Information overload is a comical understatement for most of us in today’s “always connected” world.
Between the Internet, television, smartphones, newspaper, and TV, there is no shortage of information available to each and everyone one of us.
The question is: Is any of it useful? Can we take action based on what we hear, read, or see and make tangible improvements to our well-being?
When it comes to investing, my advice is generally to tune out the noise and instead focus on timeless truths and investing facts. Things that don’t change no matter what the world at large looks like.
Once you understand and subscribe to a line of thinking rooted in evidence and objectivity, the ups and downs of the market will become much more tolerable. Even better, you’ll be free to focus on a whole host of other things (rather than how the market did on a particular day).
With that in mind, here are the first five facts about investing I want you to think about and commit to memory. I’ll share five more in my next post.
Investing Fact #1
It is mathematically impossible for most investors to “beat the market”
Have you ever heard the saying “there’s only so much juice in the orange?” That line of thinking couldn’t be more true than in the world of investing.
Take the U.S. stock market as an example.
During 2013, the market (as measured by the CRSP U.S. Total Market Index) had a fabulous year with a total return of 33.6%.
33.6% was the weighted average return of over 3,600 publicly traded stocks in the U.S., ranging from companies with well known brands (e.g. Apple and Coca Cola) to companies you’ve likely never heard of (e.g. Pokertek and Birner Dental Management).
Some of those stocks outperformed the market’s return and some underperformed. However, no matter who owned the stocks or what funds they were in, the combined return was 33.6%.
Simply put, the market cannot deliver higher returns than the sum of its parts (the underlying stocks). Likewise, the investors who own those stocks cannot all beat the market.
This concept is known as the arithmetic of active management and it was first brought to the attention of investors over 20 years ago by a very smart guy named Bill Sharpe (and a Nobel Prize winner no less).
Many investment professionals are guilty of making claims that violate this simple principle. If you keep it top of mind, you’ll be able to fend off a lot of the nonsense that is spewed as “investment advice” by fast-talking financial advisors and media pundits.
Investing Fact #2
Index investing doesn’t deliver average returns, it delivers market returns
If we lived in a world without fees, expenses, commissions, or bid-ask spreads, investing in an index fund would indeed destine you to average returns.
To be exact, in this make believe no-cost world, you could ensure yourself performance equivalent to the 50th percentile among all investors by simply buying the index.
I know a lot of people who would happily take that path to avoid the risk of underperforming the market.
On the other hand, many folks would see a big opportunity in front of them to beat the market (since they fancy themselves above average). And without costs standing in their way, the odds would be reasonably good (ignoring taxes).
However, we don’t live in a world without costs. Far from it.
This means that there are really two different games being played on the same battlefield: index investors (who incur minimal costs) and investors who try to beat the market (who often incur very significant costs).
The net result is that the
average market return earned by the index investors trumps the net after-cost return of everyone else.
This is the primary reason why we see index funds outperforming the majority of other mutual funds, particularly over longer periods of time.
Investing Fact #3
Costs are a very good predictor of success
For exactly the reasons described above (and several others), costs are a powerful tool in predicting which investors are likely to be successful and which investors are not.
More directly, although there are many factors you need to consider when making investment decisions, cost should be the #1 item on your list.
In fact, extensive research has demonstrated that cost is the single most powerful predictor of returns in the mutual fund world. To quote Russel Kinnel, the Director of Mutual Fund Research at Morningstar:
“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”
Or to quote the father of low cost investing, John Bogle:
The grim irony of investing, then, is that we investors as a group not only don’t get what we pay for, we get precisely what we don’t pay for.
Next time you get pitched the latest hot investment or fund, check the costs. The higher they are, the lower the probability the investment deserves a place in your portfolio.
Investing Fact #4
Once you control your costs, you would be wise to focus on other things besides cutting expenses by another 0.05%
Costs are a critical component of the investment decision making process. We’re all in agreement there.
However, once you have a portfolio of low-cost, passively managed funds, your best bet is probably to leave it alone. I’ve seen too many people scrutinize costs to a fault by trying to jump from a Vanguard ETF to a Schwab ETF just to save a few basis points in annual expenses.
First of all, the expense ratio is far from the only cost that an investor pays in an ETF. It’s just the only cost that is listed clearly enough for most investors to see.
However, in addition to the expense ratio, returns can be impacted by:
- Bid-ask spreads
- Trading costs and management (index tracking error)
- Securities lending
The sum of these plus the expense ratio is known as the total cost of ownership, which is much more important than just the expense ratio itself.
Secondly, moving in and out of investments in a taxable account will make Uncle Sam rich and you poor. The benefits from reducing your expenses by a few basis points will almost certainly be eaten up by capital gains taxes.
Lastly, here are 10 things you should be spending time on instead of worrying about a tiny reductions in expenses:
- Developing a sound and actionable savings and investment plan
- Creating an investment policy statement
- Reviewing your tax plan for opportunities to reduce your tax bill
- Completing your estate plan
- Reviewing your insurance to make sure you have the right coverage
- Learning how to maximize your employee benefits
- Analyzing your 401k investment options
- Setting up a 529 plan for your kids
- Double-checking your beneficiary designations and how your assets are titled
- Relax. Take a vacation.
Investing Fact #5
Investing Fact #5: Whether they like it or not, most investors need to take risk
I’ve talked about it before, but here’s the simple truth: Most investors can’t make (or save) enough money to fund their futures solely based on the cash they sock away.
They need the growth and compounding that only risky assets (namely stocks) can provide. Putting money in your savings account just isn’t going to get the job done.
First of all it would be very difficult for the average person to save, for example, $25,000 per year over a 40 year career in order to have $1 million at retirement.
Secondly, inflation would erode the value of your savings, cutting the $25,000 you saved in year one down to a measly $7,393 by the time you retired (assuming 3% inflation).
Lastly, even if you could cut your expenses so extensively that you were able to save something like 40% of your income, would you really want to live that way?
Instead of shunning risk, investors really need to take a history lesson on investing.
Are stocks volatile? Yes.
Can they decline by 30%, 40%, or even 50% during the worst bear markets? Yes.
Have they been the most consistent provider of long-term returns available to investors? Yes!
Thus, unless you are in the very unique position of having amassed enough wealth to not care about growth, you probably need to buckle up and be prepared for the ride.
That doesn’t mean you should blindly jump into 100% stocks, but it does mean that some volatility will exist in your portfolio.
If you’re not comfortable with that, you better be prepared to work longer, spend less, and die sooner. Given those options, I think most people would rather take some risk in order to hit their goals.