Too often, individuals are quick to throw up their hands and concede defeat when managing their investments. Stock market volatility makes investors uncomfortable and often leads them to the sidelines. Studies show that do-it-yourself investors underperform market averages significantly. This is unfortunate, because the odds are actually stacked in the favor of investors. Contrary to conventional wisdom, the investment game is a positive sum game and is a relatively easy one to win.
One of the biggest problems in investing is that people are paralyzed by choice in the financial arena and many don’t even know where to begin. Even something as simple as choosing which fund to allocate your assets within a retirement plan is made difficult by an overwhelming array of investment options.
Psychologically, people tend to shut down when overwhelmed by choice, and it is now known that the availability of more options is not always better and may even be worse in some cases. Experiments from behavioral economics show that fewer shoppers actually bought a jar of jelly when it was one of 24 as opposed to one of six. In the financial arena, people are less likely to join a company-sponsored retirement plan when more investment options are offered. More choice can also lead to lower satisfaction, as after a decision there is always the fear that the wrong choice has been made.
Ultimate success in investments is largely a function of two traits – time and consistency. To be successful an investor needs to invest “early and often.” In fact, time is the greatest ally of the investor.
Most people simply fail to understand the powers of compounding and why Albert Einstein was rumored to have said “compound interest is the eighth wonder of the world.” Now, Einstein likely didn’t say that, but it behooves people to operate as if he did utter those profound words.
A simple example illustrates the wonders of compounding. According to the IRS, the average tax refund this year is $3,120. Suppose the taxpayer was torn between putting aside the money for retirement and taking a wonderful vacation. If a 25-year old took that refund and put it into a tax deferred savings plan, and earned ten percent compounded annually on the funds, she would have accumulated $141,209 by age 65. When put in those terms, that is a pretty expensive vacation.
In most endeavors in life, we want to be above average. Investing is one field that, thankfully, you can be just average and achieve your goals. A very popular investment strategy is simply to invest in low-cost index funds — that is, funds that mirror a broad index such as the S&P 500. These funds have incredibly low fees and closely track the performance of these indexes. By the way, if you think ten percent is an aggressive growth assumption in the above example, since 1950, the S&P 500 has grown at a compound rate in excess of 11 percent. Being average sounds pretty good.
If you want to try to beat the market you can invest in individual stocks or active stock funds. The evidence shows that, after fees, the vast majority of actively managed funds fail to beat the market averages. The bottom line is that a simple passive indexing strategy works.
None other that Warren Buffett endorsed an indexing strategy for his heirs. In his 2014 letter to Berkshire Hathaway shareholders he wrote “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund… I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
Investors can achieve financial security by utilizing a disciplined dollar cost averaging strategy – buying a fixed dollar amount of a diversified index fund on a regular schedule, regardless of share price. Essentially, investors would be well advised to know that “time in the market is more important than timing the market.” That concept is extremely important, as individual investors tend to panic and sell when markets are down and increase their contributions when markets are soaring. To keep from “beating themselves,” investors need to keep up the fixed dollar contributions – in good market times and bad. That is the path to winning in the long run.
Simply put, start playing the game early and keep the game very simple.
Robert R. Johnson, PhD, CFA, CAIA, is president and CEO of The American College of Financial Services, a non-profit, accredited, degree granting institution located in Bryn Mawr, PA.
He is the author of multiple books and over 80 scholarly articles on portfolio management, asset valuation, wealth management, and monetary policy. He is co-author of the books Invest With the Fed, Strategic Value Investing, The Tools and Techniques of Investment Planning, and Investment Banking for Dummies.