We are, without a doubt, the most highly trained consumers in the history of the world. Sure, people have been buying and selling for centuries, but how many cultures before us had it down to such a science?
Stores line up candy at eye level, drop subtle lighting hints on new shoes and jewelry, give us every reason to buy now, not later, whatever the category or need. Courses on retail are taught in our colleges, while companies spend millions mocking up shopping aisles in order to test out new ideas.
Investing is no different and never has been. Stock brokers have long been trained to sell what’s known as a “story stock,” that is, a company with a tale behind it. People are drawn to the idea of a superstar CEO, an amazing new product or a fundamental shift that creates an opportunity.
We love stories. They help us understand the world. A conflict must be introduced and resolved, with a beginning, middle and end, and a moral is usually attached that ties things up with a neat bow.
Yet the real economy is far more quixotic and humbling. Products are introduced too early or too late. Perfectly good companies are crushed out of existence. Perfectly bad companies stay around for decades, inexplicably surviving.
Great managers fail to save the day. Stocks that should go down instead go up and vice versa. Meanwhile, incredibly boring companies — firms with truly no story to share and no uplift in their mission — they just grind on, growing and paying dividends.
When we buy individual stocks, two things can happen. We can ignore them or pay attention to them. They will perform to expectations (or they will not) regardless of how much we personally care about the story behind it all.
Yet what drives that initial impulse to buy is often the story, the hot “tip” we get from a friend, the idea that we have the inside track on something big.
In the end, if you buy, say, 50 individual stocks, you are likely to make money on some of them and lose money on others. Some will pay dividends and some will cut their dividends.
And the lot of them are likely to grow their earnings at a rate that is somewhere north of the inflation rate, once you count reinvested dividends.
Stock market stories
Once you accept that, there’s no reason to buy 10 or 20 or 50 stocks when you can diversify dramatically by owning hundreds or thousands of them in an index fund. You still get that earning growth and dividend inflows, but your individual “story stock” risk goes away.
Because you didn’t impulse buy, you are far less likely to impulse sell, too. And so the growth engine rolls on, year after year, with no worries at all.
Investing could not be any easier than that. If you want a good story, go to the movies or get a book from the library. If it doesn’t end the way you like, you can always see the next show.
A lot of small investors spend a lot of time — far too much — worrying about their investments. They buy concentrated positions in a few shining stars and then hope.
What happens next is all too predictable. One position rises and they pat themselves on the back. Another one falls and they grumble and blame “the market” or some equally nefarious force in the background.
What they never do is blame themselves. No matter how bad the pick turns out to be, any losses must be attributed to the actions of others and never the stock picker.
Then, a familiar pattern appears. Fearful of taking more losses, the investor begins to focus on the losers in the bunch. For a while, the winners offset the losers. Then the paper losses mount and the pressure is on.
Just when things are at their worst — the whole portfolio is negative for the year! — the investor decides to cut his or her losses. The dog gets sold.
Naturally, many of those supposed “loser” stocks soon spring back. The winner stocks of last quarter lose steam, too. The portfolio looks quite different only a few weeks later.
And on it goes, failing to sell a gainer while it’s high enough to warrant it, then failing to hold on to supposed losers until the loss is so bad it must be realized immediately.
The solution, the research shows, is to depersonalize the whole matter. Why pick stocks at all when you can own the whole market?
What the numbers show us that “time in the market” trumps “timing the market” year in and year out. Rather than renting stocks for a short period of hoping for a pop, you own them for years.
Why time in the market works
Over those years, the dividends pour in at about 2% a year. That money is reinvested automatically. Likewise, earnings growth is steady over the long run, about 5%. This translates into steady appreciation across the whole market.
And, just like that, you compound your money, year in an year out, just by buying and holding stocks. Add that to a portfolio of foreign stocks, bonds, commodities and real estate and you’ll likely do a bit better.
Rebalance steadily as you go and you avoid the worst of the excessive, scary highs and the depressing lows, which can happen and will happen over the years.
Time in the market works because it forces you to ignore your dangerous emotions. We love the idea of winner stocks and want to own them forever. We hate the idea of losing money and will do anything to stop that pain.
The fact is you will experience both emotions. A disciplined portfolio keep us from overreacting and hurting the long-term positive return we all need to retire well.
You’ve probably heard or read about all kinds of strategies that will make you rich investing. They go by many names, but they all follow the same basic idea: Zigging when others zag.
It might be buying sectors at certain points of the business cycle. Or stocks that have been bid down to unusual lows. Or only owning stocks ahead of elections, when Congress is out of session or the moon is full.
