Is there a way for the average man or woman on the street to beat the vast majority of stock market participants? If you get it right, the payoffs can be huge. The journey make take a little time (anything worthwhile always does) and it takes discipline and focus. But there is hope.
Many market participants are seduced by the “quick buck” – it’s human nature after all. But going for small, steady gains can lead to outsized results, and perhaps more importantly avoid outsized losses.
As an investor, I’m largely self-taught. I’ve read a good number of books and tried several approaches. My investor education (through real world investing) has cost the equivalent of a post-graduate degree. Hopefully this means the lessons are better learned.
After several years of exploration, I settled on broadly a value based approach, as described by Warren Buffett – buy quality businesses with predictable earnings, high return on equity, low debt, and a healthy margin of safety. And only buy what you understand.
My office bookshelf is stuffed with books on investing and entrepreneurship. The top shelf is occupied by the books I’ve found most valuable, and going down each progressive shelf the ranking of importance (to me) diminishes. So, the top shelf is populated by writings by and about: investors – Warren Buffett, Benjamin Graham, David Dreman, Joel Greenblatt; positive thinking – Napoleon Hill; and probability and risk – Nassim Nicholas Taleb.
Once in a while a new book comes along which disrupts your thinking. This week I read such a book – “Millionaire Teacher – The Nine Rules of Wealth You Should Have Learned in School” by Andrew Hallam. What makes the author really interesting is that he managed to build his personal wealth to over $1million while in his 30′s. All this on just a middle-income salary of a teacher in Canada. He’s subsequently relocated to Singapore to satisfy his appetite for international travel. For fun, he continues to teach.
Why did I find this book so disruptive?
In a word, this book is about how to use INDEX investing for wealth building. And to boot you’ll likely beat the pants off most investment professionals. Now, of course, I’ve come across index investing before. Basically this is when you buy a fund which owns everything within a given market index (stocks or bonds). But what was different this time? And why is it relevant to me as a specialist medtech investor?
The BIG IDEA of the book is for investors to split their investable assets between a domestic stock market index fund, a broad international index fund, and a bond index fund. Allocation is dependent on age and risk profile, and rebalancing is performed annually.
Before exploring this BIG IDEA in more detail, and how it leverages investor psychology, here’s a brief summary of the books central tenets:
1. First – Do No Harm
This is the same as doctors’ Hippocratic Oath (that’s twice I’ve signed up to it now). You may have great ideas, and engage in practices that could lead to stunning payoffs. But only do this where first you don’t do any lasting damage to your investment capital.
2. The magic of compounding
Einstein stated “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t… pays it.” Even more succinctly, he said “The most powerful force in the world is compound interest.”
When you think about it, the effects on your financial position can be truly stunning. A compound interest rate of 10% doubles every 7 years. It may not seem like much early on. Using a hypothetical example of $1000 invested at 10% per year – after 10 years it’s grown to about $2,594. Hmm. Keep going – after 20 years it’s become $6,727; 30 years becomes $17,449; and after 40 years your little pot has grown to $45,259. Pretty cool.
If you’d invested $10,000 at the start, you’re pot would have grown to $452,590. What if you would have invested $30,000 at the outset – the cost of a mid-range family car? At 10%, that would have grown to $1,357,778. Wow. What would your family car be worth after 40 years?
3. Small fees add up to big costs
Looking at compounding a different way, let’s compare average compound rates of 8%, 10% and 12% over 40 years. The table below shows what $1000 invested at each rate would grow into over 40 years.
|$1000 invested at start|
|Compound interest rate||20 years growth||40 years growth|
Wow. So a difference in return of 2% per annum from 8 to 10% leads to a difference of $23,534, or greater than 2x return, over 40 years. The difference between 10% and 12% is even greater in absolute terms at $47,792 (nearly 2x greater return).
Do you know how much most active managers charge to manage your money? Typically 1.5-2.5% per year, often with a load fee of 3-5% (that pays the sales commission that goes to the broker). So, what seems like small fees (it’s only 2%), when compounded add up to huge differences in investment returns.
The investor’s champion for low fee index funds are Vanguard. The founder, John Bogle, is quoted as an investment giant of our generation for what he has done for the average investor. Most interestingly, Vanguard is not-for profit, has about the lowest ongoing fees of any fund, and no-load fees.
