My Favorite Investment Chart

As promised, here is a post describing my favorite investment chart.  It shows how diversification reduces volatility, the value of sticking with an asset allocation, and the folly of chasing the hottest sectors--among other things. Here's the chart, titled "BlackRock ASSET CLASS RETURNS A 20-Year Snapshot":

Source:BlackRock

CLICK TO MAKE LARGER  To appreciate this chart ,you may want to go to the link above and print out the 2 pages comprising this chart for future reference and study.

The chart shows yearly returns of 7 different market sectors, including cash, international stocks, bonds, etc., color-coded each year.  The best-performing sector is shown at the top of the column, and all sectors are shown by performance in descending order.

Quiz question:  Quick:  Which was the best-performing sector in 2000?  Answer: "Fixed Income." Fixed Income is the bond sector.  What was its return?  11.6%.

Notice that Fixed Income was the best-performing sector for 3 years from 2000 thru 2002 and then fell close to the bottom in subsequent years.  Look closely at the table and you'll see this happens often with various sectors.  Sadly, investors don't understand this and chase the hottest sectors and, thereby, hurt their performance.

Several Wall Street firms put out charts similar to this one (referred to sometimes as periodic table of returns), but the reason I prefer BlackRock's is that it shows a diversified portfolio -  shown as the white box.  You'll notice that the diversified portfolio is never among the top 2 performers; but, by the same token, is never among the bottom 2 and is among the bottom 3 on only 2 occasions.  Simply, it is a visual depiction showing that diversification (the white box) reduces volatility.  Notice also when you print the chart out that the actual diversified portfolio is described in the very last footnote on page 1 - basically it is 65% stocks/35% Bonds.

The second page shows the cumulative and average numbers.  Note that the diversified portfolio returned 7.9% yearly on average, which grew $100,000 to $461,667.  You'll also notice that 

Source: BlackRock

although there were sectors that outperformed the diversified portfolio over the 20-year period, they had considerably greater volatility as indicated by the standard deviation.

A final basic point to pick out from the chart is  how Fixed Income performed when the stock market dropped.  Check especially those years when Large Cap stocks had negative performance (for example, 2008 when Large Cap was down -37%!).  This will give you a feel for the hedging property of bonds!

The chart can be used to answer a lot of questions that might occur to the curious investor.  For example, you may wonder what would have happened if you started 20 years ago with $500,000, took out 5%/year on an inflation adjusted basis (would need yearly data on the Consumer Price Index), and had a diversification of 70% stocks/30% bonds.  Using an Excel spreadsheet can answer a question like this, or your own variation, fairly easily.

Spending time with this chart will certainly pay large dividends (I apologize - I couldn't resist) ;)

RULE 5 Build Mountains of Money With a Responsible Portfio

 With Rule 5, Andrew explains how to construct a 3-sector portfolio that historically has outperformed professionals, is low cost, and takes very little time to keep on track.  The three sectors are the broad U.S. stock market, the international stock market, and short maturity bonds.

Today it is very easy to invest in funds that track these markets, i.e., are indexed to these sectors.

Once the portfolio is constructed, it needs to be kept on track.  As Andrew points out, this is very easy and takes very little time.  The jargon for doing this is called "rebalancing."  It is so easy that it is part of the family of so-called "coach potato" portfolios that Andrew mentions.  The thrust of these portfolios is that you can have very good performance and actually spend your retirement and working years, for that matter, enjoying life rather than stressing out over your investment portfolio.

To show how easy it is, let's assume that you have a $100,000 IRA at Schwab.  Following Andrew's example, you want $33,000 (one-third of the portfolio) invested in the broad U.S. stock market.  With a little research, you find that SCHB is the ticker symbol for the Schwab fund that tracks the broad U.S. stock market and that it has an expense ratio of only .06% .  To find how many shares to buy, you get the price by putting the ticker symbol in a quote box and then divide the price into  $33,000. Or, you can use the Schwab calculator that pops up on their site when you do a trade.

The point is that all of this is that the mechanics are easy to carry out, once the basic philosophy is understood.  Again, the key is to get an appropriate asset allocation, control emotions by sticking with the allocation through ups and downs, and invest in low-cost index funds.

WHAT KIND OF FUNDS ARE YOU INVESTING IN IN YOUR 401(K) ?

