Millionaire Teacher (5 page)

I threw out a minimum dollar figure that I thought they should save each month. It was double what they were currently saving.

The woman (who I'll call Julie) thought it was an attainable amount. Her husband (who I'll call Tom) thought it was crazy. So I asked them to do a couple of things:

The next time we had dinner together, they told me their results, which had given them both a jolt. Julie was surprised at how much she was spending on eating out, buying clothes, and purchasing small items such as Starbucks coffee.

Tom was surprised at how much he was spending on beers at the clubhouse when he went golfing with his buddies.

As the three-month period progressed, an awakening took place. Pulling receipts from their wallets and writing down their expenses each evening made them realize how much they were squandering. As Tom explained: “I knew that I had to write those purchases down at the end of the day, which acted as an accountability measurement. So I started spending less.”

Financially efficient households know what their costs are. By writing down expenses, two things generally occur. You get an idea of how much you spend in a month, providing an idea of how much you can invest. It also makes you accountable for your spending, which encourages most people to cut back.

The next step is to figure out exactly what you get paid in the average month.

When you subtract your average monthly expense costs from your income, you can get an idea of how much you can afford to invest. Don't wait until the end of the month to invest that money; instead, make the transfer payment to your investment of choice on the day you get paid. Otherwise, you might not have enough left at the end of the month (after a few too many nights out) to follow through with your new financial plan. My wife made that mistake before we were married, investing whatever amount she had left in her account at the end of the month or the end of the year. When she switched things around and automatically had money transferred from her savings account on the date she was paid, she ended up investing twice as much.

My friends Julie and Tom had the same realization. After a year, they had doubled the amount that they were investing. Two years later when the same conversation came up, I found they had tripled the amount they were originally putting away. Both said the same thing: “We didn't know where that money was going each month. It doesn't feel like we live any differently than we did three years ago, but the deposits in our investment account don't lie. We've tripled our savings.”

After a while, you probably won't have to write down every penny you spend. You'll fall into a healthy spending pattern, and the money that gets transferred automatically to your investment account can grow over time.

Here's another useful tip. Over the years, your salary will most likely rise. If it increases by $1,000 in a given year, add at least half of it to your investment account, while putting the rest in a separate account for something special. That way, you'll get rewarded twice for the salary increase.

When You Definitely Shouldn't Invest

Before getting wrapped up in how much money you can save and invest, there's one very important thing you need to clear up. Are you paying interest on credit cards? If you are, then it makes no financial sense to invest money. Most credit cards charge 18 to 24 percent in interest annually. Not paying them off in full at the end of the month means that your friendly card company (the one you'll never leave home without) is sucking your money from an intravenous drip attached to your femoral artery. You don't have to be smarter than a fifth grader to realize that paying 18 percent interest on credit-card debt and investing money that you hope will provide returns of 10 percent makes as much sense as bathing fully clothed in a giant tub of Vaseline and then travelling home on the roof of a bus.

Paying off credit-card debt that's charging 18 percent in interest is like making a tax-free 18 percent gain on your money. And there's no way that your investments can guarantee a gain like that after tax. If any financial adviser, advertisement, or investment group of any kind promises a return of 18 percent annually, think of disgraced U.S. financier Bernie Madoff and run. Nobody can guarantee those kinds of returns.

Well, nobody except the credit-card companies. They're making 18 to 24 percent annually
from
you (if you carry a balance), not
for
you.

How and Why Stocks Rise in Value

You might be wondering how I averaged 10 percent a year on the stock market for 20 years. There were certainly years when my money dropped in value, but there were years when I earned a lot more than 10 percent as well.

Where does the money come from? How is it created?

Imagine Willy Wonka (from Roald Dahl's classic novel,
Charlie and the Chocolate Factory
) starting off with a little chocolate shop. Having big dreams, he wanted to make ice cream that didn't melt, chewing gum that never lost its flavor, and chocolate that would make even the devil sell his soul.

But Willy didn't have enough money to grow his factory. He needed to buy a larger building, hire more of those creepy little workers, and purchase machinery that would make chocolate faster than he ever could before.

