Millionaire Teacher (9 page)

31.
Ajay Khorana, Henri Servaes, and Peter Tufano, “Mutual Fund Fees Around the World,”
The Review of Financial Studies 2008,
Vol. 22, No. 3 (Oxford University Press), accessed April 15, 2011,
http://faculty.london.edu/hservaes/rfs2009.pdf
.

32.
“The Greatest Investors: Peter Lynch,”
Investopedia
, accessed April 15, 2011,
http://www.investopedia.com/university/greatest/peterlynch.asp
.

33.
Morningstar.com
.

34.
John C. Bogle,
The Little Book of Common Sense Investing,
47–48.

35.
Andy Serwer, “The Greatest Money Manager of Our Time,”
Fortune,
November 15, 2006, accessed: April 15, 2011,
http://money.cnn.com/2006/11/14/magazines/fortune/Bill_miller.fortune/index.htm
.

36.
Jason Zweig, “What's Luck Got to Do with It?”
Money
, July 18, 2007, accessed April 15, 2011,
http://money.cnn.com/2007/07/17/pf/miller_interview_full.moneymag/
.

37.
Paul B. Farrell, “‘Laziest Portfolio' 2004 Winner Ted Aronson Scores Repeat Win with 15 percent Returns,” CBS
Marketwatch.com
, January 11, 2005, accessed April 15, 2011,
http://www.marketwatch.com/story/results-are-in-and-laziest-portfolio-winner-is
.

38.
Mel Lindauer, Michael LeBoeuf, and Taylor Larimore,
The Bogleheads Guide to Investing,
118.

RULE 4

Conquer the Enemy in the Mirror

My brother Ian is a huge fan of the 1999 movie
Fight Club
, particularly the scene where the lead character Tyler, played by Edward Norton, is shown throwing haymaker punches at his own swollen face. Norton's character is metaphorically battling his materialistic urges. Most investors fight similar battles in a war against themselves.

Much of that internal grappling comes from misunderstanding the stock market. I can't promise to collar your inner doppelganger, but when you understand how the stock market works—and how human emotions can sabotage the best-laid plans—you'll experience greater investment success.

When a 10 Percent Gain Isn't a 10 Percent Gain

Imagine a mutual fund that has averaged 10 percent a year over the past 20 years after all fees and expenses. Some years it might have lost money; other years it might have profited beyond expectation. It's a roller coaster ride, right? But imagine, on average, that it gained 10 percent annually even after the bumps, rises, twists, and turns. If you found a thousand investors who had invested in that fund from 1990 to 2010, you would expect that each would have netted a 10 percent annual return.

On average, however, they wouldn't have made anything close to that. When the fund had a couple of bad years, most investors react by putting less money in the fund or stop contributing to it entirely. Many investment advisers would say: “This fund hasn't been doing well lately. Because we're looking after your best interests, we're going to move your money to another fund that is doing better at the moment.” And when the fund had a great year, most individual investors and financial advisers scramble to put more money in the fund, like feral cats around a fat salmon.

This behavior is self-destructive. They sell or cease to buy after the fund becomes cheap, and they buy like lunatics when the fund becomes expensive. If there weren't so many people doing it, we would call it a “disorder” and name it after some dead Teutonic psychologist. This kind of investment behavior ensures that investors pay higher-than-average prices for their funds over time. Whether it's an index fund or an actively managed mutual fund, most investors perform worse than the funds they own—because they like to buy high, and they hate buying low. That's a pity.

John Bogle, the founder of Vanguard, explains in his book,
The Little Book of Common Sense Investing
, that the average mutual fund reported a 10 percent annual gain from 1980 to 2005 after fees and expenses, but investors in those funds over the same time period only averaged 7.3 percent per year.
1
Their fear of low prices prevented them from buying when the funds were low, while their elation at high prices encouraged purchases when fund prices were high. Such bizarre behavior has devastating financial consequences when investors give away 2.7 percent annually because of their knee-jerking alter egos.

Over a 25-year period, that's a pretty expensive habit:

$50,000 invested at 10 percent a year for 25 years = $541,735.29

$50,000 invested at 7.3 percent a year for 25 years = $291,046.95

Cost of irrationality = $250,688.34

But what if you didn't care what the stock market was doing?

As investors, you really don't have to watch the stock market to see if it's going up or down. In fact, if you bought a market index fund for 25 years, with an equal dollar amount going into that fund each month (called “dollar-cost averaging”) and if that fund averaged 10 percent annually, you would have averaged 10 percent or more. Why more? If you put a regular $100 a month into a fund, that $100 would have bought fewer unit shares of that fund when prices were high, but it would have bought more unit shares of that fund when prices were lower.

Most investors don't do that—they exhibit nutty behavior

Combine the crazy behavior of the average investor with the fees associated with actively managed mutual funds, and the average investor ends up with a comparatively puny portfolio compared with the disciplined investor who puts in the same amount of money every month into index funds.
Table 4.1
categorizes investors who will be working—and adding to their investments—for at least the next five years.

Table 2.1
The Average Investor Compared with the Evolved Investor

I'm not going to suggest that all indexed investors are evolved enough to ignore the market's fearful roller coaster, while shunning the self-sabotaging caused by fear and greed. But if you can learn to invest regularly in indexes and remain calm when the markets fly upward or downward, you'll grow far wealthier. In
Table 4.2
, you can see examples based on actual U.S. returns between 1980 and 2005.

Table 4.2
Historical Differences Between the Average Investor and the Evolved Investor

Note: Although the U.S. stock market has averaged about 10 percent annually over the past 100 years, there are periods where it performs better and there are periods where it performs worse. From 1980 to 2005, the U.S. stock market averaged slightly more than 12.3 percent a year.
2

The figure on the left side ($84,909.01) is probably a little generous. The 10 percent annual return for the average actively managed fund has been historically overstated because it doesn't include sales fees, adviser wrap fees, or the added liability of taxes in a taxable account.

