Investment Primer: Part II

I know there is a substantial group out there that doesn’t really want to understand everything, so much as just know what they should do, and maybe a little why. While I am by no means an expert in wealth-building and management, I do feel comfortable outlining a basic plan that I am sure will work for anyone that adheres to it.

This was designed with a few things in mind: starting with a small amount of money, extremely long-term horizons (10 years or more), and low involvement from you. The long-term horizon is important as well as tricky. Active management (moving your money around a lot to try to allocate it in whatever way will return the most at any given time) is expensive (in terms of fees AND time) as well as extremely risky, so the best option really is just to put your investments in place and then sit on them. Low involvement occurs because, while paying attention to this sort of thing all the time is both interesting to me, I know most people would rather deal with it as little as possible.

The basic strategy can be outlined as a series of do’s and do-not’s.

DO:

Start Saving Now, Keep Saving Often – This is stupid and obvious, but it needs to be said. The longer you save, the better. Compound interest is one of the miracles of the modern world. Not to mention it’s far far easier to put aside $100 a month for several years than to find $10,000 for your down-payment on a house out of your paycheck. Take as much of your savings as you are comfortable with, and start investing it now. You’ll probably find a way to spend it otherwise. Furthermore, make sure you withhold a small amount from every paycheck, if at all possible, and regularly add on to this investment. Most of the investments I will outline later will allow monthly deductions from your bank account, which is an easy way to do this.

Take Free Money – If your job offers any kind of matching in a retirement plan, maximize this. THIS IS FREE MONEY. If you make $100 a month, and your employer will match up to 2%, by taking advantage of this you give yourself a raise to $102 a month, for all intents and purposes.

Stand by your Convictions – It’s easy to get discouraged. Watching your savings grow isn’t nearly as rewarding in the short-term as that HDTV plasma-screen and an XBOX360. Markets fluctuate and go through cycles. However, if you made the right kind of investments in the first place (more on this later) then the WORST thing you can do is sell an investment during a period of poor performance. Like I said, markets are cyclical, so a period of bad returns often means a period of great returns is just around the corner. Consider this, buying a total-market index fund, even at the peak right before the worst crash in history, still paid handsome returns if you held the investment for 20 years, and beat any other general asset class over that time period. (See: http://www.amazon.com/Stocks-Long-Run-Jeremy-Siegel/dp/007058043X)

Diversify – Putting all your eggs in one basket makes it even harder to stand by your convictions. If you have multiple classes that tend to move in opposite directions (e.g. bonds go up when stocks go down, etc etc) then you can be insulated somewhat from the day-to-day vagaries of the markets, and enjoy gains in a variety of assets.

Rebalance – This may be a little advanced, but it’s simple enough to do in a simple portfolio, and it’s an important concept that most people don’t bother with. Assume you own two investments; say a S&P Index Fund and an Asian Index fund, starting with an equal share in each, not overly committed to the American market, not overly committed to Asia, great. If one continues to perform far better than the other, say America has a very expensive war and rough economy, slowly your investment in Asia is 80% of your assets, so when asia goes back down, 80% of your assets go down, with a resurgent America benefiting you very little, as it’s a small percentage of your assets. This sort of simply riding market trends back and forth is no good. Better, is to re-balance your portfolio. As Asia performs well, keep whatever initial balance you felt was appropriate (50-50 in this simplified case) by either putting new investments into the lagging asset (which would be the easiest option, given that we’re talking about starting with a small amount of money, so monthly additions can have a big effect on distribution), or selling some of the outperforming one to put in the underperformer. Yes, this seems ass-backwards, but it keeps your risks balanced correctly, and can actually prove very profitable. The excess profits found this way come from essentially fighting market cycles. As one asset reaches a peak value, you’ll automatically sell it off to an extent, without even having to pay attention to market research or fundamentals, and you’ll use that income to buy an asset that is probably just about to rise in value from being depressed, again without having to pay overmuch attention to what’s going on in the extremely complex market. Just keep an eye on your asset distribution and adjust it when you make a monthly contribution.





DO NOT:

Chase Performance – The largest inflow of cash into a market usually occurs right before it peaks and crashes. People see everyone else has made a ton of money, and wants to get in on the game too. After several record years of profits in tech stocks, billions more was invested in 2000, right before the entire market blew up. Make smart investments and sit on them, don’t chase performance (or run from poor performance). Not only do you have a very good chance of missing ALL the good performance and simply buying into the bad, you are guaranteed to lose some amount to the costs of selling what you currently own and buying new assets.

