Become a Millionaire by Investing
Be sure to check out my recent article at Yahoo!Finance
As a multi-decade investor, professional portfolio manager, and University Investments Instructor, I will reveal easy to implement strategies to build wealth. Traditional wisdom recommends looking at your total investable assets like a pie. Put the largest piece of pie – up to 80% in stock investments and watch your portfolio surge.
Why This Investment Strategy is Incomplete
Historically broad stock market indexes have returned more than 9% annually over long periods of time. In fact, from 1928 to 2011, the average stock market return was 9.23%. Thus, the investor believes she’s destined to earn 9% annualized return.
Notice the difference between stock investment returns from 2002 to 2011 at 2.88% and the historical long term averages of 9.23%. Fast forward to the most recent 10 year period and stock returns are back up in the 8% range. In reality, most investors do not achieve an average annualized return over time on their long term stock investments.
The typical investor, due to fear, greed, or a belief that she can outperform the market will buy and sell various individual stocks and managed mutual funds. When stocks are on a normal cyclical downturn, investors get scared, and sell. Conversely, during cyclical stock return upswings, investors, afraid of missing the boat buy as the markets hit a peak. This type of behavior leads to buying high and selling low.
According to Barber, UC Davis and Odean, UC Berkley in the Behavior of Individual Investors,
(1) Underperform standard benchmarks (e.g., a low cost index fund)
(2) Sell winning investments while holding losing investments (the “disposition effect”)
(3) Are heavily influenced by limited attention and past return performance in their purchase decisions
(4) Engage in naïve reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain.
(5) Tend to hold undiversified stock portfolios.
These behaviors deleteriously affect the financial well being of individual investors.
So although, over long periods of time, investments averaged 9% annualized returns, most investors do not achieve those same returns.
How to Combat Investment Underperformance
The research is abundantly clear that it is extremely difficult to beat the returns of the overall market. Even exceptional mutual fund managers who outperform the major stock market indexes before expenses, fail to surpass their benchmark indexes when expenses are factored in.
Sure there are exceptions, Warren Buffett, Peter Lynch, and George Soros are extraordinary investors. Chances are, you’re not one of them. The majority of highly compensated managed mutual fund managers fail to outperform their market benchmarks, so what makes you think you are smarter, more astute or just plain luckier than the top paid mutual fund managers? As stated before, factor in expenses and it is almost impossible to beat the returns of a diversified index fund.
What does this information mean for the individual investor?
HOW TO ACHIEVE THE BEST PERSONAL INVESTMENT STRATEGY
- Invest for the long term. If you cannot leave your money in a stock index fund, for at least 8-10 years, do not invest. Markets are volatile and over the short term, your returns are random. Over the long term if you believe industries will grow and prosper, then their underlying stocks will advance as well.
- Cut investment expenses to the bone. Realize that investment expenses are taken off the top. If you invest in a managed mutual fund charging 1% per year, then out of every $1,000 you invest, only $990 is going towards building wealth. And that’s not just in year one, that’s every year, that 1% is taken out. Thus, if the fund loses 3% one year, you lose 4%. Go with the lowest expense mutual fund or Exchange Traded Fund (ETF) you can find. For example, VTI, Vanguard Total Market Index ETF charges, 0.05% per year while the category average is 0.33%. Less money toward annual management fees means more money in your pocket.
- Don’t fight the market. Accept the fact that it is highly unlikely that you will beat the market, so choose highly diversified low fee investment funds for your portfolio.
- Choose your asset allocation carefully. Divide your investment pie among stock index mutual funds or ETFs, and fixed income investments like bonds and cash. Plan your investment pie according to how much risk or volatility you can stomach. If you don’t like the ups and downs in value of stock investments then place a smaller percent in those types of investments. Be aware that the opportunity for greater returns comes from taking on more risk. And more risk means a larger part of your pie invested in stock investments.
- Stick with your plan through market downturns. No one has a problem when their investment values surge. The problem comes when fear kicks in and you get scared during market downturns. I know more than a few folks who let fear get the best of them and sold during market downturns only to miss the subsequent advance in later years. Understand that the nature of investing is that returns are volatile.
Become a Millionaire in 25 Years of Investing
Start at age 40 and become a millionaire by age 65. Even if you have not begun investing and have nothing saved at age 40, it is possible to reach $1,000,000 by age 65. You and your partner (or just you alone) invest $1,236 per month combined into a portfolio similar to the one above; equally divided between a USA stock index fund, an international stock index fund, and a Treasury Inflation Protected Securities (TIPS) fund. Assume historical returns prevail and you earn 6.9% annually, at the end of 25 years, your $370,800 investment will be worth $1,000,000.
Of course, if you start investing younger, you can achieve $1,000,000 with less money. Start at age 25 and you and your partner only need to invest $385 per month to achieve $1,000,000 by retirement. And if each of you invests $385 per month, you’ll likely manage $2,000,000 by age 65.
What is your personal investment strategy? How is it working out?