Blog 3: I want you to be average

How can I be telling you to be average? I am not talking about the pursuit of your goals. In that regard, we always taught you to aspire to be the best you can absolutely be, and I still believe that to be true. But when it comes to the world of investing, my hope for you is to be absolutely boring and completely average! By average, I mean I want your investment portfolio to get the average return the stock market provides in any given year. In my previous post, You will spend every penny you earn, we talked about how to live on less than you earn. Today’s post is about what to do with those savings.

I am attempting to make my posts more concise (and less boring), but I admit up front that this post will fail. It will probably be a little long (and boring) because there are a lot of terms I want to explain and not just assume you know what they mean. Investing in the stock market is the most counter-intuitive endeavor you will ever undertake. That is because it is the only thing where the LESS you do, the BETTER your outcome will be. Imagine if that were true in school??? Or in sports?? Or in getting stronger? Nope, we know it doesn’t work that way. In just about every field the more effort you put in, the better your outcome. Well, I am here to tell you that your investment portfolio works the exact opposite, and I am going to prove it to you!

WHAT IS A STOCK?

When you own a stock in a company, you are a part owner of that company. You own a very very small part of that company. In my experience, people inside of those companies are very good at trying to survive. They work to create new products, they work to stay ahead of their competition, they work to grow their businesses and be more profitable. They do this to make themselves AND the shareholders (i.e. those who own the company) rich! When you own a share of Apple, Inc. the CEO down to the factory janitor are working to make you rich! All those people driving around trying to get to work in the morning, to the extent they work in a public company that has stock shares outstanding, they are working for you! The better they do, that will be reflected in their stock price and the higher the stock will go. So, if you see some guy taking a two-hour lunch, you might want to tap him on the shoulder and tell him: “Hey buddy, get back to work!”

INDIVIDUAL STOCKS VS. MUTUAL FUNDS

Should you own an individual stock or own a bunch of different stocks? Owning an individual stock is a little bit like gambling and takes a lot of work to be good at it. You have to decide which company to buy, when to buy it and when to sell it because no company succeeds forever. See this chart below, it shows the top 10 stocks in the S&P 500 (which is an index of the largest 500 companies in the U.S. – more on that in a minute):

A table of numbers and numbers Description automatically generated with medium confidence

https://awealthofcommonsense.com/2023/06/the-stock-market-will-pick-the-winners-for-you/

Notice how often the list of top 10 companies changes every few years? Look at IBM, they were the biggest company in 1980 – 1990. They fell off the top 10 completely, only to come back in 2010. If you are an individual stock owner, you will have to try to keep up with who is winning and who is losing. Then look at Apple. They were not in the top 10 in 2005, then shot to #2 in 2010 (thank you iPod/iPhone). They have been a top dog ever since. My point in all this, it is extremely difficult (meaning impossible) for an individual to pick individual stocks and expect to achieve good results over time.

Luckily you don’t have to. There is a financial instrument you can buy called a mutual fund. A futual fund is a collection of many different stocks wrapped up in a single investment. You buy a single share of a mutual fund and you own a small piece of all the individual stocks that are contained inside this mutual fund. Owning a large basket of stocks gives you diversification. Therefore, you are not at the risk of trying to pick an individual winner. You own a bunch of stocks and just need there to be more winners than losers.

ACTIVE VS. PASSIVE INDEX MUTUAL FUNDS

There are over 7,000 mutual funds in the US, so how do you decide which one is best for you? First, all mutual funds measure themselves and their performance against a benchmark. Depending on the type of mutual fund, they have different benchmarks they measure themselves. The most common benchmark is the S&P 500, which is the 500 biggest companies in the U.S.A.

Mutual funds can be grouped into two types: Active vs. Passive. Active means that the mutual fund has managers that are actively trying to pick individual stocks to outperform their benchmark (i.e. S&P 500). Passive mutual funds don’t try to beat their benchmark, they simply match the benchmark (i.e. S&P 500).

This sounds easy, doesn’t it? Just pick the mutual funds that consistently beat their benchmarks – DONE! Not so fast! My preference, and what we do personally is invest in passive index mutual funds either the S&P 500 or the Total Stock Market Index, which is all US publicly traded companies in the U.S.A. (~4,000 stocks).

I think this is the best approach is for two main reasons:

  1. Fees or expenses ratios (or ER)
  2. Overall Performance (what does best over time)

Fees are what mutual fund companies charge you to run the mutual fund. As you can imagine, a fund that is “active” has smart, very highly paid people trying to outsmart the market. They have to do a bunch of research, run complicated algorithms to pick the winners and avoid the losers. They are “actively”trading during the year to ourperform. Those expenses can be ~1%. On top of that, many people have financial advisors to help them decide which of these funds are best and those people charge you ANOTHER 1%. So we are talking about 2% of the value of your portfolio. That doesn’t sound so bad. They get 2%, you keep 98%.

In a passive index fund, the expenses are more like 0.04%. The reason is nobody is doing any research or running elaborate models, all they are doing is matching the index benchmark. No need to outsmart, no need to pick the next up and coming winner (like Apple) or decide on the losers to drop (like IBM). But can ~2% in fees really make a difference on the size of your investment returns over time?

In the example below you can see the difference between two portfolios. Both invest the same amount, for the same period of time. One is in an active fund with 2% fees, the other is in a passive fund with 0.05% in fees.