Yet any kind of market timing or stock selection strategy depends on the same basic mechanism to work out. You have to know something that others don’t.
If you’re talking about a tiny microcap, it’s possible you know something absolutely nobody knows. Not likely. Just possible.
It’s also possible that anyone in the world with deep enough pockets will bet against your position for any reason or no reason, wiping out your investment in seconds.
If you’re looking at a large, publicly traded company, you might have an inkling that management will move one way or another on an opportunity. But the chances you’re the only one taking that bet are few. And plenty of deep pockets could invest against you.
Or you could take advantage of the only free lunch in investing — rebalancing.
Rebalancing does not depend on factors beyond your control. It simply recognizes reality and reacts accordingly. Your decision to buy or sell an investment rests solely on the fact that it has risen to a value and now represents a larger portion of your total portfolio than intended (so you sell some of it).
Or that it has fallen and is now a smaller portion of your portfolio than intended (so you buy).
Here’s the neat thing: You can buy using incoming cash from contributions, of course, but also incoming dividends and interest. If you sell and generate cash, that money has a home elsewhere in your portfolio, even if nothing has gone down.
Get your free lunch
Since something went up (what you sold), that means something else is relatively less in your total portfolio. That’s what you buy with the cash.
Do this over and over and you can’t help but sell high and buy low, efficiently and at a low cost. That’s how your portfolio grows steadily and compounds into a powerful, effective retirement plan.
You aren’t tempted by stories of winner stocks that end up being dogs. You aren’t worried when some part of the market falls. To you, it’s an opportunity. In fact, the only “danger” left is cost.
Cost is the killer, and you can manage that by using inexpensive index-style ETFs. The only free lunch in investing can be had without a lot of tricky trades, costly advisors and complex research.
All it takes is zigging when they zag, the right way.
Investing for the long term means you should own a portfolio of stocks, bonds and other types of investments. But why, and what is a portfolio, really?
First, let’s consider some of the common investments chosen by people who use a 401(k) plan at work. Many of them by default are put into mutual funds. That’s a kind of portfolio, but usually a portfolio of stocks and only stocks.
Increasingly, too, people are being placed by default into target-date funds. These are collections of mutual funds that cover a variety of asset classes, such as stocks, bonds, foreign investments and real estate, and then rebalance them.
A target-date fund is supposed to lower your risk over time by increasing the proportion of less-volatile investments.
Of course, volatility and risk are not synonyms, nor is it true that the target date you might choose for retirement is the best fit for your circumstance. But that’s where people end up.
Another way that some people are invested in workplace plans is cash, or a cash equivalent such as a money market fund.
This isn’t investing at all. It’s just saving, and usually high-cost saving, since you have to pay the plan administrator a fee and inflation is weakening the purchasing power of your money steadily over the years.
Finally, a lot of people in workplace plans are given or have a chance to buy their own company’s stock, usually at a discount. The problem here is the risk of concentration. Owning a lot of one stock is a huge risk. The fact that it’s your employer does nothing to reduce that risk.
What’s the answer? Own a real portfolio, and own it as cheaply as possible using index funds. A true portfolio will hold thousands of stocks and bonds, greatly reducing concentration risk.
It also will be diversified into a broad variety of asset classes, including the kinds of investments you find in target-date funds. However, instead of mechanically moving toward a distant date, a great portfolio is adjusted to match your personal goals and will change dynamically over time to match the material events in your life.
Understanding what is a portfolio
Finally, you will own no cash at all, or hardly any. A real portfolio rebalances periodically, investing incoming contributions and cash from dividends and interest payments as they come in.
In the end, you shouldn’t be able to say “I own that stock” or, to the contrary, “I’m in cash now.” Rather, you should be saying “I own stocks, and that means I own nearly all stocks” through an index fund and “My cash is working for me, all the time” since you stay in the market through thick and thin.
Risk is adjusted by reviewing your personal tolerance for the ups and downs — volatility — and in the context of when you actually might need your money for living expenses in retirement, whatever year that turns out to be.
One of the longstanding idiosyncrasies of stock market investing is patterns. Human beings are keen on finding them, often where they don’t exist.
Scientists even have a word for it: “apophenia.” It means seeing connections and patterns that aren’t meaningful, and we all fall victim to it.
The crackpot version of our tendency to see patterns is the conspiracy theory. Odd lights flash in the sky and we imagine aliens are among us. People become transfixed by famous murders and ascribe motives to strangers in the background of random media images.
But we all do it, and especially stock market traders. Right about this time of the year you are likely to see headlines about how you should “Sell in May and Go Away.” This is a version of what’s also called the Halloween Indicator.
