In my last blog I encouraged you to invest your tax refund to create wealth for you in the future rather than spend it all now. I gave you several statistics from the book “Everyday Millionaires” by Chris Hogan that showed that most millionaires were normal folks that had no special privileges and that did not have paying jobs. 79% of them became millionaires by simply investing in their employer sponsored retirement plan for 20+ years. Their wealth came from the compound interest on those deposits each month. For the steady long-term savers, the rule of thumb is ~30% of the money in their accounts came from them putting money in and 70% of the money in their accounts came from the compound interest earned on the money they invested over the 20+ years of steady investing. The compound interest created their wealth.
Those that study the wealthy usually recommend the most effective ways to invest are:
- Invest in yourself. Examples include investing in books, training, mentoring, and so on to develop your God given natural gifts to become the best (i.e., top 10%) at what you do at your job or in your own business.
- Invest in assets that create income. While there are many assets that create income the most proven & reliable assets to create income are:
- Ownership of the Stock Market
- Ownership of Real Estate
- Ownership of your own business
- Ownership of Intellectual Property (inventions, published books, training, etc…)
In each case the asset creates the wealth and because you are the owner the wealth goes to you. This blog will focus on investing tips for ownership of stocks (based on lessons learned from my investment geek husband).
Lets begin with what is most important. The 2 biggest drivers for creating wealth through investing in stocks are:
- The amount of money you put in each month
- The percent of investment in Stocks vs Bonds
While there are many other parameters such as, the particular funds & industries you invest in, the advisory fees, the fund fees and so on it is important to realize that the 2 biggest determiners of your future wealth is that you consistently put money in each month to investments that a good percent of those investments are in stocks. Stocks have far more risk that bonds but the reward for taking that risk is a larger return over the long term (>10years). I like the slogan “Be an owner not a loaner”. In other words, you have a higher likelihood of creating more wealth statistically by owning a piece of publicly traded companies than by investing in bonds where you are part owner of a loan. In general businesses create more wealth over the long term than loans. However, if you need the money in <10 years then stocks are not worth the risk. They money in stocks is much more likely to be made if you buy and hold for >10 years.
When investing in stocks there are risks that you can mitigate and there are risks that you can’t mitigate. The risks that you can mitigate are:
- The risk of individual stocks going bankrupt (e.g., Enron, Lehman Brothers, etc..) or loosing significant value
- The risk of stock industries (e.g., health care, financial, real estate, technology companies, etc….) loosing significant value
Both risks are mitigated through diversification by owning as many stocks and industries as possible rather than just a few. In other words, by investing in globally diversified index funds or mutual funds you reduce your risk by effectively owning a small piece of all the companies in the market rather than just a few. There is less risk in owning 10 thousand companies in index/mutual funds than owning 10 companies. This is because when some companies have significant losses their losses are averaged out by the significant gains of the companies that had record years. There are many studies that show how difficult it is to pick the companies in advance that have the record years. The statistics show that the folks that do well at picking stocks do not persist at it. They may do well in one year, two years, even three years in a row but most don’t do well at it for 10 years in a row. The huge percent (e.g. >99%) of stock pickers that are unable to persist in picking the winners 10+ years in a row cause the studies to conclude that when they do pick winners it is more due to luck than skill. The big winners in one year are often the big losers in the next year or a few years later. The reason for tagging it as luck is due to what the academics call the “efficient market hypothesis”. Well known academic Eugene Fama (Nobel Prize winner in Economics in 2013) used that term to mean that all the available information on companies is already built into the stock price and therefore the prices are fair. In our free market where millions of investors are making trades each day by putting out bidding prices and asking prices those prices are based on what will attract willing buyers and willing sellers who have access to all the same information on the stocks. This means in general each stock is priced fairly to both the buyers benefit and the sellers benefit so that they are both motivated to make the trade. This means there is ~ a 50% probability the stock price will go up in the future and a 50% probability the stock price will go down in the future. When stocks are priced fairly then what determines the future price is future news about the companies which no one knows. This means unless you have insider (i.e., illegal information) you have as much likelihood of picking a winner as a looser. Therefore, few people can pick winners consistently and when they do it is more due to luck than skill. This means the wisest thing to do is to not try to pick individual stocks and instead invest in large globally diversified index/mutual funds so that you capture the returns of the market to effectively get the bird in the hand than try for the 2 in the bush and come up empty.
The risk you can’t mitigate is the risk of the entire stock market having a significant loss. This happened in 2008 when almost all stocks lost significant value. However, you can manage this risk by:
- Buying and Holding stock funds for >10 years. For most periods of 10 years or more the owners of a large % of the market (e.g., via index/mutual funds not individual stocks) made a profit rather than a loss. Those that traded when the market went down rather than held on to the funds usually lost money.
- Investing in passive index funds rather than actively managed mutual funds to reduce the trading costs, reduce the yearly tax on profitable transactions, & reduce management fees.
- Having bonds in your portfolio whose profits & losses are not correlated with stocks.
In summary, the investment tip here is to invest in passive, no load, globally diversified index stock funds to capture the returns of the market and to consistently buy and hold them for >10 years.