 Roberta started teaching at 16, and it took her 40 years to save $500,000. At the age of 56, she enlisted the help of investment adviser Robert Borden. He put most of her money into conservative bonds and blue-chip stocks, such as banks and insurance companies. Although Roberta wanted to invest in companies involved in anti-pollution work, Robert limited these risky ventures to 10 percent of her portfolio. Thanks to this disciplined investment strategy, and the magic of compounding returns, Roberta’s $500,000 grew to more than $4 million by the time she died. Note that it took a lifetime for Roberta to become wealthy by investing. The bottom line is that investing is a slow way to make a lot of money, unless you’re a stock-picking genius or incredibly lucky. Don’t get me wrong—it’s important to know how to invest. Just don’t count on getting rich quick. For millionaires, the top three investments in their financial portfolios are stocks, real estate, and fixed-income investments. In the Saving and Spending article, we learned how to get a great deal on a house. In this article, we’ll learn how to get great deals on stocks and bonds.
Mutual Funds Most Americans invest in stocks by buying mutual funds, index funds, and other investment funds through their banks or brokers. These funds account for nearly 25 percent of the typical portfolio, and almost 50 percent of the money invested in pension plans and Individual Retirement Accounts (IRAs)2. There are a lot of funds out there. In 2006, there were 8,726 funds in the United States alone. It’s expensive to run a mutual fund. There’s advertising expenses; commissions for salespeople, brokers, and financial advisors; and salaries for high-priced managers to analyze and pick stocks. To cover all of these expenses, the typical mutual fund charges a Management Expense Ratio (MER) of 1.51 percent every year. This means you pay a management fee of $1.51 for every $100 you invest in their funds. You pay this fee whether or not the fund makes money for you. Index funds are a special type of mutual fund because they don’t try to guess which stocks will go up or down. Instead, they use computer programs that “index” the market by automatically purchasing an equal weighting of every stock. This means index funds don’t need high-priced managers. They also minimize expenses by avoiding advertising and commissions. This allows most index funds to charge an MER of 0.20 percent or less, a fraction of the price of actively-managed mutual funds. Not only are they cheaper, but they also perform better. Wall Street’s dirty little secret is that index funds beat the pants off almost all actively-managed funds.
Paying for Underperformance In a study that tracked 355 actively-managed mutual funds from 1970–2006, only three funds consistently outperformed the index3. The other 352 did worse than the index, or went out of business. David Swensen is the Chief Investment Officer of Yale Unversity’s multi-billion-dollar endowment fund. According to Swensen, “A miniscule 4 percent of funds produce market-beating after-tax results, with a scant 0.6 percent annual margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.” Morningstar is a well-known investment research company that rates mutual funds on a scale from one to five stars. To test the Morningstar system, financial editor Mark Hulbert tracked the performance of mutual funds that received their highest five-star rating. From 1994–2004, a portfolio continuously adjusted to hold Morningstar’s five-star funds generated an annual return of 6.9 percent. This was almost 40 percent lower than the 11.0 percent return generated by the stock market index. It’s definitely possible to beat the index. Warren Buffett is known as the “Oracle of Omaha” because of his stock-picking prowess. From 1965–2006, his Berkshire Hathaway investment company returned an average of 21.4 percent every year4. This trounced the performance of the S&P 500 Index, which returned 10.4 percent over the same period. Hindsight is 20:20. In retrospect, it’s obvious that Warren is a financial genius. But how do you identify the next Warren Buffett out of a universe of 8,726 mutual funds? The odds are stacked against you. That’s why Warren says, “A low-cost index fund is the most sensible equity investment for the great majority of investors.” The tragedy is that low-cost index funds only account for about 10 percent of the money that Americans have invested in mutual funds. Banks, brokers, and financial advisors have little incentive to recommend index funds because they don’t receive commissions or kickbacks.