4. You can beat the majority of investment professionals
You may think that all those highly qualified and very highly paid investment and fund managers would run rings around the stock market (or bond) index. Surprisingly, they don’t. Two simple explanations are:
- The fees they charge in managing your money, and employing all these experts in swanky offices can kill your return (just look at the table).
- Most investment managers suffer the “instituitional imperative.” They’re more concerned about hanging onto a lucrative, highly paid job than do anything which might be poorly understood by most journeyman analysts – and thus they suffer mediocrity, or revert to the average. As the saying goes – “no fund manager one ever got fired buying IBM.”
5. Indexing for wealth building
Going an index route implies you have given up (most) hope of beating the market. In itself this may be no bad thing. A quick look at Yahoo! Finance interactive charts for the S&P 500 shows that, from January 1950 to January 2011, the market averaged a return of 7.35% per year compounded. That’s equivalent to an 81x gain (no-one expects you’d be in the market necessarily that long, but it does show historical return). But you have to be IN the market.
Further supporting index funds, the book highlights that three of the greatest stock market investors of all time – Warren Buffett; Peter Lynch (Magellan Fund, Fidelity); and Bill Miller (Legg Mason) – recommend that most investors use index funds.
The vast majority of investors just don’t have the time, energy, focus or interest to devote to sufficient investment research that’s needed to outperform. Even then there’s no guarantee. So, for most, index investing is probably the biggest favor they can do for their long-term wealth.
6. If you must, use 10% and follow Warren Buffett
Let’s face it. If you get into it, trying to beat the index is addictive. For me, stock research and “playing the game” is addictive AND cathartic. I get into flow.
I could happily spend 10 hours, or more, a day sat in front of a screen – reading annual reports, comparing companies, looking at ratios and historic earnings, and reading endlessly from the investment greats trying to gain new and subtle insights. For me it’s doubly interesting, since I get to read about medtech companies where I also have an entrepreneurial interest. It really isn’t work.
Yet, I still don’t have the luxury of spending ALL my time doing investment research. I also love working with entrepreneurs building emerging medtech companies. That’s my “day job”, if you will. Also, as I wrote about in Macro insights for specialist investors – in the current market, I’m only about 40% in stocks and the rest in cash.
I’m waiting for new buying opportunities to come along. I have a watchlist, with over 50 medtech stocks highlighted – they have the features I seek: long history of earnings growth, high return on equity and low debt – yet I still have to wait until the price is attractive enough that I get a good margin of safety.
So, while being Buffett like in my stock-picking, what should I do with my assets overall? The book recommends, if you must, allocate just 10% to Buffett-like stock-picking. And index the rest.
The BIG IDEA
Now you have a flavor of what the book is about, what is the BIG IDEA? And how does it take advantage of investor psychology?
Split your assets between a domestic stock market index fund, a broad international stock market index fund and a bond market index fund. The bond fund allocation is roughly equivalent in percentage terms to your age (you can go lower on bonds if you have more risk appetite). The remainder is split equally between the domestic and international stock fund.
Bonds are used to cushion the volatility in the normal stock indices. Though they can add extra juice in an unexpected way.
So, as a 41 yr old, with some risk appetite, the suggested split for me might be 35% US stock index fund (I live in UK, but for investments US centric), 35% international index fund, 30% bond index fund.
Then, once a year you spend an hour and rebalance the allocation. If stocks have done really well, their allocation will have naturally gone up. So you buy less stock index going forward, or possibly even sell some stock index funds and buy more bonds to bring the allocation back in line. If stocks do poorly, you buy more of those over bond index funds, and maybe even sell some bond index funds to allow more stock purchases – again to bring the allocation back in line.
What this means is, without trying to think, guess the market, or speculate, you buy more stocks when they are cheap, and sell-off some when they are expensive. You are only able to do this because some of your allocation is in bonds. As obvious as it sounds, this is the EXACT opposite of what most investors do in the market.
Perhaps Buffett says it best: “be greedy when others are fearful, and fearful when others are greedy.”
Will I continue to invest in medtech using a value based approach? Absolutely. But for my broader portfolio, a 3 index fund strategy now has a place.
This post is by Raman Minhas
Image: Singapore Tourism Board