So Willy hired someone to approach the New York Stock Exchange and before Willy knew it, he had investors in his business. They bought parts of his business, also known as “shares” or “stock.” Willy was no longer the sole owner, but by selling part of his business to new shareholders, he was able to build a larger, more efficient factory with the shareholder proceeds, which increased the chocolate factory's profits because he was able to make more treats at a faster rate.

Willy's company was now “public,” meaning that the share owners (should they choose to) could sell their stakes in Willy's company to other willing buyers. When a publicly traded company has shares that trade on a stock market, the trading activity has a negligible effect on the business. So Willy, of course, was able to concentrate on what he did best: making chocolate. The shareholders didn't bother him because generally, minority shareholders don't have any influence in a company's day-to-day operations.

Willy's chocolate was amazing. Pleasing the shareholders, he began selling more and more chocolate. But they wanted more than a certificate from the New York Stock Exchange or their local brokerage firm proving they were partial owners of the chocolate factory. They wanted to share in the business profits that the factory generated. This made sense because shareholders in a company are technically owners.

So the board of directors (which was voted into their positions by the shareholders) decided to give the owners an annual percentage of the profits, known as a dividend, and everyone was happy. This is how it worked: Willy's factory sold about $100,000 worth of chocolate and goodies each year. After paying taxes on the earnings, employee wages, and maintenance costs, Willy Wonka's Chocolate Factory made year-to-year profit of $10,000, so the company's board of directors decided to pay its shareholders $5,000 of that annual $10,000 profit and split it among the shareholders. This is known as a dividend.

The remaining $5,000 profit would be reinvested back into the business—so Willy could pay for bigger and better machinery, advertise his chocolate far and wide, and make chocolate even faster, generating higher profits.

Those reinvested profits made Willy's business even more lucrative. As a result, the Chocolate Factory doubled its profits to $20,000 the following year, and it increased its dividend payout to shareholders.

This of course caused other potential investors to drool. They wanted to buy shares in the factory too. Now there were more people wanting to buy shares than there were people who wanted to sell them. This created a demand for the shares, causing the share price on the New York Stock Exchange to rise. (If there are more buyers than sellers, the share price rises. If there are more sellers than buyers, the share price falls.)

Over time, the share price of Willy's business fluctuated: sometimes climbing, sometimes falling, depending on investor sentiment. If news about the company was good, it increased public demand for the shares, pushing up the price. On other days, investors grew pessimistic, causing the share price to fall.

Willy's factory continued to make more money over the years. And over the long term, when a company increases its profits, the stock price generally rises along with it.

Willy's shareholders were able to make money in two different ways. They could realize a profit from dividends (cash payments given to shareholders usually four times each year) or they could wait until their stock had increased substantially in value on the stock market and choose to sell some or all of their shares.

Here's how an investor could hypothetically make 10 percent a year from owning shares in Willy Wonka's business:

Montgomery Burns had his eye on Willy Wonka's Chocolate Factory shares, and he decided to buy $1,000 of the chocolate company's stock at $10 a share. After one year, if the share price rose to $10.50, this would amount to a five percent increase in the share price ($10.50 is five percent higher than the $10 that Burns paid).

And if Burns was given a $50 dividend, we could say that he had earned an additional five percent because a $50 dividend is five percent of his initial $1,000 investment.

So if his shares gain five percent in value from the share-price increase and he makes an extra five percent from the dividend payment, then after one year Burns potentially would have made a 10 percent profit on his shares. Of course, only the five percent dividend payout would go into his pocket as a “realized” profit. The five percent “profit” from the price appreciation (as the stock rose in value) would only be realized if Burns sold his Willy Wonka shares.

Montgomery Burns, however, didn't become the richest man in Springfield by buying and selling Willy Wonka shares when they fluctuated in price. Studies have shown that, on average, investors who buy shares and sell them again quickly don't tend to make profits as high as investors who hold onto their shares over the long term.

Burns held onto those shares for many years. Sometimes the share price rose and sometimes it fell. But the company kept increasing its profits, so the share price increased over time. The annual dividends kept a smile on Montgomery Burns' greedy little lips, as his profits from the rising stock price coupled with dividends earned him an average potential return of 10 percent a year.

