Friday, October 18, 2013

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!


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?

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