no ties to any other business I am effectively "selling" information for free. If I were to knowingly give people bad information, over time my reputation would be ruined and I would have less people follow and read my material. So I am incentivized to give you all the very best material and information I can find and bring as much value as I can to your lives. This is a good thing for you as my "customers" as I am incentivized to give you the best I can. So let's look at Vanguard. What is Vanguard incentivized to do for us? One of the main reasons I like Vanguard is that it has a very unique structure that sets it apart from any other competitor out there. The picture below explains it all.
This is taken directly from their website here.
The typical fund management company is owned by third parties, either public or private stockholders, not by the funds it serves. These fund management companies have to charge fund investors fees that are high enough to generate profits for the companies' owners. In contrast, the Vanguard funds own the management company known as Vanguard—a unique arrangement that eliminates conflicting loyalties. Under its agreement with the funds, Vanguard must operate "at-cost"—it can charge the funds only enough to cover its cost of operations. No wonder Vanguard's average fund expense ratio in 2014 was 0.18%, less than one-fifth that of the 1.02% industry average. That means Vanguard fund investors keep more of any returns their funds earn.
Therefore Vanguard is incentivized to act in your interest rather than in the interest of the private or public shareholders as most publicly traded investment banks are. Try to look up what the stock price is for Vanguard as a company? You won't find it. In order to invest in Vanguard you simply buy its funds. It's investors and clients are one in the same. This unique structure is what is so brilliant about the creator of Vanguard, Jack Bogle. This is not to say that there is something wrong with a company like Fidelity. It's just that they may not be incentivized to do what is in the best interest for you. Like I said before, I am not an affiliate of Vanguard. I make no money off you investing in their funds personally. I do, however, personally have my retirement in Vanguard funds.
Why This Fund?
Next let's talk about why I chose this fund. The VTSAX is an index fund that is designed to match the US stock market as a whole. So let's break that down. First why would I choose an index fund? That is fairly easy. When you look at the expense ratio on this fund it is .05%. The industry average for this category of fund is around 1%. That means every year, regardless of performance, the mutual fund will take 1% of your invested money to cover the cost of operations (and to cover the profit for it's company shareholders as we learned above). With this fund you pay .05%. So on $10,000 invested you pay... $5. For the cost of one Starbucks pumpkin spice latte per year you can own a piece of the entire US stock market. That is what I call a bargain.
The next, and probably more important question is, why the US total stock market? What you are effectively doing is betting that the US economy will prevail over the long term as it has done for the past 100 years or so. Let's look at some charts (these awesome charts are courtesy of FinanceAndInvestments.Blogspot.com):
What these are showing is the the annualized returns of the S&P 500 since 1926. I think the most practical information is the column to the far right. That is the 25 year annualized return from the year you are looking at back. Let's look at 2014. If in 1989 you were to invest in the S&P 500 through the 2000 and 2008 financial busts which are some of the worst in history, you would have averaged 9.62%. That is a damn good return for just setting something and forgetting it. Now if you look at the column on the left you can see that it was by no means a smooth ride. You must have the gaul to invest continuously no matter what. Also notice that in NO 25 year period did the market as a whole lose money. It is not until you get to the 10 year column that you start to see small losses. This is really good news for those long term investors and further proves that if you take a long term approach to investing you stand to gain.
Looking at all these returns we can say that we have a pretty good chance that the US economy will grow in the future. Also the stock market is what we call "self cleansing". Every year poorly run companies are thrown to the wayside as they go bankrupt and they are replaced by the new, up and coming companies that will create value for their customers. In order to lose money in the long term the US economy would need to take a deep nosedive for many, many years. My argument is that since the global economy is so dependent on the US economy that if this were to happen then your investment return would be the least of your worries. We would be under threat of a nuclear war or mass rebellion or many other bad things. So taking the long term bet on the whole US economy is a pretty good option for those looking for a low cost and simple investment over time.
Why Investing Continuously Over Time
Lastly, why do I say invest continuously over time no matter what the performance? This leads to something called Dollar Cost Averaging. So how does it work? Let's use an example. Let's say you have $1,000 every month that you can invest in general investment X. Currently the price of X is $10. For $1000 you can by 100 shares of investment X. Right after you put your $1000 in the price of X goes up by 10% to $11/share. You now have $1,100 and you are pretty happy! Now let's say the next month right before you put your money in the price drops by 30% to $7.70/share. You now have $770 in your account. A huge drop by any measure. Most people would see this as a scary situation and think "eh I will hold off for a bit and wait until the price comes back". So they hold off for a bit and the price comes back to $10 per share the next month and then they buy $2000 worth. Now they have 300 shares of X in their account and managed to avoid a loss and break even. Now let's say you took a different route. Let's say you didn't care about the price drop, you just have your $1000 per month on auto pilot and it just goes in. At a share price of $7.70 per share. That means your $1000 would have bought you about 130 shares. Now when the price comes back to $10/share you put in your other $1000 and now you are holding a total of 330 shares so you would have about $3300 in your account. A total gain of $300 over the other person who waited! Here is a summary chart:
So while they broke even during this time you actually MADE 10% and didn't have to do any work at all. This is known as Dollar Cost Averaging. What it does is effectively makes you buy more shares when the prices are low and buy less shares when the prices are high. This is buying low and selling high which is what you want to do as an investor! Obviously this is just an example where I have picked numbers. But this is the exact effect we saw in 2008. Those who invested continuously during the crash and out ended up making a great return after a couple years while those who simply waited it out didn't make anything or lost money.
So let's summarize what the take aways are. First, you need to decide what type of investor you are: passive or enterprising. Next I lay out the simplest investment plan every: buy the Vanguard Total Stock Market Index Fund (VTSAX) and invest in it continuously every month over time regardless of performance. I chose Vanguard because their unique structure that aligns your financial interests with theirs. I chose the index fund for it's ridiculously low expense ratio of .05% per year. I chose the overall US stock market because of it's past performance and overall importance to the total global economy; and I reccomend you invest continuously over time regardless of performance to take advantage of the dollar cost averaging effect. This can be done either inside of a retirement account such as a ROTH IRA or outside in taxable accounts. If you are doing it outside of your retirement then the minimum to invest is $10,000.
In later posts I will go into some things you can do to get some Asset Allocation going. I will also be going into more advanced investing techniques for you Enterprising Investors. Subscribe below to stay tuned and leave your feedback in the comments!