However, Burns wasn't rubbing his bony hands together as gleefully as you might expect because at the same time he bought Willy Wonka shares, he also bought shares in Homer's donuts and Lou's bar. Neither business worked out, and Burns lost money.

Driving him really crazy, however, was missing out on shares in the joke-store company, Bart's Barf Gags. If Burns had bought shares in this business, he would be laughing—all the way to the bank. Share prices quadrupled in just four years.

In the following chapter, I will show you that one of the best ways to invest in the stock market is to own every stock in the market, rather than trying to follow the strategy of Burns and guess which stocks will rise. Though it sounds impossible to buy virtually every stock in a given market, it's made easy by purchasing a single product that owns every stock within it.

Before getting to that, remember that you can invest half of what your neighbors invest over your lifetime and still end up with twice as much money—if you start early enough. For patient investors, the aggregate returns of the world's stock markets have dished out phenomenal profits.

For example, the U.S. stock market has averaged 9.96 percent annually from 1920 to 2010. There were periods where it grew faster than that, while it dropped back at other times. But that 9.96 percent average return, as shown in
Table 2.1
, has provided some impressive long-term profits. Invest early, and invest frequently. The odds are high that you'll slowly grow very wealthy. Let me show you how.

Table 2.1
How $1,000 Would Grow Over Time If It Made 9.96% Annually

Source:
The Value Line Investment Survey; Morningstar

Notes

1.
Jay Steele,
Warren Buffett, Master of the Market
(New York:Avon Books, 1999), 17.

2.
Andrew Kilpatrick,
Of Permanent Value, The Story of Warren Buffett
(Birmingham, Alabama: Andy Kilpatrick Publishing Empire, 2006), 226.

3.
The Value Line Investment Survey—A Long-Term Perspective Chart 1920–2005 and Morningstar Performance Tracking of DOW Jones ETF from 2005 to 2011.

4.
Jeremy Siegel,
Stocks for The Long Run
, 3rd ed. (New York: McGraw-Hill, 2002), 18.

RULE 3

Small Percentages Pack Big Punches

In 1971, when the great boxer Muhammad Ali was still undefeated, U.S. basketball star Wilt Chamberlain suggested publicly that he stood a chance beating Ali in the boxing ring. Promoters scrambled to organize a fight that Ali considered a joke. Whenever the ultraconfident Ali walked into a room with the towering Chamberlain within earshot, he would cup his hands and holler through them: “Timber-r-r-r-r!”

While Chamberlain felt that one lucky punch could knock Ali out and that he stood a decent chance in a fight, the rest of the sporting world knew better. Chamberlain's odds of winning were ridiculously low, and his bravado could only lead to significant pain for the great basketball player.

As legend has it, Ali's “Timber-r-r-r-r!” taunts eventually rattled Chamberlain's nerves to put a stop to the pending fight.
1

Most people don't like losing, and for that reason there are certain things most of us won't do. If we're smart (sorry Wilt) we won't bet a professional boxer that we can beat him or her in the ring. We won't bet a prosecuting lawyer that we can defend ourselves in a court of law and win. We won't put our money down on the odds of beating a chess master at chess.

But would we dare challenge a professional financial adviser in a long-term investing contest? Common sense initially suggests that we shouldn't. However, this may be the only exception to the rule of challenging someone in their given profession—and beating them easily.

With Training, the Average Fifth Grader Can Take on Wall Street

The kid doesn't have to be smart. He just needs to learn that when following financial advice from most professional advisers, he won't be steered toward the best investments. The game is rigged against the average investor because most advisers make money for themselves—at their clients' expense.

The selfish reality of the financial service industry

The vast majority of financial advisers are salespeople who will put their own financial interests ahead of yours. They sell you investment products that pay them (or their employers) well, while you're a distant second on their priority list. Many of us know people who work as financial planners, and they're fun to talk to at parties or on the golf course. But if they're buying actively managed mutual funds for their clients, they're doing their clients a disservice.

Instead of recommending actively managed mutual funds (which the vast number of advisers do), they should direct their clients toward index funds.