A screenshot of a calculator Description automatically generated

https://www.choosefi.com/financial-independence/cfp-diy-why-fees-matter/

Over a 30-year period the difference in ending balance of the two portfolios is more than a MILLION dollars! 2% in fees, compounded over 30 years really adds up!

But what if the active funds perform better than the passive index fund to “make up” for those fees? Surely these smart active managers, and your financial advisor must do better than the boring passive index fund, right? Wrong again!

A table with numbers and text Description automatically generated

https://awealthofcommonsense.com/2023/09/how-to-outperform/

This table looks at various types of active mutual funds and how they perform vs. their benchmark or index. The numbers in the chart represent the % of time those active funds UNDERPERFORM their index. Take a look at the top row. It says 72.44% of all domestic funds underperform their index in a single year. Go out 20 years, that number shoots up to 93.12%.

In short, not only is it nearly impossible to pick individual stocks and beat the index, even an active mutual fund is very hard to beat the index. Add on the fees that you are paying a million dollars to do worse than the index. Hopefully now you can see why I believe that best advice is simply to be average, or just get the index benchmark return itself. No fees and better performance. Average is BEST!

BUCKLE UP FOR THE RIDE OF YOUR LIFE!

Stocks are extremely volatile; they go up and down. The ride can be scary. If you don’t have the conviction to hold onto your investments when the stock market is crashing, and it will periodically, then you should not invest in the stock market. But if you can hang on and wait for the stock market to come back, and it always does, you will obtain great returns.

A graph showing the stock market returns Description automatically generated

https://awealthofcommonsense.com/2023/08/rolling-the-dice-in-the-stock-market/

The chart above shows the annual returns of the S&P stock market each year from 1928-2022. You will notice that there are a lot more lines on the top part (positive years) than the bottom part (negative years). But there are some years where the negative was 40% or more! Yikes, that means if you started with $100,000, by the end of the year you had $60,000, scary stuff!

The way you smooth out the ride is with time. The longer you are invested, the less risk you take. The ride gets wild from day to day (56% of the time its up, 44% down), month to month or year to year. But when you look at this chart below, it shows what percent of the time the stock market is up over a certain period. Notice that over a 10 year period, the stock market is up 95% of the time. You go out 20yrs+ the stock market has been positive 100% of the time. So that is where I like to play, and I suggest you do the same. Any money you need within five years should not be in the stock market (we will talk about that in another post). Any money that you can afford to leave in the market for more than that, let it ride and history is on your side!

A graph with numbers and text Description automatically generated

https://awealthofcommonsense.com/2023/07/are-the-markets-stacked-against-the-little-guy/

MY PATH 

It is not that one path is “right” and the other one is “wrong”. It is just that one is far superior and only requires you to get a few things right. That superior path that we follow, and think is best is simple, boring, passive index funds. It took us almost 30 years to get on this path. To be clear, we were always saving and investing, so that was good. However, we always had a “financial guy” (that we were paying high fees to) and we were always in active mutual funds (that had high expenses) and I was on auto pilot. I have an MBA in finance, of course I love finance and investing. We were taught primarily about how to value stocks and companies. Basically, how to be active. Why? The answer is because the financial investment community makes a lot of money from fees. The way they make that money is by selling you products. Products with high fees that you don’t need. So the deck is stacked against you in the sense that we get convinced that we have to do the complex investments. Stuff that we can’t even understand. The reason is that is a way to justify paying the financial advisor his/her fees. Why would you pay someone 2% of your money (or $1,000,000 over 30 years) to buy one single boring index fund? The answer is you wouldn’t! It took me 30 years, but we are now 100% DIY (do it yourself), because what I am doing requires a few clicks of a mouse, and I feel confident that we will get the average (i.e. BEST) return!

OK, now your turn. Please leave any comments or questions below in the comment section!

4 thoughts on “Blog 3: I want you to be average”

  1. Are you still invested in only the stock market or are you starting to put some money into bonds and less risky securities?

    1. Great question Marco! The question you are asking is what is regarded as asset allocation. Asset allocation is generally something that changes over time based on a person’s risk tolerance and what time horizon you are expected to be invested. First, as you start building savings, a general rule of thumb is that you should hold 3-6 months of living expenses in cash. This is what is called an emergency fund. You want enough money in cash so that if something happens (i.e. car repair) you can comfortably pay for it without having to sell stocks or go into credit card debt. It is also a cushion in case you lose your job and need to live a few months before you are able to find another job. So when we talk about asset allocation, that is beyond an emergency fund.

      For you or someone just starting out, you can feel comfortable with 100% in a stock index fund. The reason is you won’t need that money for decades (30-40 years). So you have a very long time horizon and you want the benefits that come with taking more risk, which is more return/reward. For someone with that time horizon, you want to keep investing automatically from your paycheck and let it ride. As you get closer to wanting to use that money (i.e. retire), then shifting some percent of your portfolio to cash/bonds makes more sense. The reason is that you will be living off that money and so you want something that is less volatile than stocks, like bonds (I will write a future post on asset allocation at some point). For us, we are 80/20 equity to bonds/cash asset allocation. This is considered pretty aggressive. A “standard allocation” is 60/40 and is considered a balanced portfolio. In the next few years, we will probably look to get into a more balanced asset allocation.

      Hope that helps!

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