Everyone loves stocks. Maybe because they were the first easily investable security. Maybe because betting on businesses satisfies our gambling instinct – everyone fancies himself a handicapper when it comes to things we can read about in the paper. You can express yourself through stock picking – gunslinger, value hunter, socially responsible investor – whatever your narrative the market can gratify your emotions. And of course stocks are staples of polite male conversation.
Stocks can work – they are capable of providing a rate of return adequate to satisfy long-term goals. Save moderately, buy and hold stocks, and you are pretty much assured of a comfy retirement. A 4-5% risk premium (the amount over T-bills that you are compensated for taking extra risk) will do that. So why do so few high-earning baby boomers have comfortable nest eggs? The average investor underperforms the S&P 500 by 6% annually, meaning that they would be better off in a savings account.
Our emotions conspire against us, leading us to chase recent performers and panic sell when we should be buying in bulk. The financial media is unhelpful, since most journalists are equally clueless, and worse, cater to an industry that lives on commissions, sales fees, and management fees. Even the savvy self-directed investor who comes across Warren Buffett or reads his mentor Graham can get impatient and wreck his account. Intelligence alone won’t cut it in this counterintuitive game, and the market is unforgiving of hubris.
But stocks can work. All you have to do is give up trying to beat the market. Treat it like a savings account – save regularly and automatically invest in an index fund. If you’re earning, you’re investing, no matter what you hear on the news. Ride out the bear markets – if anything invest more, since future returns go up as prices go down.
That’s it. If you can stand being a dull conversationalist you’ll not only beat all of your friends, but most fund managers. It’s easy because you’re getting paid for risks they are taking. For a long-term investor, volatility doesn’t matter, and for an indexer business risk doesn’t matter. You’re eating others’ lunch.
That’s really all you need to know, since the 4-5% equity risk premium will get the job done. Just add some Treasury notes as you get older to reduce the volatility (or don’t – you should be rich enough by then not to care).
Just one more thing – since you’re the kind of person who does things right, you may as well pick up an extra couple percent of premium (which gives you twice as much money by retirement). Just use a better index fund, one that is equal-weighted (such as RSP) instead of market cap weighted like SPY. Market cap weighting sounds logical until you think about how much harder it is for a huge company to double in value than a small company. Better still, eliminate your home country risk and use an international index fund like VT.
That’s it. That’s not what I do, but it will do, and it’s free.