Index funds—What experts love but advisers hate

Every nonfiction book has an index. Go ahead, flip to the back of this one and scan all those referenced words representing this book's content. A book's index is a representation of everything that's inside it.

Now think of the stock market as a book. If you went to the back pages (the index) you could see a representation of everything that was inside that “book.” For example, if you went to the back pages of the U.S. stock market, you would see the names of such listed companies as Wal-Mart, The Gap, Exxon Mobil, Procter & Gamble, Colgate-Palmolive, and the directory would go on and on until several thousand businesses were named.

In the world of investing, if you buy a U.S. total stock market index fund, you're buying a single product that has thousands of stocks within it. It represents the entire U.S. stock market.

With just
three index funds
, your money can be spread over nearly every available global money basket:

I'll explain the bond index in Chapter 5, and in Chapter 6, I'll introduce you to four real people from across the globe who created indexed investment portfolios. It was easy for them (as you'll see) and it will be easy for you.

That's it. With just three index funds, you'll beat the pants (and the shirts, socks, underwear, and shoes) off most financial professionals.

Financial Experts Backing the Irrefutable

Full-time professionals in other fields, let's say dentists, bring a lot to the layman. But in aggregate, people get nothing for their money from professional money managers . . . The best way to own common stocks is through an index fund.
2

Warren Buffett, Berkshire Hathaway Chairman

If you were to ask Warren Buffett what you should invest in, he would suggest that you buy index funds. As the world's greatest investor, and as a man slowly giving away his fortune to charity, Warren Buffett's testimony is part of his pledge to give back to society. In this case, he's giving back knowledge: be wary of the financial service industry, and invest with index funds instead.

I don't believe I would have amassed a million dollars on a teacher's salary while still in my 30s if I were unknowingly paying hidden fees to a financial adviser. Don't think I'm not a generous guy. I just don't want to be giving away hundreds of thousands of dollars during my investment lifetime to a slick talker in a salesperson's cloak. And I don't think you should either.

What would a nobel prize-winning economist suggest?

The most efficient way to diversify a stock portfolio is with a low fee index fund.
3

Paul Samuelson, 1970 Nobel Prize in Economics

Arguably the most famous economist of our time, the late Paul Samuelson was the first American to win a Nobel Prize in Economics. It's fair to say that he knew a heck of a lot more about money than the brokers suffering from conflicts of interest at your neighborhood Merrill Lynch, Edward Jones, or Raymond James offices.

The typical financial planner won't want you knowing this, but a dream team of Economic Nobel Laureates clarifies that advisers and individuals who think they can beat the stock market indexes are likely to be wrong time after time.

They're just not going to do it. It's just not going to happen.
4

Daniel Kahneman, 2002 Nobel Prize in Economics, when asked about investors' long-term chances of beating a broad-based index fund

Kahneman won the Nobel Prize for his work on how natural human behaviors negatively affect investment decisions. Too many people, in his view, think they can find fund managers who can beat the market index over the long haul.

Any pension fund manager who doesn't have the vast majority—and I mean 70% or 80% of his or her portfolio—in passive investments [index funds] is guilty of malfeasance, nonfeasance, or some other kind of bad feasance! There's just no sense for most of them to have anything but a passive [indexed] investment policy.
5

Merton Miller, 1990 Nobel Prize in Economics

Pension fund managers are trusted to invest billions of dollars for governments and corporations. In the U.S., more than half of them use indexed approaches. Those who don't, are, according to Miller, setting an irresponsible policy.

I have a global index fund with all-in expenses at eight basis points.
6

Robert Merton, 1997 Nobel Prize in Economics

In 1994, Merton, a University Professor Emeritus at Harvard Business School, probably thought he could beat the market. After all, he was a director of Long Term Capital Management, a U.S. hedge fund (a type of mutual fund I will explain in Chapter 8) that reportedly earned 40 percent annual returns from 1994 to 1998. That was before the fund imploded, losing most of its shareholders' money, and shutting down in 2000.
7

Naturally, a Nobel Prize winner such as Merton is a brilliant man—and he's brilliant enough to learn from his mistakes. When asked to share his investment holdings in an interview with PBS News Hour in 2009, the first thing out of Merton's mouth was the global index fund that he owns, which charges just eight basis points.
7
That's just a fancy way of saying that the hidden annual fee for his index is 0.08 percent. The average retail investor working with a financial adviser pays between 12 to 30 times more than that in fees. These fees can cost hundreds of thousands of dollars over an investment lifetime. I'll show you how to get your investment fees down very close to what Robert Merton pays, learning from his mistakes.