The ticker symbols for the international stock index at Schwab is SCHF, and the symbol for the broad bond market is SCHZ. With these symbols, you hopefully know how to get a quote on each (hint: go to www.schwab.com and use the quote box at the lower left) and figure out the number of shares to buy.  That's it!  15 minutes and you have a portfolio that (again for the umpteenth time) has historically outperformed professionals after all costs are taken into account.

For other providers, such as Fidelity and Vanguard, you just need to find funds corresponding to those of the Schwab funds described here.  Whomever the fund provider for your IRA and 401(k), the principles are the same.  You are looking for low-cost index funds.

An important part of this chapter is Andrew's explanation of how bonds work.  This is a part of the market that most investors don't understand.  The key, as Andrew explains with examples, is that bond prices and yields move in opposite directions. Because they do, they tend to offer a really good hedge when stock markets drop. Read this section of the chapter very carefully.

Later in the week, I will present a chart that illustrates how this hedging ability of bonds has played out over the past 20 years. It is my favorite investment chart, so be sure to look for the post!

RULE 4 Conquer the Enemy in the Mirror

The advent of defined contribution plans made us responsible for our own retirement.  But nobody gave us an owner's manual on how to proceed.

This we are getting in Millionaire Teacher.  In chapter 1, we learned that it all begins with our spending.  To put it bluntly, we can spend $1 today frivolously ; or, if we are smart, we can invest it and have upwards of $4 to spend in retirement.  In chapter 2, we learned about the value of time in the investment process.  No matter what your age, you need to start  saving and investing  today.  Procrastinate a mere 5 years, and it will make a huge difference in how much you'll need to save.  In chapter 3, we found out that fees which appear to be minuscule in percentage terms can take a chunk out of your nest egg.

In fact, nickle-and-diming  fees is how Wall Street thrives.

So 3 action items:

1. Understand and control our spending
2. Start the Saving/Investment Process Today (this may very well mean getting on a path to get debt-free first and setting up an emergency fund second)
3. Understand and seek to intelligently minimize the fees you are paying.

Have You Started On These?

Still, we are left with all kinds of retirement questions.  How much do I need to save?  How do I choose funds in my 401(k)?  How do I even structure a portfolio?  And one that bedevils many investors who throw their hands in the air and hand over the management of their assets for a high fee - how do I know when to buy and sell?

These are the questions Andrew begins to address in chapter 4.

Trying to figure out when to buy and sell is called "timing the market."  The objective of timing the market is to buy low and sell high.  Guess what?  Investors, both individuals and professionals, do exactly the opposite.  When the stock market is on a tear, seemingly going higher and higher, investors pile in - like the late 1990s.  But when the market has dropped and stock prices are lower, like early 2009, investors flee the market.  As Andrew points out, this is clearly revealed in academic studies that have studied fund flows. He cites John Bogle, founder of Vanguard, who found that the average mutual fund gained 10% on an average annualized basis from 1980 to 2005 but investors in those funds earned 7.3%!  As Andrew emphasizes, this difference can be costly over the long haul!

IF YOU'RE A SKEPTIC, TRY TO TIME THE MARKET.  OVER THE NEXT 30 DAYS, WRITE DOWN EACH NIGHT WHERE YOU THINK THE MARKET WILL GO THE NEXT DAY.

Andrew explains how the stock market works by presenting an analogy of a young dog on a leash.  In the short run, the dog is going to dart all over the place.  What would you think if someone suggested betting your retirement assets in which direction the dog was likely to go next!

 But in the end, it is constrained by the leash and will necessarily come back to its master.

The master in the stock market is earnings!  Sometimes the market will get ahead of earnings and sometimes it will get behind.  In the end, however, it will move in sync with earnings over the longer term.

Understanding this behavior is key to understanding the low-cost index approach favored by Andrew, myself, and many others.  A really great feature is that most people can do the low-cost index approach  themselves (if they can conquer the enemy in the mirror ;)).  Its philosophical basis rests on the idea that the overall market is unpredictable in the short run and will move ever higher over the long run.  A giant step in investment sophistication is taken when you appreciate that the person looking back at you is hard-wired to do the wrong thing in trying to predict markets!

Importantly, the low-cost index approach has historically outperformed upwards of 80% of so-called active managers who explicitly seek to beat the market after accounting for fees!  This has held for various asset types, for different time periods, and even for investors in different countries!