Future Returns In 2003, Roger Ibbotson and Peng Chen published a study showing that the compound annual return for the U.S. stock market was 10.7 percent from 1926–20005. This is the basis of the “10 percent return” number that is cited in a lot of financial literature. But past performance is no guarantee of future results. The United States was the world’s best performing stock market over the past century. It’s unlikely that America can keep up the same rate of growth for the next 100 years. As they say on Wall Street: “Trees don’t grow to the sky.” For the next few decades, most experts are predicting that the U.S. stock market will return an average of 6–8 percent per year6,7,8. There will be years when the market is higher, and there will be years when the market is lower. But the long-term trend is less than 10 percent. Keep this in mind when you plan your financial freedom. If you retire with $1 million in investments, you can expect an average return of $70,000 a year. Is this enough to afford the lifestyle you want? The other consequence of lower returns is that lower fees matter even more. An MER of 1.5 percent, on a total return of 7 percent, means that 21 percent of your earnings are going to mutual fund managers to cover their expenses. With an index fund, an MER of 0.20 percent means you’re only losing 3 percent of your total return to expenses. Diversification In addition to investing in an index fund for the U.S. stock market, you should allocate a portion of your portfolio to bonds and international stock markets. Diversification gives you higher returns with lower risk. Also, international stock markets have the potential for greater returns. In 2003, Americans held 18 of the top 25 spots in the Forbes’ list of the world’s richest people9. In 2008, this declined to only four Americans in the top 25. This is a sign of a bigger long-term trend. Economies such as China and India are growing like gangbusters as billions of people discover the rewards of capitalism. But rapid growth carries the danger of booms and busts. Bonds and U.S. stocks generate lower returns, but their stability balances out the risk from developing markets.
Financial Advisers If you’re afraid of managing your finances, and you want someone to hold your hand, then find a trustworthy financial advisor. Even with their help, you still need to monitor your investments carefully because there are always a few bad apples in any profession. You don’t want someone stealing your money after you’ve worked so hard to save it. In general, your advisor shouldn’t charge more than a 1 percent fee to manage your money10. This should drop to 0.75 percent or less to manage $1 million, and 0.5 percent or less to manage $5 million. Make sure your advisor picks low-cost index funds, and isn’t getting a commission or kickback from the funds they recommend. Picking Stocks Most people should stick with index funds and avoid buying individual stocks. That being said, I don’t want to discourage you if you’re the next Warren Buffett. Also, picking stocks is a good way to learn about finance and business in general. Let’s discover the secrets to Warren’s success by hearing from the master himself:
Great Businesses How do you recognize a great business? Mary Buffett is the ex-wife of Warren’s son, Peter Buffett (a musician and composer). In Buffetology, Mary explains the six questions that determine if a business is truly great.
Great Price Now that you know how to identify a great business, how can you tell when it goes on sale? The fair value of a company may be calculated based on its Discounted Cash Flow (DCF). It’s the sum of a company’s total expected earnings over time, adjusted by a discount rate that reflects the risk that those earnings won’t materialize. For example, suppose you own all of the shares of Acme Widget Co. The company decides to liquidate its assets, and pay you $1 per share tomorrow before closing down permanently. Therefore, DCF analysis indicates that the company is worth a little less than $1 per share. Why less than $1? It’s because there’s a small risk you won’t receive the money tomorrow. A dollar in hand is worth two in the bush. The farther out in the future, the higher the chance that something will go wrong and you won’t get paid. DCF helps you determine a stock’s fair value today, based on estimates of its earnings in the future. By comparing the stock’s current price to its calculated fair value, you can determine if it’s on sale.
DCF Assumptions The DCF calculator required us to make a lot of assumptions. We had to estimate Microsoft’s future earnings growth, and the probability it would achieve its future earnings. Perhaps the biggest assumption was that earnings would continue rising, or at least remain stable. The calculation isn’t accurate if earnings decline in the future. A company must have an overwhelming advantage over its competitors to sustain this sort of track record for years, let alone the decades assumed by the DCF calculator. In general, DCF analysis works best for companies that dominate their markets with brand-name products that people will always buy. That’s why Warren Buffett stays away from technology stocks—technology changes so fast that it’s hard to predict which companies will be the leaders in the future. Look at how fast Google and Apple eclipsed Microsoft and Yahoo. But 20 years from now, people will still be drinking Coca-Cola and eating Kellogg’s corn flakes. Value Investing Waiting for stocks to go on sale is known as “value investing.” Warren Buffett and many other value investors have become fabulously rich by following this investment approach. When stocks are cheap, they buy stocks. When real estate is on the bargain table, they buy real estate. When bond yields are juicy, they buy bonds. If there are no sales, they wait patiently on the sidelines and keep their powder dry. Researchers have shown that value investing consistently outperforms the market over the long-term. Josef Lakonishok is a professor of finance at the University of Illinois. He analyzed the performance of stocks from 1963–1990, and found that value investing works because it invests in stocks that are underpriced, and underinvests in stocks that are overpriced11. Over time, the market raises the price of underpriced stocks, and lowers the price of overpriced stocks. The reason that underpriced and overpriced stocks exist is because human nature is prone to fear and greed. Fearful investors oversell stocks that have fallen out of favor, and greedy investors get too excited about stocks that have done well in the past.