In short, some traders believe that we should get out of stocks entirely in May or, failing that, by June (thus the “June swoon” when hangers-on finally give up and sell). Then, it is supposed, we should all buy back in by October.
The point is to own stocks in winter and not in summer. The strategy’s proponents contend that the idea continues to work, while most economists and academics dismiss it as folk wisdom or pattern-seeking.
The funny thing is, the more people think it’s there, the more likely it is to be there for real. Fearing that they might miss a chance to market-time profitably (for once), the Halloween Indicator can become a self-fulfilling prophecy.
Naturally, selling all of your stocks and going to cash is very costly, and not just because of commissions. In fact, you are likely to miss a lot of months of appreciation and dividend income, money that could and should be growing your portfolio through compounding.
Likewise, if you hold stocks all through the winter, you are just as likely to see a downturn that will test your belief in any kind of market timing theory and could lead you to panic and sell for no good reason at all.
A far better approach is to own a portfolio of stocks, bonds, real estate, foreign stocks and bonds and commodities and to rebalance them. That way, you only sell when there is a good reason and you buy with good reason, too.
You can keep your costs minimized by using inexpensive exchange-traded funds instead of specific stocks or bonds, and the results are incontestable. Burton Malkiel, the author of the investment classic A Random Walk Down Wall Street, maintains that just rebalancing stocks and bonds over the past 15 years earned a 1.5% premium over the straight stock market.
That’s real money and a real return that could be had year-in and year-out and absolutely won’t be made by the folks sitting on uninvested cash all summer every year.
If you think you have a stomach for watching stocks rise in the summer while you are out of the market and then fall in the winter while you are in and you can afford that kind of emotional risk every single year, then “sell in May” might be for you.
But the surer path to retirement is buying your investments once and then rebalancing as need be, no timing necessary.
If the stock market fell 10% in the next week, what would you do? What if it fell 20% in a day? What then?
These seem like wild questions, but it’s a point worth pondering. How would you personally react to a rapid decline in stock market valuations?
If it were a decline like the infamous “flash crash” of a few years back, probably nothing. Really, there’s nothing to do when the market goes straight south and then straight back up before you even notice.
Those events are rare, but what about sharp declines over a few weeks, which happen more frequently? There’s a whole class of “experts” out there who believe that they can see these events coming.
Called “technical” analysts, they look at complex charts and attempt to find signs of investor psychology in action. They’ll draw straight lines from market tops to bottoms, hoping to convince themselves (and you) that the next move has to be down, or up, or whatever fits their theory.
Problem is, by the time it becomes patently clear which direction the market is going overall, you’ve often already taken most of the hit. Sell now and you lock in the loss. Wait and you might experience even more losses.
It’s a no-win scenario because there’s literally no way to know what the next day will bring, positive or negative. Worse, if you just sit out the market roller coaster in cash, you might miss a big climb in stock valuations, a risk people too often discount.
Index investing would seem to be the perfect way to suffer in all markets, but it isn’t and here’s why: If you own your investments in the form of a portfolio, indexing gives you real diversification while allowing you “wiggle room” to capture gains in both directions.
Sound impossible? Not really. If you buy a portfolio of several asset classes, you can be sure of one thing. More often than not, if one asset class goes up another is going to be flat or go down.
Yes, sometimes both stocks and bonds appreciate. But not U.S. stocks, foreign stocks, emerging market stocks, government bonds, corporate bonds, high-yield and real estate, all at the same time.
Index investing genius
For example, over the past few years foreign stocks were getting pummeled while the U.S. markets have gone higher. What’s happening now? Well, foreign stocks are back in vogue and U.S. stock have flattened.
An index investing strategy that relies on a portfolio approach was positioned to sell off those U.S. gains as they came in and redistribute cash to foreign stocks that were comparatively cheap.
You don’t have to know which foreign firms will have better earnings or worse. All that matters is that you took money off the table and reinvested in real time. Research shows that rebalancing alone can get you 1.5% above the straight stock market return.
Yes, we might have a “down market” ahead of us. Or not. It works out fine if you own a portfolio and smartly rebalance it as those realities become more clear, and do so at the lowest possible cost using index funds.
As U.S. stocks skid lower, the big question hanging in the air for many investors seemed to be: Should I sell and go to cash?
Of course, that question is always hanging over the heads of stock market investors. After all, you can’t realize a gain without selling. The only way to lock in profits on a stock holding is to sell, right?
Not entirely. Here’s the thing you need to understand about portfolio investing, as opposed to stock picking and market timing. In a portfolio, you are always selling and you are always buying.