So let's look at why focusing on the long run makes sense from an economist's perspective.

Those who have studied history understand the wealth-creating ability of a free market, capitalistic system with well-defined property rights.  Granted it has its flaws; but, from the wealth creating perspective, there has been no other system that even comes close when it comes to creating well being (investors can think profits!).  Simply, the smartest and most creative among us are working 24/7 to figure out what we want in all areas of our life so that we can get a huge piece of the so-called pie.

And this isn't just true in the U.S. but also throughout the Western economies and even many emerging economies.

The really neat thing is that we can easily participate in this wealth-creating machine--not by guessing which entrepreneurs will succeed, but by buying the whole pie!  How do you do this?  Simply, buy funds comprised of broad parts of the market.  This is what index funds are!

Have any of you invested in index funds? What has been your experience?

RULE 2: Use the Greatest Investment Ally You Have

Willy and his workers

Now that we've got Rule 1 plastered on the refrigerator and on our laptop/tablet, when should we start investing with the funds available as we start spending like a millionaire?

Here's the answer:  today.  Time is our greatest investment ally. A corollary is that procrastination is our greatest enemy.

Andrew gives you the math based on compounding. Compounding is simply earning interest on your interest!  If this is a new concept for you, read carefully the story of Star and Autumn.  Star invests $32,400 to end up with $1,050,180 and Autumn invested $240,000 and ended up with $813,128!

There is a rule of thumb (about which we will say more later) that says you can safely spend 4% of your nest egg and not run out of money.  With this rule of thumb, Star can start spending approximately $42,000 at age 65 and Autumn can spend approximately $32,000!  So, the compounding math works into real standard of living consequences, dependent on using time wisely.

If you like to do math, you can do the same thing yourself for your specific age.  You can work up the impact of, say, investing $5,000/year now versus waiting 5 years to start investing. What's the difference if the market returns 6%,8% or 10%? .

Note that Andrew started investing when he was 19 years old.

WHEN DID OR WILL YOU START INVESTING?

When this time issue comes up, light bulbs go off for many parents.  Their inclination is to want to set aside money for their young children to take advantage of compounding over a long period.  Here's Andrew's response, which I agree with:  "Giving money promotes weakness and dependence."  Instead, Andrew stresses to teach young children money lessons. Teach your children how to invest and how to manage their lifestyle so that they have money to invest!

Gifting money to yourself is, of course, different.  Andrew tells how Tom and Julie tracked their spending and found that they could cut spending and maintain their lifestyle, thereby producing investment funds.

In my situation, I had a job that paid a nice bonus once a year.  Many of my co-workers actually spent the last three months of each year trying to figure out what the bonus would be and actually had their bonus spent before they even got it.  I (patting myself on the back) was satisfied with my family's life style and sort of looked at the bonus as found money.  I invested it each year and figure that, in the end, it gave me about 5 years of extra semi-retirement!

At the very least, I would recommend that at least half of any type of "found money" be invested. Surprised that you're getting $1,000 tax refund? Invest at least $500!

As another example, I knew a young lady who a short time ago won $20,000 in the lottery.  She is a low-income worker with about $40,000 invested for retirement in her company 401(k).  I suggested she put $5,000 of her lottery winnings (which she didn't like!) in her investments.  Like a lot of people in their mid-30s, it is hard for her to understand that one day she will be 65, tired of working, and that her future self will be very grateful for the delayed gratification that enabled her to set aside funds!

HOW DO YOU TREAT "FOUND MONEY"?  WHAT KIND OF "FOUND MONEY" DO YOU COME ACROSS?

I hope you have read Charlie and the Chocolate Factory by Dahl because Andrew uses it to give a nice example of how the stock market works.  This really strikes a chord with me because I see so many young people who view the market as a casino.  And, actually, this is warranted if you are in the market trying to time it and pick and trade individual stocks and, at the extreme, day trading by jumping in and out during the day.  But this isn't what investing is about, as shown by the Willy Wonka example.  INVESTING IS ABOUT OWNING REAL BUSINESSES THAT ARE PROSPERING!

Sadly, Wall Street and the brokerage community have a huge incentive to get you to trade like a maniac.  They have very smart people, creating clever commercials (with talking babies, etc.) to get you to open trading accounts.  If you go this route, you may just as well head for the casinos of Vegas.

HOW DO YOU VIEW INVESTING?