What you will learn in Part 1
What is investing and why do we do it?
• Investing is laying out money now to receive more back in the future.
• We invest for several reasons.
• Sending kids to college
• Saving for a house or car
• For fun or speculation
Write down why you are investing
Why is this important?
Investing is a marathon, not a sprint. Having a why will keep you on track when you are tempted to take money out of your account to buy something you don't need.
What is compounding and why it's important?
Compounding is this:
• Beginning of year 1, you invest $100 and earn 10%.
• End of year 1, you have $110 dollars. To get that, you take ($100* 10% or .10 = $10) then take ($10 + $100 = $110).
• Beginning of year 2, you invest $110 and earn 10%.
• End of year 2, you have $121 dollars. To get that, you take ($110* 10% or .10 = $11) then take ($11 + $110 = $121).
In other words, your money earns money, year after year, as long as you keep your money invested.
The above is a simplified example. Investing is never in a straight line. Gains and losses tend to come in bunches.
Now let's talk about the most important factor in compounding.
Let's look at two scenarios (Warren and Charlie)
The only difference between the two is time. In scenario 2 (Charlie), the compounding process starts 10 years later at age 35.
• Initial investment-$10,000
• Contribution amount-$200/month
• Years of compounding-40 years(starts at age 25)
• Initial investment-$10,000
• Contribution amount-$200/month
• Years of compounding-30 years(starts at age 35)
We are going to run these examples through a compound calculator to see how much money each will have at age 65.
At age 65, Warren will have $838,980.
At age 65, Charlie will have $372,506.
The main takeaway...
From the two scenarios, you can see how ten extra years affects the final result.
Ten years doesn't seem like a big difference, but 10 more years of compounding yields an extra $466,474 in your bank account.
Which is a life-changing amount of money for most people.
Having proper expectations
David Rock, the director of the NeuroLeadership Institute, says there is a physiological reason we are disappointed when life does not meet our expectations.
The neurotransmitter dopamine is released in our brain — and makes us feel good — when something positive happens.
When we don’t hit our expectations, our brain doesn’t just get slightly unhappy, it sends out a message of danger or threat. That suggests that the cliché “hope for the best but expect the worst” has a lot of truth.
In investing, having proper expectations is important because your expectations will determine how you allocate your investing dollars.
Returns in any given year are volatile. (See below)
The returns we care about are real returns. There are two types of returns.
- Nominal-The stated rate of return.
- Real-The return after taking inflation into account.
If your portfolio returned 10% in 2017 and the inflation rate was 3%; your nominal return was 10% and your real return was 7% (10%-3%).
A real world example:
From 1966 until 1982 the S&P 500 earned a respectable 6.8% in nominal returns.
However, during this time period, inflation averaged 6.8%. Making real returns from stocks a break-even trade over 17 years.
What's even worse is real returns for bonds during the same 17-year period was -40%.
That's why it's important to think about real returns, not just nominal returns.
Active vs Passive Management
What's the goal of active management?
• The goal of active management is to achieve alpha or "beat the market".
• Active management is when other people pick your investments; such as mutual funds, hedge funds, or smart beta ETFs.
• In addition, you can do your own research and choose investments for yourself.
What's the goal of passive management?
• The goal of passive management is to earn the market return of an index such as the S&P 500.
• If the S&P 500 returns 10% for 2018, your return would be 10% minus the cost of owning that fund.
• Vanguard's S&P 500 ETF (VOO) charges 0.04% or 4 basis points. You're charged 4 cents for every $100 invested.
• With this approach, you want to be well diversified and seek out investments with the lowest costs.
In our example,
If you owned Vanguard's S&P 500 ETF, VOO, your return would be 10% minus 0.04%.
Leaving you with a net return of 9.96% for 2018.
So... Should you pick active or passive?
The research states that most active managers fail to beat a low-cost index fund.
From the report above:
Over the 15-year period ending Dec. 2016, 92% of large-cap, 95% of mid-cap, and 93% of small-cap managers failed to beat their benchmark.
In addition, your ability to pick which managers will outperform in advance will prove challenging.
In 2010, Morningstar named Bruce Berkowitz, portfolio manager of the Fairholme fund, manager of the decade.
He had an average annual return of 13.2% during his ten run up until 2010; beating the S&P 500 by 13% a year.
In the five years since 2010, his fund has averaged 3%; lagging the S&P 500 by 10% or more.
Can he make a comeback?
Sure, every investing style goes in and out of favor.
The hard part is knowing if an investor's strategy is due for a bounce back or if the investor has lost his touch.
So what's the solution if it's impossible to choose an active manager in advance who will outperform the S&P 500?
In my view, there are two paths you can take.
Put all your money in passive products and don't try to pick managers or investments that will outperform.
Be satisfied with the market return.
Most academics and financial advisors will tell you this is the path you should take.
The second path is to put a majority of your money in low-cost passive products and take what's left over and invest in more active or speculative ventures; whether that's in stocks, real estate, angel investing, or a private business.
If you had $10,000 dollars, you could take 80% ($8,000 dollars), and invest in a low-cost ETF that tracks an index.
Then take the rest, $2,000 dollars, and take risks with that money.
However, if you choose the second path and want to pick your own investments, realize that you are competing with professionals who do this for a living.
You need to bring energy, discipline, and structure when picking your investments; things we will cover in later videos.
Don't do like most people, who invest because they saw a talking head on TV recommend a stock or read an article about this or that stock that is poised to double over the next year.
It's ok to hear other opinions; learn to think for yourself and conduct your own research.
Investing is hard, to have success, you have to treat it like a business.
Looking for help in managing your money
The resources below will give you a good start.
Looking to pick your own investments?
These websites will come in handy when doing research on potential investments.