THE BEST PERSONAL INVESTMENT STRATEGY

By on Oct 25, 2012 in Asset Allocation, Automatic Saving, Investing, Mutual Funds, Retirement, Saving, Stocks | 18 comments

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.

 ASSET ALLOCATION-BEST INVESTMENTS

Why This Investment Strategy is Incomplete

Assumptions:

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.

 

historical stock and bond returns

LONG TERM HISTORICAL STOCK AND BOND RETURNS

 

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”,

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

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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?

    18 Comments

  1. So great to see someone remind us that even at 40 it’s not too late to be successful! There is one caveat, though: be mindful of the economic cycle. Because it moves so slowly, it’s easy to miss one of the biggest impacts on the results of your investing.

    William @ Drop Dead Money

    October 25, 2012

  2. The last 10 years has been unusual, but over a 40 years period somewhat expected. I have always looked at investing long term. It is good to know my investments will grow over the next 30 years.

    krantcents

    October 25, 2012

  3. Great post. My strategy is much like the one you outlined. Keeping those emotions separate is a major key. I purposely hold back about 20% cash so I can take advantage of major lows so I can come in and get a stock at a discount.

    John S @ Frugal Rules

    October 26, 2012

  4. I started investing in mutual funds last year and so far, so good. I selected ones that had a strong historic performance, two that were more “risky” but offer a slightly higher return (and that’s been working out) and one that’s much safer but offers a lower return (that one’s a bit of a stinker right now.) I’ve also been good about not touching them. I’ve let them be remembering that it’s the long term I’m trying to achieve. Now I just need to boost the rest of my retirement plan and increase my investment amount.

    Little House

    October 26, 2012

  5. I love inspirational posts like this (at least I find them inspirational). Your 5 points are all things I consider when making my investments (though I do also dabble in individual stocks), and I feel very confident in the strategy. And thinking about my money compounding and calculating how long it will be until I’m a millionaire is just so much fun. :)

    Gen Y Finance Journey

    October 26, 2012

  6. You rock, Barbara! Excellent stuff. It should be 101, but you and I both know that the average person does exactly the opposite (as you noted in the piece).

    I not only stick to my guns during a downturn now, but I find every chance I can to get even more aggressive. Sometimes that doesn’t work out well in the short run, but I’m using long term funds and keep a long view.

    AverageJoe

    October 26, 2012

  7. Thank you for writing this, Barbara. Apart from being helpful and making loads of sense, I do find it woderful that you are an exception to ‘start investing at 12 to compound otherwise you are lost’ chorus. Yes, people can start later and finish in a very good place – it is called ‘the rule of equifinality’.

    maria@moneyprinciple

    October 26, 2012

  8. @William, I wanted to put a plug in for those getting a later start. It’s never too late!
    @Krantc- I expect your investments will continue to grow. But…. no one has a crystal ball :)
    @John, Good idea and thanks for mentioning the possibility of holding out some cash to take advantage of market downturns.
    @Little House, Congrats on getting started investing. This last year has been great for stock returns. Just a quick reminder that there will be negative return years as well. Don’t freak out if there’s a down year every so often.
    @Gen Y-It’s very gratifying to hear that this post was inspiring. I’m so committed to promoting financial and life long wealth building and am pleased to hear you appreciated the article.

    Barb

    October 26, 2012

  9. @Joe, Although I’m not thrilled when the downturns come to see my new worth go south, I too like the opportunity to invest a bit more during those market declines.
    @Marie, I must correct you and clarify, I did not start investing at 12 but in my 20′s :) I’ll have to check out the rule of equifinality. Sounds compelling.

    Barb

    October 26, 2012

  10. Great post as usual Barb. Investing isn’t brain surgery. The tough part is having the discipline to put a strategy in place, monitor and adjust that strategy when appropriate, and stick with your plan through thick and thin in the markets.

    Roger Wohlner

    October 26, 2012

  11. My strategy was been to invest monthly in as diversified a portfolio as I can — but then I took a year’s break (at least for my 401k investing) to get the house paid off. I plan to start back up again next month.

    Jackie

    October 27, 2012

  12. @Roger, Discipline in investing (and life) is so difficult to muster, but pays off big!!
    @Jackie, Wow, I’m impressed getting the house paid off. That’s a great accomplishment.

    Barb

    October 27, 2012

  13. I, too, appreciate the reminder that 40 isn’t necessarily too late to start investing. It is also a good reminder not to be too greedy; the stock market can be almost impossible to navigate. We are only investing in the 401k/403b right now, but will add an ETF after we pay off some of the school loans.

    Wayne @ Young Family Finance

    October 28, 2012

  14. Great article, I’d also include dollar cost averaging for monthly regular investing.

    Brent Pittman

    November 5, 2012

  15. If your employer offers a match on your 401k you should put in as much as possible. I know everyone’s situation is different but even if you can only put in 1% of your salary and your employer matches it then you have a 100% return on your money!

    David Landen

    November 20, 2012

  16. @David-Thank you thank you. Wonderful advice. We have always scrimped in order to fully fund our workplace retirement accounts. But, as you said, even 1 % contribution (with or without) employer match is 1% more than zero and will compound into the future!!!

    Barb

    November 21, 2012

  17. The compounding effect can be quite incredible especially after several years. I think the trick is to get people to start contributing. Once they start (and learn to live without their 401k contribution) they are likely to continue.

    David Landen

    November 24, 2012

  18. Hi David, That is my goal, to get people to start saving and investing and realize the beauty of letting your money work for you!!! Thanks for chiming in DAvid.

    Barbara Friedberg

    November 25, 2012

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