Some harsh truths about saving and investing: 12 things every investor should know
Reprinted courtesy of MarketWatch.com.
Many of us think we are smarter than the experts and with our own savvy and common sense we can beat the market. That’s generally far from reality; although there are some nearly universal truths.
Here are a dozen of them:
1) There is no risk in the past. We always know how things turned out, and therefore what we “should have done.”
Securities salespeople and newsletter publishers like to tell prospects about the recommendations they have made that turned out well. Often, the prospects never find out about all the recommendations that lost money.
Although past risks look benign, risk is real. It is worth your time to seriously consider what you are willing to lose along the way to achieving your goals.
2) Wall Street has only one free lunch to offer, and that’s diversification. According to the experts, the expected return for any one stock is the same as the expected return for all stocks in the same asset class.
No matter how much you want to pick your favorite stocks, an index fund is much less risky, and statistically just as likely to succeed. Sorry about that.
3) Almost all your expected return in the stock market — the experts estimate from 90% to 99% — comes from the asset class in which you invest. The other 1% to 10% comes from choosing individual stocks or a manager or from timing your purchases and sales.
Put this expertise to work by carefully choosing the right asset classes and then investing in those asset classes via index funds.
4) Reliable information on investments is easy to access without cost. At Morningstar.com you’ll find everything you need to bone up on the important facts about index funds and ETFs.
For every fund or ETF you are considering, you should take the time to familiarize yourself with the Morningstar pages that highlight portfolio holdings, expenses, performance, taxes, and risk.
5) In any asset class you choose, the most likely path to better returns is reducing your expenses. That statement is backed up by more academic research than you’ll ever want to read.
Here’s an example based on the Standard & Poor’s 500 Index SPX, +1.37% which represents U.S. large-cap blend stocks. There are many funds and ETFs in this popular asset class.
Low expenses: The Vanguard 500 Index Fund Admiral Class VFIAX, +1.38% charges expenses of 0.05% (rock-bottom low). According to Morningstar, this fund compounded at 7.46% over the 15 years that ended Feb. 24, 2017.
Average expenses: The median large-cap blend fund charges expenses of 0.9%. The average compound return of all those funds over the same period was 6.96%.
6) In choosing funds for a portfolio, you should look for more than rock-bottom expenses.
It’s normal and reasonable for expenses of index funds (and actively managed funds) to rise with higher risks and more complex portfolios involved in asset classes beyond the S&P 500.
In the U.S. large-value asset class, the Vanguard Value Index VIVAX, +1.43% charges expenses of 0.08% (still extremely low) and compounded at 7.83% over the past 15 years.
By contrast, the average fund in that category charged expenses of 0.9% (more than 11 times as much as the Vanguard fund) and compounded at 7.02%. The difference in return was almost all about expenses.
7) Long-term investors should expect (and almost always receive) higher returns for accepting the risk of equities as opposed to bonds.
This is true even for very conservative investors who choose to keep 80% of their money in bonds and hold 20% in equities.
Over the 46 calendar years from 1970 through 2015, a portfolio made up 100% of intermediate government bonds had a compound return of 6.2%. Shifting 20% of that portfolio into diversified stock funds would have boosted the return to 7.4%.
That’s enough to make an enormous long-term difference. On an initial investment of $10,000 held for 46 years, it’s the difference between $266,808 (holding 20% in stocks) and only $159,121 (all bonds).
Yes, but what about the risks?
As we saw above, there is no risk in the past. BUT the standard deviation of the 20% equity portfolio (4.6%) was not much higher than that of the all-bond portfolio (4.1%).
And get this: The worst calendar year loss of the all-bond portfolio was actually higher (4.5% in 2013) than the worst calendar year loss of the 20% equity portfolio (4.4% in 2008).
8) Long-term investors should expect (and almost always receive) higher returns from adding small-cap stocks to their portfolios.
Over the past 15 years, the Vanguard Small Capitalization Index FundNAESX, +1.64% compounded at 9.89%, compared with 7.46% for the S&P 500 fund mentioned above.
This is not just a recent phenomenon. From 1928 through 2015, the S&P 500 compounded at 10.7%, while the small-cap blend asset class grew at 13.8%.
9) Long-term investors should expect (and almost always receive) higher returns from adding value stocks to their portfolios.
If we track all the 15-year periods from 1928 through 2015, we find that large-cap value stocks averaged returns of 13.2%, compared with 10.7% for the S&P 500.
10) Long-term investors can expect (and usually receive) even greater rewards for combining the advantages of small and value.
In those same 15-year historical periods, small-cap value funds compounded at 16.1%. Over 15 years on an initial investment of $10,000, that more than doubles your money: $93,860 for small-cap value vs. only $45,942 for the S&P 500 at 10.7%.
11) Future returns will be different from past ones. Therefore, you should not count on getting returns just like the ones I have cited.
Obviously, anything can happen. Most researchers believe the premium returns from owning stocks over bonds will continue. Likewise, the long-term premium returns from small-cap stocks and from value stocks are likely to continue.
But relatively few experts try to forecast the absolute returns of the benchmark S&P 500 Index.
Future returns could be much lower. The S&P 500 could compound at 6% instead of 10%. Small-cap and value premiums could shrink to only one to two percentage points. There’s no way to know.
12) There are two obvious things you can do as a result of all this, and I recommend you do them. First, do the very best job you can of investing wisely based on long-term probabilities. Second, save as much money as you possibly can, as early as you possibly can.
Based on everything I know, I can promise these two things will increase your chances of retiring earlier, with more to spend and leave to others, and with greater peace of mind.
Richard Buck contributed to this article.
ot own the investments mentioned in this column.