More often (alas) the conclusions (supporting active management) can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.
8

William F. Sharpe, 1990 Nobel Prize in Economics

If you were lucky enough to have Sharpe living across the street, he would tell you that he's a huge proponent of index funds and suggest that financial advisers and mutual fund managers who pursue other forms of stock market investing are deluding themselves.
9

If a financial adviser tries telling you not to invest in index funds, they're essentially suggesting that they're smarter than Warren Buffett and better with money than a Nobel Prize Laureate in Economics. What do you think?

What Causes Experts to Shake Their Heads

Advisers get paid well when you buy actively managed mutual funds (or unit trusts, as they're known outside of North America) so they love buying them for their clients' accounts. Advisers rarely get paid anything (if at all) when you buy stock market indexes, and desperately try to steer their clients in another (more profitable) direction.

An actively managed mutual fund works like this:

While a total U.S. stock market index owns nearly all the stocks in the U.S. market all of the time, an active mutual fund manager buys and sells selected stocks repeatedly.

For example, an active mutual fund manager might buy Coca-Cola Company shares today, sell Microsoft shares tomorrow, buy the stock back next week, and buy and sell General Electric Company shares two or three times within a 12-month period.

It sounds beneficially strategic, but academic evidence suggests that, statistically, buying an actively managed mutual fund is a loser's game when comparing it with buying index funds. Despite the strategic buying and selling of stocks by a fund manager for his or her fund, the vast majority of actively managed mutual funds will lose to the indexes over the long term. Here's why:

When the U.S. stock market moves up by, say, eight percent in a given year, it means the average dollar invested in the stock market increased by eight percent that year.
10
When the U.S. stock market drops by, say, eight percent in a given year, it means the average dollar invested in the stock market dropped in value by eight percent that year.

But does it mean that if the stock market made (hypothetically speaking) eight percent last year, every investor in U.S. stocks made an eight percent return on their investments that year? Of course not. Some made more, some made less. In a year where the markets made eight percent, half of the money that was invested in the market that year would have made more than eight percent and half of the money invested in the markets would have made less than eight percent. When averaging all the “successes” and “losses” (in terms of individual stocks moving up or down that year) the average return would have been eight percent.

Most of the money that's in the stock market comes from mutual funds (and index funds), pension funds, and endowment money.

So if the markets made eight percent this year, what do you think the average mutual fund, pension fund, and college endowment fund would have made on their stock market assets during that year?

The answer, of course, is going to be very close to eight percent. Before fees.

We know that a broad-based index fund would have made roughly eight percent during this hypothetical year because it would own every stock in the market—giving it the “average” return of the market. There's no mathematical possibility that a total stock market index can ever beat the return of the stock market. If the stock market makes 25 percent in a given year, a total stock market index fund would make about 24.8 percent after factoring in the small cost (about 0.2 percent) of running the index. If the stock market made 13 percent the following year, a total stock market index would make about 12.8 percent.

A financial adviser selling mutual funds seems, at first glance, to have a high prospect of getting his or her hand on your wallet right now. He or she might suggest that earning the same return that the stock market makes (and not more) would represent an “average” return—and that he or she could beat the average return through purchasing superior actively managed mutual funds.

If actively managed mutual funds didn't cost money to run, and if advisers worked for free, investors' odds of finding funds that would beat the broad-based index would be close to 50–50. In a 15-year-long U.S. study published in the
Journal of Portfolio Management
, actively managed stock market mutual funds were compared with the Standard & Poor's 500 stock market index. The study concluded that 96 percent of actively managed mutual funds underperformed the U.S. market index after fees, taxes, and survivorship bias.
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