Part 3: Investing Smart

Editors Note:
Burt Mayer, a senior at Lakeside High School in Seattle, WA interned at Merriman this summer with the intention of creating educational material for young investors.  This three part series is perfect for those investors who are looking to get started but need to know the basics first.

If I’ve already convinced you to begin investing your money towards your future, give me a pat on the back.

But you’re not out of the woods yet. There’s a big difference between investing and investing intelligently. In this article I’ll try to figure out what it is, and then pass it along to you.

Stocks

Too many of my friends, mostly the sketchy ones I used as examples in describing debt securities, invest in individual stocks. They brag about their brilliant decisions and how much money they’ve made because of them (so why haven’t they paid me back yet?) As they get cockier they try to time the market, buying and selling whenever they ‘feel a hunch’. A tip: those hunches are never correct. Eventually – inevitably – they lose big and it’s going to be me buying their milkshakes at McDonalds once again.

I’m not saying that buying individual equities is always a bad idea (the filet o’ fish is, however). In fact, researching a stock and then tracking its ups and downs can be extremely fun and exciting. I do believe, though, that the purchase of individual stocks should be treated as just that: exciting entertainment.

My dad always tells me whenever I play poker with friends that I should first set aside the amount of money that I’d be willing to spend on the entertainment value of the game. That way I’m simply paying for the fun experience I’ll have playing. He also happens to know that I’m a terrible poker player, but regardless, I believe investing in an individual or small group of corporations should be treated in a similar manner. Invest how much you think the experience will be worth – if it turns out you earn money then that’s a pleasant surprise.

There are, however, smart ways to invest in equity such that you can count on positive long-term returns…

Mutual Funds

It’s a scientifically proven fact: you can’t tell whether a chocolate is going to be any good by its physical appearance. Picking one out at random is a dangerous endeavor – it could be delicious, but it could also be disgusting. That’s why the smartest chocolate eaters among us always buy the ‘assorted varieties’ box. Most likely some of the chocolates will be terrible, but others will great, and your overall chocolate eating experience will be net-positive.
That box of chocolates is, in essence, a sort of mutual fund. A mutual fund is a package consisting of little bits of hundreds, or even thousands, of different stocks.  Owning a little piece of so many different companies makes it possible to enjoy the aggressive returns of equity without being overly dependent on a single stock.

There are over 14,000 mutual funds in the world. They specialize in all different areas of the market and are managed according to different styles and strategies. They have teams of analysts who search day and night for the next hot stocks and up-and-coming asset sub-classes. And all for one single purpose: to beat the overall market. Yet almost all of them fail.

In any given year fewer than ¼ of all mutual funds, with their ivy-league brainpower and six-monitor desk setups, will beat the U.S. market as a whole, as measured by the S&P 500 index. According to the Motley Fool, over the past 10 years only 10 of the 10,000 actively managed funds in the world outperformed this most basic of indexes with any kind of consistency. That’s only 0.1%! And I can say with confidence that taken to an even longer time-span than 10 years the number of funds outperforming the market would drop effectively to 0.

So if you can’t beat the market index over the long haul, why not just invest in the index itself! Passive index funds track the market, or a select segment of the market, without anyone picking and choosing stocks or times to buy. Every year they’ll be outperformed by somebody, but over the long term they’re virtually unbeatable. As long as you have faith that the market will go up in the future, (and you should,) it’s always smarter to just ride the tide than try to paddle through it.

“The American economy is going to do fine. But it won’t do fine every year and every week and every month. I mean, if you don’t believe that, forget about buying stocks anyway… It’s a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market.”

-Warren Buffet

“..the best way to own common stocks is through an index fund…”
-Warren Buffett

I’d trust Mr. Buffett. Worth an estimated $62 billion he is by all means the Jay-Z of investing. But just in case you don’t trust Buffs and myself, here are some advantages to owning index funds over other, actively managed, mutual funds:

• Low costs – Index funds have extremely low expense ratios. Research done by Vanguard founder John Bogle suggests that the best indicator of fund performance is a low expense ratio. After all, any money you pay in fees to a mutual fund is money not going into bling.
• Tax efficient – Actively managed funds average an annual turn-over rate of 85%. That means that at the end of the year they only have 15% of the same stocks that they had at the beginning. The problem is that every time a security is sold at a profit their investors are subject to capital gains taxes. All of that buying and selling can cost an investor a full 1% of the funds annual return. Meanwhile, funds that track indexes tend to hold on to their stocks since the indexes themselves don’t change all that much.
• Simplicity and lack of style-drift – Index funds are just plain easier. They require no research into the qualifications of a fund manager, their style and strategy, or their past performance. Indexing is typically a  hands-off, long-term buy and hold approach.  Furthermore, they don’t change strategies like a fund manager might. As market conditions change or a fund manager is replaced, the style of a fund can change abruptly and dramatically. With a passive fund you always know what you’re getting because your holdings are defined by a simple, non-changing set of rules.

Diversification

“Risk is good. Not properly managing your risk is a dangerous leap”
-Evel Knievel

You’ve probably heard about the correlation between risk and return. It’s extremely straight-forward: when you take more risk in the stock market you have greater potential for higher returns. This rule is very concrete, but there exists one gaping exception: The only way to increase your expected investment return while reducing your risk is through ‘portfolio diversification’.

InvestorWords.com defines ‘diversification’ as: A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.

I define it similarly.

It’s counter-intuitive to think that adding lots of different risky market sectors will reduce the overall risk of a portfolio, but it’s absolutely true. The more you’re able to expose yourself to lots of different asset sub-classes like small and large companies, growth and value, and domestic and international, the higher you can expect your returns to be over the long run and the less risk you’ll take getting there.