Patience and Discipline Value investing requires a lot of patience. You’ll examine hundreds of stocks to find a few worth buying. As usual, Warren has some helpful advice: “When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in.” Charlie Munger is Warren’s sidekick at Berkshire Hathaway, and an investing genius in his own right. Summarizing their philosophy, Charlie says, “The objective is to buy a non-dividend-paying stock that compounds for 30 years at 15% a year and pay only a single tax of 35% at the end of the period. After taxes this works out to a 13.4% annual rate of return.” Find great stocks. Buy them on sale. Hold them forever to minimize taxes and trading costs. It’s a proven strategy for market-beating returns. Expected Value  The expected value is the odds that the coin will be heads (50 percent) multiplied by the payout of $100 (50 percent × $100 = $50), plus the odds that the coin will be tails (50 percent) multiplied by the potential loss of $80 (50 percent × -$80 = -$40). Since the expected value is $10 in winnings, you should take the bet if you can afford to lose $80. As mathematician and trader Nassim Taleb warns, “It does not matter how frequently something succeeds if failure is too costly to bear.” But researchers have found that most people will turn down this bet unless the potential loss is less than $50. In other words, they need an odds advantage of 50 percent or more before they’ll bet. In contrast, casinos make millions of dollars with an odds advantage that’s less than 1 percent for blackjack, and less than 10 percent for $1 slots. The human brain is wired to avoid big losses, even at the cost of sacrificing good opportunities to make money. On the other hand, people will happily bet on long shots, as long as the potential loss is very low. For example, your odds of winning the Mega Millions jackpot are about 1 in 175 million. Since the payout is usually less than $100 million, the expected value is $0.57 or less for every $1 ticket. Not a good investment. But millions of people play every week in the hopes of striking it rich. In fact, 21 percent of Americans believe that winning the lottery is the most practical way of becoming rich. As a smart investor, stay away from bad bets like this that are rigged against you. Instead, look for situations where the expected value is in your favor.
Master Your Emotions The rules for making money are simple: buy on sale, and hold for the long-term. The hard part is sticking to the rules. In Your Money and Your Brain, financial author Jason Zweig reviews the research about how your emotions can sabotage your investing. When everyone believes the sky is falling, that’s when stocks are the most on sale. But it takes tremendous courage to go against the crowd. Also, there’s the risk that your stocks will fall further after you buy them. Then you’ll feel like kicking yourself for not waiting longer. Zweig says, “If you think a plunge in the value of your investments won’t bother you, you are either wrong or abnormal.” Your brain responds to financial losses in the same way as life-threatening events. It’s an emotional roller-coaster ride of surprise, fear, panic, and regret. But if a stock is truly on sale, the right action is holding for the long term. Companies that consistently grow their earnings will eventually see their stock price rise to fair market value. It’s easier to take the long view if you’re not compulsively checking stock prices every day. Psychologist and Nobel-prize-winner Daniel Kahneman says, “If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It’s the worst possible thing you can do, because people are so sensitive to short-term losses. If you count your money every day, you’ll be miserable.” Black Swans  In Black Swan: The Impact Of The Highly Improbable, Nassim Taleb advises you to maximize your exposure to positive black swans and minimize your exposure to negative black swans. A positive black swan is something that has the potential to make a large positive difference in your life, and vice versa for a negative black swan. Examples of protecting yourself against negative black swans include holding some ultra-safe investments that are immune to stock market crashes, and avoiding unnecessary risks in your everyday life. It’s a bad idea to jaywalk because one freak accident will cripple you for life. In ancient times, a Chinese general said, “I fear not the 10,000. I fear the 1 in 10,000.” All it takes is one lucky strike from an enemy soldier, and the general is dead. On the other hand, you should aggressively pursue positive black swans. Write a book, start a part-time business, audition for a movie—the risk is low, but the rewards could be enormous. If a big publisher or wealthy investor wants to talk, cancel all your other appointments because the window of opportunity may never open again. Big cities such as New York and London are particularly good for positive black swans because there are more opportunities for networking and random encounters with powerful people.
Slow and Steady Saving and investing is a slow way to accumulate wealth. The average American family earns $48,201 per year. If they manage to save $10,000 a year for 20 years, this results in a net worth of about $477,000, assuming a 7 percent annual return. Not bad, but definitely not super-rich. That’s why most millionaires are self-employed professionals or entrepreneurs. With hard work and a bit of luck, you can grow a business to a few million dollars in 5–10 years. Saving and investing provides the foundation, but entrepreneurship is the golden path to wealth.
References
Copyright © 2009 by Paul Lem, M.D. Buy the book at www.MasterLifeFaster.com |
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