That’s right, “passive” investing is terribly misnamed. It’s not really a set-it-and-forget-it approach to the problem of long-term investing. Rather, portfolio investing is a set-it-and-reset-it approach. Over and over.
Here’s how it works. You buy a selection of asset classes. Not individual stocks. Not specific sectors. You aren’t looking for the underappreciated gem or the quick-hit small cap that everyone else is trying to ride.
No, you buy asset classes, big broad slices of the markets in the form of index-style exchange-traded funds (ETFs). Technically, that’s the passive part. You don’t try to pick stocks at all. You buy them to own them and hold them for long periods.
You do sell, just not 100% of any given asset class. You are never zero percent in stocks. Never zero percent in real estate. Never completely out of bonds. You never go to cash.
Yes, stocks are sliding a bit year-to-date. But the portfolio investor is not concerned about this. See, he or she was selling off stocks as they rose, all through the last several years.
Those gains already have been taken, the money redistributed to other parts of the portfolio that were out of favor as U.S. stocks got all the attention. The portfolio effect is a better total return, since those disfavored asset classes are now getting their day in the sun.
All along the way, risks are limited in two important ways. One, the portfolio investor stays in the market. Rather than miss the great days when stocks really put on gains those gains are won and, thanks to rebalancing, mostly held.
Secondly, the long-term portfolio investor gets dividend payments all that time. If you sell all of your equities and go to cash, you end up losing an extra 2% bump from stock dividends. That money should be steadily reinvested and really amps up your performance over time.
Mostly, though, the portfolio approach ends the concern of selling and going to cash. If your portfolio always has the right proportion of stocks to bonds by design, you never need to panic over rising stock prices.
Rebalancing is the icing on the cake. You get appreciation, investable income from dividends, a chance to realize gains programmatically and to reinvest those gains in a timely fashion. Nothing passive about that!
A significant number of young people are not investing in the stock market, and the implications of that fact are staggering: Like their parents before them, for many of them retirement won’t happen at all.
Bankrate.com did a survey of millennial attitudes toward investing in stocks. In case you aren’t aware, millennials are people under 30, the other end of the spectrum from today’s baby boomer retirees.
Roughly 1 in 4 (26%) own stocks, according to the survey. Of those that don’t invest, the reasons are both compelling and frustrating. More than half (53%) said they don’t have the money to invest. One in five (21%) said they don’t know enough about stocks to invest.
The remainder cited mistrust of stockbrokers and fear of paying too much in fees. Of all the reasons, these last two we find the most legitimate, but the whatever the reason, the kids just aren’t that into investing.
Yes, they could cut back on other things they do spending money on, like eating out, vacationing and expensive gadgets and find a way to get started. As a group, they have unusually high student debts, we know, but saving and investing is a habit that starts with willpower.
Here’s the really big problem. If they don’t start now, the habits won’t form. And if they fail to invest early enough, they lose the awesome power of compounding.
Compounding is magic. If you invest $1 today, it turns into $2 in some period of time. Maybe that’s a few years, maybe longer. But it will double.
Then your $2 turns into $4, and $4 turns into $8 and so on. Over the course of a working life, money saved early is the yeast which causes the bread to rise and rise and rise.
Imagine you are 25 and planning to save for 30 years. You target $5,000 a year and earn an 8% annual return over those years. Some years more, some years less, but it averages out to 8% a year, a return commensurate to a portfolio with a healthy allocation to stocks.
Three decades on, your account reaches $625,124. Great!
Now, let’s say you don’t invest in stocks. You just put money in a bank account and earn a CD rate. It’s crazy low now, but image you average 2% over the decades. Your account at the end of the run is $205,644. Big difference.
Now let’s say you get religion on investing but you get start late. You hold off to 45 to begin investing. You now have 10 years to make it happen. How much cash will you need to set aside to get the same result?
If you do the $5,000, you are going to end up 10 years later with just $76,736. In fact, to get a result comparable to our young, steady investor, you will have to target $41,000 a year into your retirement accounts.
Or, you could save just $5,000 and hope you get a return of 39.5% a year for all 10 of those years. Either way, that’s how it breaks down.
The takeaway here is that doing nothing is not really going to work out. You might think you have all the time the world to save for retirement, but the truth is these next few years are much, much more valuable to your long-term results than the later years, when you might or might not have a higher income.
Once they pass, they pass. There is no do-over, no trick shortcut to retirement. It’s time, diligence and good habits from the start, not luck or fortune or know-how. Go get started!
By about this point, you are likely to begin running into columns online giving advice about what to do when the stock market enters yet another potential up year — it’s seventh since the lows of 2008 and early 2009.