Different market areas can be fairly non-correlated, so a diversified portfolio will always have investments on the rise and on the fall. With diversification you can benefit from the aggressive gains of a risky investment, like an emerging markets fund for example, and when it inevitably underperforms you have many other semi-independently moving assets that might be having their day in the spotlight.

Ideally a diversified portfolio will contain over 10 different index funds. Unfortunately, all funds carry a minimum investment and owning 10 could potentially cost upwards of $30,000. If you’re young enough to be enjoying this article then you probably don’t have that much money.
The easiest and best one-stop path to diversification is the Vanguard Total World Stock Index Fund. It tracks the FTSE (pronounced footsie) All World Index which consists of 60% international stock and 40% U.S. stock. Money in this fund essentially moves up and down with the global market as a whole.

Thinking about Retirement Already

I’m fairly confident that my idea for a business that produces bagels with cream cheese pre-injected inside will provide adequately for me and my family in the future. But just in case my business fails, or R&D can’t problem-solve out the sogginess, I plan on starting my own tax-sheltered retirement account this summer.

Of all the advice I’ve given in this and my other articles, by far the most important is as follows: begin investing in a 401(k) or an IRA fully and consistently from as early an age as possible.

But before you start putting money into a retirement account there are a few minor things to get out of the way. Firstly, pay off all of your credit card debt. You’ll find saving becomes cruelly ironic when you’re paying 18% in interest rates. The next step is to save up a small safety cushion to put in the bank in case of emergency. It doesn’t need to be very much, just enough so you won’t have to buy Fruity Hoops instead of Fruit Loops at the grocery store when things turn bad. After completing this, you’re ready to start investing.

The first pre-investing question you should ask yourself is: “Do I have any taxable earned income?” If you answered “no” then these won’t help you. Get a job.

If you answered “yes” then you’re eligible for the best tax break you’ll ever receive. It’s called a tax-sheltered retirement account and it’s the key to your money growing really quickly.

If you do have a job then you may have already been offered one such retirement account, called a 401(k). A 401(k) is a type of employer-sponsored retirement plan which allows employees to save money while deferring their income taxes on those savings. In a normal taxable account you’d have to pay income taxes before you invest, then your investments would be taxed continuously on their dividends and capital gains distributions. Uncle Sam could end up eating over half of your money. In a 401(k), on the other hand, your money is directed straight from your paycheck into the account without being taxed (so your principal is larger) and then is never taxed while in the account (so your effective rate of return is higher). The only time you will ever pay taxes on that money is when you start to take distributions from it. A sweet deal.

Most 401(k)’s consist of a list of mutual funds that you can pick and choose between. I’ve taught you well, so naturally you’ll search for a diversified collection of index funds.

You can direct your employer to put a certain portion of your pay each month into the funds you’ve selected, and you should put as much in as is possible for you. A very minimum of 10% of your income should go into a tax-sheltered retirement account each and every month without exception. If you can get in the habit now of setting this money aside you won’t regret it later, when you can afford better hearing aids than all of your friends.

Many employers offer to match some of your contributions to a 401(k). Always take them up on it! This is extra income, a bonus above your normal salary. Don’t be stupid.

If your employer doesn’t offer any 401(k) you’re not out of luck. You can open an Individual Retirement Account, or IRA, which behaves essentially the same. The only major difference is that any fund can go into an IRA, instead of just the options your employer gives you for a 401(k), but you’ll have to put the money in yourself.

Much bigger than the difference between a 401(k) and an IRA is the difference between the traditional version of either and the Roth version. While in a traditional retirement account money is only taxed when it’s taken out, in a Roth 401(k) or a Roth IRA your money is taxed before you put it in and then never again. Because you’ve paid taxes on the front end the principal is slightly lower than it would be with a traditional account, but it grows tax-free at the same pace and then is not taxed when withdrawn.

Both traditional and Roth retirement accounts grow far faster than a normal taxable account and if interest rates as well as your tax bracket stay the same then they’ll both yield the same ultimate return. For most young adults, however, you can count on your income, and therefore your tax bracket, increasing before retirement so it’s smarter to pay your taxes when you’re young. The Roth is your best bet.

The only downside to these retirement accounts is that your money is locked in until you reach the age of 59½. Any withdrawals made before this time are pretty heavily penalized. But before you decide that 59½ is far too long for a young adult to wait, think about this: Many academic studies have suggested that not having the ability to buy and sell in and out of the market based on psychological and emotional factors, is a huge advantage in terms of returns.

Dalbar’s famous 2004 study “Quantitative Analysis of Investor Behavior” concluded that investors who attempt to time the market by putting money in when the market is going up and taking money out when it’s going down usually have a negative rate of return. They almost always have significantly smaller returns than an investor who invests consistently and automatically without ever pulling money out. Believe it or not, having your money stuck in a retirement account is likely better for its performance than if you had full control over it.

I do understand, however, that you’ll probably want to buy things before you retire. While the first 10% of your income should go into a retirement account any savings after that should go into shorter term, taxable accounts. Money for a purchase you plan to make within the next 5 years should go into a savings account or money market fund, but for anything farther down the road than that, your money should be parked in an equity and fixed income portfolio of index funds. (The more long-term your plans, the more heavily equity it should be.) That way your money is liquid, meaning it can be taken out whenever you need it.

The decision to begin saving and investing for the future and for retirement is an important one. I guarantee you’ll make it at some point — the question is when. Starting early and doing it correctly can mean everything when you get older. I’d like to leave you with a couple of inspirational quotations:

“Money really isn’t that important. Is a guy with fifty million dollars happier than a guy with forty eight million dollars?”
-Milton Berle

“Money is better than poverty, if only for financial reasons.”
-Woody Allen