Disciplined index investors who don't self-sabotage their accounts can end up with a portfolio that's easily twice as large as that of the average investor over a 25-year period.

Small details like these can allow people with middle-class incomes to amass wealth more effectively than their high-salaried neighbors—especially if the middle-class earners think twice about spending more than they can afford. Even if your neighbors invest twice as much as you each month, if they are average, they will buy actively managed mutual funds, and they will either chase hot-performing funds or fail to keep a regular commitment to their investments when the markets fall. They'll feel good about buying into the markets when they're expensive, and they won't be as keen to buy when they're on sale.

I don't want you to be like your neighbors. Avoid that kind of self-destructive behavior and you'll increase your odds of building wealth as an investor.

It's Not Timing the Market that Matters; It's Time in the Market

There are smart people (and people who aren't so smart) who mistakenly think they can jump in and out of the stock market at opportune moments. It seems simple. Get in before the market rises and get out before the market drops. This is referred to as “market timing.” But most financial advisers have a better chance beating Roger Federer in a tennis match than effectively timing the market for your account.

Vanguard's Bogle, who was named by
Fortune
magazine as one of the four investment giants of the twentieth century has this to say about market timing:

After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don't even know anybody who knows anybody who has done it successfully and consistently.
3

When the markets go raving mad, dramatically jumping in and out can be tempting. But stock markets are highly irrational and characterized by short-term swings. The stock market often will fly higher than most people expect during a euphoric phase, while plunging further than anticipated during times of economic duress. There's a simple, annual, mechanical strategy that you can follow to protect your money from excessive crashes, which I'll outline in Chapter 5. Your investment will still fall in value when the stock market falls, but not as much as your neighbor's—and that can help you sleep better when the stock market isn't cooperating.

The strategy that I'll show you doesn't involve trying to guess the stock market's direction. Forecasting where it's going to go over a short period is like trying to guess which frantic, nightly moth is going to get singed by the light bulb first.

Doing nothing but holding onto your total stock market index fund might sound boring during a financial boom and it might sound terrifying during a financial meltdown. But the vast majority of people (including professionals) who try jumping in and out of the stock market allow their emotional judgments to hurt their profits as they often end up buying high and selling low.

What can you miss by guessing wrong?

Studies show that most market moves are like the flu you got last year or like the mysterious $10 bill you found in the pocket of your jeans. In each case, you don't see it coming. Even when looking back at the stock market's biggest historical returns, Jeremy Siegel, a professor of business at University of Pennsylvania's Wharton School, suggests that there's no rhyme or reason when it comes to market activity. He looked back at the biggest stock market moves since 1885 (focusing on trading sessions where the markets moved by five percent or more in a single day) and tried connecting each of them to a world event.
4

In most instances, he couldn't find logical explanations for such large stock market movements—and he had the luxury of looking back in time, and trying to match the market's behavior with historical world news. If a smart man like Siegel can't make connections between world events and the stock market movements with the benefit of hindsight, then how is someone supposed to predict future movements based on economic events—or the prediction of economic events to come? It's as improbable as guessing which directional changes a frantic, unleashed 10-month-old Labrador retriever is going to make in an open field.

If you're ever convinced to act on somebody's short-term stock market prediction, it could end up being a very expensive mistake. Let's look at the U.S. stock market over the period of January 1, 1982, to December 31, 2005, as an example.

During this time, the stock market averaged returns of 10.6 percent annually.

But if you didn't have money in the stock market during the best 10 trading days, your average return would have dropped to 8.1 percent annually. If you missed the best 50 trading days, your average return would have been just 1.8 percent annually.
5
Markets can move so unpredictably, and so quickly. If you take money out of the stock market for a day, a week, a month, or a year, you could miss the best trading days of the decade. You'll never see them coming. They just happen. More importantly, as I said before, neither you nor your broker are going to be able to predict them.

Legendary investor and self-made billionaire Kenneth Fisher, who has his own column in
Forbes
magazine, had this to say about market timing:

Never forget how fast a market moves. Your annual return can come from just a few big moves. Do you know which days those will be? I sure don't and I've been managing money for a third of a century.
6

The easiest way to build a responsible, diversified investment account is with stock and bond index funds. I'll discuss bond indexes in Chapter 5, but for now, just recognize them as instruments that generally create stability in a portfolio. Many people view them as boring because they don't produce the same kind of long-term returns that stocks do. But they don't fall like stocks are apt to do either. They're the steadier, slower, and more dependable part of an investment portfolio. A responsible portfolio has a certain percentage allocated to the stock market and a certain percentage allocated to the bond market, with an increasing emphasis on bonds as the investor ages.

But when stocks start racing upward and everyone's getting giddy on the profits they're making, most people ignore their bonds (if they own any at all) and they buy more stocks. Many financial advisers fall prey to the same weakness. But those ignoring their planned allocations between stocks and bonds set themselves up for disaster.

How can you ensure that you're never a victim? It's far easier than you might think. If you understand exactly what stocks are—and what you can expect from them—you'll fortify your odds of success.

On Stocks . . . What You Really Should Have Learned in School

The stock market is a collection of businesses. It isn't just a squiggly bunch of lines on a chart or quotes in the newspaper. When you own shares in a stock market index fund, you own something that's as real as the land you're standing on. You become an indirect owner of all kinds of industries and businesses via the companies you own within your index: land, buildings, brand names, machinery, transportation systems, and products, to name a few. Just understanding this key concept can give you a huge advantage as an investor.