Using phrases such as “fear an aging bull” and “bears throw in the towel,” the general purpose of these articles is to reassure market timers, those investors who think they know exactly which way the markets will go next.
Nobody knows. That’s the simple fact. It’s only in retrospect that people find their philosophical positions validated. Think back to all the weddings you’ve been to over the years. Now consider who is divorced and who is not.
Be honest, now. Some of the relationships you might have written off are going strong, while some of the “dream couples” we all knew broke up.
That’s the really interesting part about investing psychology. We are big into confirmation bias, evidence that things we already believe to be true must be true. If you’re a natural bull, a rising stock market proves your trust is well-placed.
If you’re more of a bear, well, seven years of rising stocks is certainly a test of your patience. But it’s no proof of your wrongness, just of the level of delusion among others.
The middle ground feels like a weak choice. Our human nature, besides making us rampant devourers of any evidence we were right all along, also makes us want to pick a side. Luck favors the bold, right?
Yet the data shows how wrong that is. J.P. Morgan and market research firm Dalbar found that individual investors are absolutely terrible at picking sides. The average investor has a 20-year return of 2.5%, just a hair above inflation.
Bonds alone would have earned you 5.7% over that period, from 1994 through 2013, while the S&P 500 returned 9.2%.
Bull? Bear? It doesn’t matter at all. What matters is when do you need your money?
If the answer is “Oh, in about 20 years,” then you should own a portfolio that is mostly stocks, including foreign equities and emerging markets.
If you said something more like, “I think I need my retirement money in just a few years,” own a portfolio that is more conservative.
A well-designed portfolio that is matched to your risk tolerance and time horizon will inevitably capture most of the bull years while being conservatively invested later, when you can’t afford to lose too much.
Removing your emotions — and your reward-seeking brain — from the equation allows you to get a return close to the long-term return of the stock market while not taking on a huge amount of risk late in the game.
The secret is discipline, rebalancing and keeping an eye on cost. The mutual fund industry would like you to believe that it’s more complicated than that, but it’s just not. Ride a bull, fend off a bear and retire on time — it really is within your grasp.
A new study points out a pretty scary statistic: Of middle-class kids who go to college, just 40% finish with a degree. If you’re a parent with young kids and saving for your own retirement, the reason why this happens matters to you.
Think about it for a minute. Ten capable high-school graduates from middle-class backgrounds enter college and just four walk out six years later.
Not even in four years, the traditional calendar for a BA. They had 50% more time (and more money spent) and still don’t finish.
The reasons vary. Financial problems crop up. Some realize they were never ready for the rigors of higher ed. Some cite “personal reasons” with no real explanation. Maybe they all got great jobs and moved on, but almost certainly not.
The really interesting part is how the kids who finish managed it. Being from a wealthy family helps, of course. But so does being a full-time student. A strong majority (63%) of middle-class students carrying a full load of classes got degrees on time.
There is one key thing to learn here in regard to lifelong success: Start early and commit to a goal. This relates very specifically to retirement saving and investing, too, and I’ll explain why.
You can think of motivated college students a number of ways, but the bottom line is the same. Something or someone lit a fire under them at an early age. Finishing college became a priority to them personally.
Maybe they got excited about their coursework. Maybe a fascinating job offer on the other side wouldn’t happen without a diploma.
More likely, they had strong role models at home, achieving parents who set the bar high and simply didn’t present an alternative, like dropping out or combining work and school to the point of taking 10 years to graduate.
A very similar dynamic happens with investing and retirement. Parents who are savers set an example for kids to become savers. Parents who spend wildly and go into debt do the opposite.
Saving early is a lot like getting an associate’s degree while still in high school. Yes, it’s hard to do. But you get to start off the next stage well ahead of the game. It means you are much more likely to make your goal.
Likewise, saving enough is like going to class full-time. Yes, saving adequately costs you in the here and now. But building up savings buys you freedoms later on that your peers cannot access.
Freedom to choose between jobs. Freedom to retire on time, or even early. Freedom to make interesting life choices.
Here’s your homework assignment. If you have kids going to college some day, sit down and share with them these stats on graduation. Set a hard line on finishing on time and help them find the resources to make it work, such as living at home and summer jobs.
Then immediately link those achievements to retirement saving and investing, starting young. Show them how you are doing it and share the real numbers of your own experience. The time for these conversations is now, while you can still mold a young mind by example.
Otherwise, you find yourself later throwing thousands of dollars at yet another kid with no clear path to graduation, a job and the firm, secure future you want them to have.