Photo by Chris Liverani
It’s hard to believe that the financial services industry in the United States makes billions and billions of dollars every year convincing investors that they need the latest stock or mutual fund, inevitably encouraging takers to time the market. What is needed is an alternative way to build wealth.
Although investors are cautioned daily not to be susceptible to market timing strategies or to purchase the latest and greatest investment, individual investors do so out of desperation to make up for lost time in the market. As a result, they lead themselves down the path to the Wall Street slaughterhouse of high fees, commissions and bad market timing.
There is NO wrinkle in the stock market to exploit
So with all the advice being provided to investors not to engage in this type of behavior, why do investors still do it? The bottom line is that most investors make the assumption that they can make up for lost time in the market by finding the ‘wrinkle in the market’ that they have assured themselves must exist. This wrinkle amounts to picking what they believe is the right investment at the right time. Invariably, however, this leads more time than not to the investor buying at the height or near height of the valuation of that particular investment, as they are chasing past performance. Rarely does the average investor, or an even experienced trader for that matter, get it right.
An alternative investment strategy
So other than being lucky enough to pick the best performing stock, what is the alternative investment strategy? As unamazing as it sounds the alternative is quite simple;
(1) Buy a broad stock Index Fund such as Vanguard’s VTSAX or S&P 500 and
(2) Commit to invest a much more substantial amount of your annual income, such as between 30% to 50%, in the chosen stock Index Fund.
By investing in a broad stock Index Fund, you are avoiding the temptation of trying to “beat the market” and simply “owning the market”. With an investment in a broad Index Fund you are invariably mirroring the overall market performance both in gain and in loss.
The simple truth of the stock market is that 94% of all stock fund managers don’t beat the S&P 500 in any given year and the 6% that are able to do it in that specific year are not normally the same to do it year to year.
The ‘age-old- advice is risky
In addition, in order to receive the type of returns that the investors expect these stock fund managers to get they also have to take much greater risks to get those returns. So not only do these fund managers NOT beat the market consistently from year to year BUT they also take much greater risks than simply having your money invested in VTSAX or a S&P 500 Index Fund. Oh and by the way, you pay them for this unamazing service! In some cases, quite handsomely.
So the bottom line is this…most investors try to make up for lost time in the market by buying the latest trend in mutual funds or individual stocks in the hot industry sector (today it’s technology, yesterday it might have been biotech) and purchase…possibly unbeknownst to them…what turns out to be pricey managed funds that have higher risk profiles with obviously no guarantee that they’ll beat the broader market.
But HOW could so many “smart” people continue to repeat this behavior year in and year out? There HAS to be some very compelling reasons or solid positive evidence to support this behavior, right? Well you’d hope so but the evidence shows just the OPPOSITE. Take the following as an example:
Investor 1:
This investor doesn’t believe that you have to “beat the market”. All you have to do is match the market by investing in the S&P 500 Index Fund. So with this strategy this investor commits to put $10,000 a year for 10 years in an S&P 500 Index Fund.
Let’s assume the S&P 500 Index Fund will generate a constant 7% annual return with a total management fee of .14% for an effective annual rate of return of 6.86%.
Investor 2:
This investor believes that he/she has time on his/her side. As a result of his/her ‘superior’ strategy, they’re going to put off investing because they know they can get much higher returns if they put their money with someone “who knows what they’re doing”.
As a result, they are going to commit to start investing when Investor 1 has hit year 6 and then invest each year thereafter until year 10 (5 full years). BUT…they’re going to employ their ‘superior strategy’ and invest DOUBLE of what Investor 1 is investing, $20,000 a year, AND receive a phenomenal annual rate of return of 12%! WOW! Maybe these investors REALLY DO know that they’re talking about!
However…in order to get these types of returns, there is going to need to be a steady hand at the wheel with someone who ‘knows what they’re doing’. As a result, there’s going to be a LOT of buying and selling (we’re not even going to talk about the tax implications of such an investment fund in this post) and the cost of trying to out-perform the market comes at a cost…a 2% annual fund management fee.
So…this greater risk, less tax efficient fund actually will only return an annual 10%. That’s still a 45% higher return than the S&P 500. That’s financial Rockstar territory!