Cash Out – Most people will change jobs many many times during their lives, and many of them will cash out their retirement plan every time they change, incurring huge taxes, and then wasting the money on big tvs or what have you. It’s obvious, but don’t do this. Maintain that plan, because the whole idea is to AVOID the taxes for as long as possible. (more on this when I get around to talking about various retirement accounts).

Buy a ‘story’ – this shouldn’t be a problem given the kind of investor my audience should be, but do not buy into something just because it has a neat story. You know, the guy starts telling you how gold trading is all the rage, or flipping houses makes unfair profits, or whatever. Do you know anything about the gold market? Neither do I, so why get involved in something you can’t understand? You’ll probably just get hosed by the people who actually know what they’re doing.

Stock Pick – Why would you think you know more about a stock than the institutional investors (Morgan Stanley, enormous mutual funds) that have already priced them? Not only do you have to out-pick all the experts, but you have an additional “hurdle” in that you incur large costs by buying individual stocks, which will erode your returns. Just please, don’t do it. To see large returns, you’ll have to buy a concentrated portfolio of only a few stocks, and then you’ll be subject to day-to-day variance in those prices, so your risk will be stratospheric. The only time I'd recommend your average private investor to buy and hold a single stock would be your own company stock, if you get preferential treatment on purchases of it.



Okay, now that we have covered do and don’t, buy the Vanguard S&P 500 index.

The Vanguard group is one of the largest mutual-fund groups in the world. It’s also one of the best. Somewhat uniquely, it is organized as a not-for-profit. That means most of the abuses/excess expenditures and general problems with mutual funds do not apply to its funds. Furthermore, any profit a company makes has to come out of your money somewhere, so if Vanguard makes no profit, you have an automatic advantage day-in and day-out for your returns. You’re getting more pennies from every dollar. Plus, the business is honest. “Pay-to-play” is a process where a broker gets a kickback in return for pushing a specific fund family. Fidelity gives your broker money (out of the pockets of its investors) in return for the broker recommending its funds. Many brokers will NOT mention funds that do not pay this bribe. Of the five largest mutual-fund groups, only Vanguard categorically does not take part in “pay-to-play”. Vanguard’s director of institutional sales, as quoted by the New York Times, “When brokers realize they won’t be compensated for placing our funds in a plan, they typically hang up on us.” (For more information on all kinds of problems with mutual funds read Swensen’s “Unconventional Success”). Vanguard’s S&P 500 index fund has an expense ratio of .18% other funds indexing the S&P 500 average .87% and may go as high as 2%. In general, this level of fee advantage is true across all of Vanguard’s funds.

Okay, so I’ve sold you on Vangaurd, why the S&P 500 index fund? Because it’s a simple investment, that anyone can understand. As I discussed, the S&P 500 represents the largest companies in America. Is it a safe bet to assume that on average, the largest companies in America are going to make money, expand, and find ways to make even more money, over long time periods? Yes. The Vanguard S&P 500 index fund not only outperforms every other S&P Index fund (by virtue of having cheaper expenses than they do), it also outperformed 80% of mutual funds over a 20 year period, with the average fund trailing it by 2.1%. These are actively-managed funds, where an expert manager is supposed to be BEATING the market. This also does not include the tax implications of the average mutual fund’s much higher capital-gains tax from more frequent trading. Considering tax implications, only 14% of mutual funds gave higher returns over the 1978-1998 period, with the average ‘winner’ beating the vanguard index by 1.3% a year, and the average ‘loser’ losing by 3.2% a year. So, there you have it. Over long periods, the Vanguard S&P 500 index, by virtue of its broad base across American businesses and low expense ratio, will beat almost every other investment. Plus it’s simple as hell.

You can invest online, through their website, and I would advise you to do it when you have the cash on hand (the minimum investment is $3,000)

While you can automate further deposits, even the S&P 500 isn’t ALWAYS going to be a great performer, so I would advise saving up for investment in an international stock fund from Vanguard, rather than just increasing your investment in the first fund. As before, the most important things to watch (far more important than past performance) are expense ratio and portfolio turnover. But further investments will be covered later, I guess.