In three simple sentences
All investment gurus are scamsters. Think about it. If they really knew exactly how to invest to gain exponential gains on their money, would they waste time writing books and conducting lessons to teach losers like you and me? I wouldn’t!
The truth is that squiggly lines and candle graphs are all justifications for an entire industry of investment professionals, instructors, personal finance gurus, and mutual fund advisors to earn millions, on the back of retail investors who are just fatigued by the plethora of information available. Who produces this information? The same industry. It is as if there is a giant conspiracy to confuse all investors to a point where they are forced to engage — and pay — one of the abovementioned professionals.
There is one exception to my overarching dismissal of an entire industry. And that is writers like Dave Ramsey and Ramit Sethi. These are the ones who try to simplify personal finance so that you and I can handle our own finances without wanting to tear our hair out.
When it really comes down to it, investment for common folk like us can really be percolated down to just three sentences. I will back it up with research, so you don’t have to take my word for it. Follow these three steps, and you will do as good, or in all probability, much better, than handing over your money to these good people.
1. Invest automatically and monthly, no matter what
YOU CANNOT TIME THE MARKET. Please, please, I beg of you. No matter what else you take away from this article, remember this mantra. There are two major (legal) reasons for this: one, investors are emotional creatures. Time and again, we have proved that instead of buying low and selling high, we do the exact opposite. It takes a lot of financial and emotional wherewithal to do what investors like Warren Buffet do on the regular, which is to buy undervalued stocks when the world seems to be ending and everyone else wants to hold on to cash.
The second reason is that markets are pretty efficient in incorporating the publicly available information into the price. That means that any and all ideas that you could have about a stock, from which you could profit, have already been used and the profit-potential has come down to zero. Of course, there are criticisms of this hypothesis (called the Efficient Market Hypothesis). However, broadly, it means that it is all but impossible to time the market consistently. You can get lucky and earn some short term profit once in a while, but as a long term investment strategy, it is quite poor.
The solution is to utilize a strategy called the dollar-cost averaging. In simple words, it means that you must invest in small but constant sums, regularly and automatically. Whether that is once a month, once biweekly, or once a week, it must be consistently done, no matter the highs or crashes of the market, in order for it to work.
DCA works because it will average out your cost of purchasing between crashes and peaks. It ensures that you are not buying when stock prices are at an all-time high.
Here is a study showing how it beats even an investor who times the market perfectly. Again, there are studies showing the exact opposite as well.
Then why DCA? Because the studies showing that lumpsum investment works better, assume two things:
- That you have the lump sum to be invested available at the beginning of the investment period. Unless you have received a windfall gain or an inheritance, this is usually not true. For an average investor, that would be akin to assuming that you have $12000 to invest at the beginning of the year, instead of having $1000 per month.
- That you will be extremely disciplined in investing whatever lump sum you receive and immediately put it into the market. As we have noted before, investors are emotional and this is, in all likelihood, not a correct assumption.
If we remove these two unrealistic assumptions, the studies show that DCA is superior to lumpsum investing. And of course, it removes three huge decisions from our heads — of deciding whether to invest, when to invest, and in what to invest. You simply plan your investments at the beginning of the year, set it, and forget it — the only kind of plans that actually work.
2. Invest in low-cost Index Funds — directly
Did you know that the most well-known investor, Warren Buffet, once bet a million dollars on an index fund beating the performance of the best hedge fund managers on the street? And the more important part for us — he won?
So what are index funds, and how were they able to beat hedge funds? To understand that, you need to know two broad philosophies of investing — active and passive. Buffet’s bet was a resounding success of passive investing over active investing.
Active investing is what most of us do. When we invest in any mutual fund which has a ‘portfolio manager’, who tracks the market, researches, and analyzes, and buys and sells stocks based on that analysis, it is active investing, despite the fact that you may not be the active one.
Passive investing, on the other hand, is usually buying an index fund — a fund that mimics the market indices like the S&P500 or DJIA.
Though active investing may generate more returns, there are costs associated with them that you can skip by investing passively:
- Cost for engaging the portfolio manager
- Cost of conducting research, analysis, etc
- Transaction costs of buying and selling, as the portfolio manager attempts to implement the analysis
- Capital gains tax as the buy-sell nature leads to short term capital gains
A study by MorningStar found that only 23% of all active funds surpassed their passive rivals over the 10-year period ended in June 2019. That means that only about 1 in 4 active funds can beat your basic index. Why would you pay fund managers hefty fees, just for a one in four chances of getting a 1–2% excess return on your investment — before fees?
And while we are on the topic of fees, an average active fund charges 1.4% as compared to an average passive fund which only charges 0.6% — and some charge as low as 0.04%.
To summarize, you would be best served by investing in an index fund that broadly mimics your equity market — the S&P500. Secondly, the only bit of research that you need to do, is to find the lowest cost index fund that you trust. This one step alone can increase your return, instead of hunting around for a well-run active fund that can beat the market.
3. Rebalance your portfolio every year
When you begin investing, you would have a set plan for investing in various categories. For example, you would have a certain percentage in cash/liquid funds, a certain percentage in more stable assets like debt, and some in equity. If you are slightly more bougie, you would also have assets like crypto, gold, and foreign currency.
As time goes, our various categories of investment perform at differing levels. Sometimes, equity performs remarkably well, at others, gold is the one glowing.
Every year, without fail, you must compare the actual values of your investments with the ratios you had set out to accomplish. Whenever these are breached, you need to rebalance — sell the ones that have done too well, and invest in the ones lagging.
The logic behind this advice is exceedingly simple. All asset classes are cyclical, and hence different ones will do well at different points of time. Instead of trying to predict economic cycles (when trained economists have failed spectacularly in doing so, who are we?), we need to follow this simple rule. Whenever an asset class breaches your limit, it means it has done well, and by selling it at the time, you ensure that you are booking the profit by selling it at a high. Similarly, when you buy into an asset class in order to bring it up to the set percentage, you buy it at a low.
For example, suppose you had a simple portfolio consisting of 50% equity and 50% gold at the beginning of the year. If equity does amazingly well in that year but gold doesn’t, you will end up with 75% equity and 25% gold. At the end of the year, sell off your equity (which has been doing well) and buy gold (which isn’t doing too well) to bring it back to a 50:50 split.
Rebalancing is not only a great way to keep your portfolio within what your risk appetite allows but also an easy way to bolster the returns on your portfolio over the long term — a lesser-known but very important advantage, in my eyes. Here is a study showing how an annually rebalanced portfolio provides higher returns than one that isn’t.
Investing is not that complicated, and now, with years of data and investor behavior studied, we have the three golden rules of investing:
- Invest automatically and monthly, no matter what
- Invest in low-cost Index Funds — directly
- Rebalance your portfolio every year
So go ahead, and make sure your money is working for YOU.
I have put together a handy little Personal Finance Crash Course e-book, covering everything from budgeting and investing, to retirement and goal planning. Click here to check it out, and thank you!