So here’s what happens:
Investor 1 receives $157,835.44 at the end of 10 years by only taking the inherent risk of being in the broader market. Other than worrying about whether the market would be up or down, they didn’t have to worry about timing the market or ‘picking the right horse’ in the race. They’ve put their money on the race so to speak.
How did Investor 2 do with his/her superior investing strategy? Well, by incurring much greater risk, trying to pick the right fund manager, timing the market and arguably having tax implications if investing outside of a retirement instrument, they received $154,311.71 for their efforts. Hummm…that’s actually LESS than Investor 1.
Why the age-old investment strategy doesn’t work
So what happened here? A few very important things actually. The first is the phenomenon of time in the market. Not “timing” the market but “time in” the market. Those extra 5 years in the market compounding returns, even at a lower investment level and a lower rate of return, has a huge impact on the growth of money.
Second, although Investor 2 thought he/she would be getting the full advertised return of 12%, the cost of getting that return comes with it a lot of daily buying/selling and analyzing investments. This takes time which in turn, takes money.
The loss of this 2% annually really has a negative impact on compounding, especially when you have fewer years. Lastly, Investor 2 had to make a MUCH bigger annual investment commitment in order to just about keep up…not blow away…Investor 1.
Let’s go back to the earlier proposition that all it takes to have an incredible investment strategy is the following:
(1) Buy a broad stock Index Fund such as Vanguard’s VTSAX or S&P 500 and
(2) Commit to invest a much more substantial amount of your annual income, such as between 30% to 50%, in the chosen stock Index Fund.
In reflecting on the example of Investor 1 and Investor 2 in this post, we see the hard math as to why number (1) above makes sense. We’re simply trying to match the market, not take on additional risk of market timing, tax liabilities and high management fees. The math shows this to be a sound strategy.
Now, if we could only increase the amount of “time in” market as well as the amount of money (number 2 above) we put into that broad stock Index Fund (number 1 above) we’d have a low-effort, solid investment strategy that would match the market year in and year out.
So we know what number (1) does but where’s the evidence on why (2) is part of this strategy? The sad truth of the matter is that the age-old advice to save and invest 10% to 15% of your annual income each year simply doesn’t work for most people.
Why? The simple truth is that if you are like most people, you didn’t start investing until you were around 35 or 40 years old.
You didn’t have the 40 years of annual investing that this age-old advice is built on. So as a result, if you follow this advice you’ll look more like Investor 2 in this post. And you now know how that turns out!
Even if you start late…YOU can win
So here’s a thought. When you’re around 35 or 40 years old and you’re starting to think about retirement AND presumably have a lot more available money to invest than you did when you were in your 20’s, consider the advice in number (2) above. This is time to invest 30% to 50% of your annual income so that you don’t have to play the game of Investor 2.
But seeing that I didn’t start investing until I was 35, aren’t I going to have to take the same approach as Investor 2 in order to catch up for all those years that I didn’t invest? NO! This is the beauty of strategy number (2).
Conclusion
If you were to start investing at 35 years old and made $75,000 annually (22% above the median United States annual income of $61,371) and the S&P 500 Index Fund generated an annual return of 6.86%, if you invested just 30%, or $22,500 annually, you’d have accumulated a retirement account worth $2,072,576.82 at age 65!
Now consider this: If you used an annual withdrawal strategy of 4% (which is argued in the ‘Trinity Study’ as having a high percentage of not spending down your principal) on that $2,072,576.82 you could enjoy an annual withdrawal amount of approximately $83,000! That’s MORE than your current annual salary!
THAT is the power of investing at least 30% of your income annually and having “time in” the market.
Now what would happen if we dismissed this advice and went back to that ‘age-old advice’ of investing 10% of our annual salary starting when we were 35 years old? Well, if we were making $75,000 a year that would be an investment of just $7,500 a year for 30 years at 6.86% annualized for a retirement amount of $690,858.94 at 65 years old and an annual withdrawal amount of $27,634.46 (using the 4% withdrawal rule).
If you were expecting to live a similar life in retirement to what you are doing now on $75,000, $27,634.46 in annual draw is roughly 37% of your existing lifestyle! That’s going to be some SERIOUS belt tightening.
So, $2,072,576.82 or $690,858.94? 30% or 10%? $83,000 annually or $27,634.46?
The choice is up to you!
