4 Time Tested Secrets to a Successful Investment
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You see, research shows that a ton of American households could benefit from investing in index funds that track the performance of the U.S. stock and bond markets.
Sure, there might be other ways to invest, but there are countless ways to lose money, too. That's why sticking with index funds has remained a solid choice.
The information I'm about to share in this post is gonna be a game-changer in how you view investing. Once you understand how financial markets work, you'll realize that index funds are the key to ensuring you get your fair share of those profits.
And guess what? Some of the smartest and most successful investors out there, including Nobel laureate and economics professor Paul Samuelson, are big fans of the index fund approach. In fact, among academics, it's practically a unanimous consensus.
1. Approach The Market Independently and Avoid Dealers
You know what's fascinating? The returns that businesses make eventually turn into the stock market's gain. But here's the kicker: studies show that if you're a typical investor in individual stocks, your returns are probably trailing the market by around 2.5 percentage points per year.
Let's put that into perspective. If we look at the annual return of 12 percent over the past 25 years by the S&P's 500 Stock Index, your yearly return is actually less than 10%. So, basically, you're only getting about 80% of the market pie.
And if you're a typical mutual fund investor, you're probably faring even worse. But hey, don't just take my word for it – it's all about the unyielding rules of humble arithmetic. These rules are what define the game, and at the end of the day, investors as a whole are, well, average.
Now, listen to this mind-blowing fact: every extra return one investor earns means another investor falls short by the exact same amount. So, before you even consider the costs of investing, beating the stock market is pretty much a zero-sum game.
But what about those pesky investment costs? Well, they just make the winners' gains smaller and the losers' losses bigger. So, who's really winning here? It's the folks in the middle – the brokers, investment bankers, money managers, marketers, lawyers, accountants, and operations departments in our financial system.
That's right, the financial dealers always come out on top. In fact, they rake in a staggering $400 billion each year from investors like you and me. It's just like the casino where the house always wins, horse racing where the track always wins, or the Powerball lottery where the state always wins.
Investing isn't any different. After accounting for all those costs, beating the stock market turns out to be a losing game. And no matter how many self-help investment books claim to make winning easy, the reality is that, after all the expenses, it's still a game for losers.
2. Avoid Investing The Most
It's kind of amazing how compounding returns can turn the long-term productivity of businesses, like those in the US, into some fantastic stock market returns. However, the compounding costs of investing can quickly overshadow those returns, leaving investors with a pretty raw deal.
The truth is, if you decide to play the investing game, the odds of achieving superior returns aren't exactly in your favour. In fact, the average investor falls way short of the stock market's long-term returns. Now, you might think you can dodge these investing pitfalls through careful research and quick trades, but think again.
You see, investors who trade less frequently have a better shot at capturing the market's return, while those who trade the most are pretty much doomed.
An academic study found that the most active stock traders earned a market return of 17.9% per year between 1990 and 1996, but their trading costs were a whopping 6.5%. This left them with an annual return of only 11.4%, which is just two-thirds of the returns in that booming market.
For the past 80 years, the S&P 500 Index has been the go-to stock market portfolio. Created in 1926, it consists of the 500 largest U.S. corporations, weighted by market capitalization. Over time, these 500 stocks have represented about 80% of the market value of all U.S. stocks.
The beauty of such an index is that it automatically adjusts to changing stock prices without the need to buy or sell stocks.
As corporate pension funds grew between 1950 and 1990, the S&P 500 became the ideal benchmark to measure the performance of professional managers. Today, it remains a solid standard for comparing returns earned by pension funds and mutual funds alike.
But in 1970, an even more comprehensive U.S. stock market measure was developed. Originally called the Wilshire 5000, it's now known as the Dow Jones Total Stock Market Index, which includes some 4,971 stocks – that's the S&P 500 plus an additional 4,471 stocks.
However, since the stocks are also weighted by market capitalization, the remaining 4,471 stocks only account for about 20% of the index's value. Still, this broad index is the best measure of the aggregate value of U.S. stocks and a fantastic way to gauge the returns earned by all investors as a group.
3. To Buy an Interest in Each Stock in The Stock Market
Successful investing fundamentally relies on common sense. While it is simple in concept, it can be challenging in practice. By adhering to mathematical simplicity and historical precedent, investors can be confident that they will secure a considerable portion of the total returns generated through dividends and earnings growth.
One effective approach to implementing this strategy is to invest in a fund that maintains a consistent market portfolio. This type of fund is known as an index fund, which is a portfolio composed of numerous individual stocks designed to yield results representative of an entire financial market or sector. Traditional index funds offer exposure to a comprehensive range of stocks, as opposed to a limited selection.
By investing in such funds, stock market risk remains, but individual stock risk, sector risk, and manager selection risk are all mitigated. Although index funds may not provide immediate excitement, their long-term productivity is noteworthy.
The accumulations of wealth generated by these returns, facilitated by the power of compounding, have been remarkable over time.
A classic index fund, characterized by broad diversification, minimal expenses, absence of advisory fees, low portfolio turnover, and high tax efficiency, effectively owns a share of the $15 trillion capitalization of the U.S. stock market.
To invest successfully in the United States, one must acquire an interest in each stock in the market proportional to its market capitalization and retain it indefinitely.
For those residing in the U.S., it is crucial not to underestimate the compounding power of the substantial returns earned by businesses. Over the past century, U.S. corporations have generated a return on their capital of 9.5%.
Compounded at this rate, an initial $1 investment can grow to $2.48; over two decades, $6.14; over three decades, $15.22; over four decades, $37.72; and over five decades, $93.48.
For much of the past 80 years, the Standard & Poor's 500 Index, established in 1926 and comprised of 500 stocks, has been the accepted representation of the stock market portfolio. It consists of the 500 largest U.S. corporations, weighted by the value of their market capitalizations.
In recent years, these stocks have accounted for approximately 80% of the market value of all U.S. stocks. The cap-weighted index's advantage is its automatic adjustment to fluctuating stock prices, eliminating the need for buying and selling stocks.
The S&P 500 has served as an ideal benchmark for comparing the performance of professional pension funds and mutual fund managers.
In 1970, a more comprehensive measure of the U.S. stock market was developed, initially called the Wilshire 5000 and now known as the Dow Jones Wilshire Total Stock Market Index. This index includes around 4,971 stocks, encompassing the 500 stocks in the S&P 500.
Although the remaining 4,471 stocks are also weighted by market capitalization, they represent only about 20% of the index's value.
Despite this, the broadest of all U.S. stock indexes remains the most accurate measure of the aggregate value of stocks and, consequently, an excellent indicator of the returns earned in U.S. stocks by all investors collectively.
4. Don't Put Too Much Trust in Financial Advisers
As I previously mentioned, successful investing requires purchasing a portfolio containing shares of the most stable and profitable business and holding onto it indefinitely. This straightforward concept ensures financial success in a world where most investors consistently lose.
In 1320, William of Occam articulated this principle well: when faced with multiple solutions to a problem, choose the simplest one. Consequently, 'Occam's Razor' became a fundamental tenet of scientific inquiry.
As mentioned earlier, the most straightforward way to own all U.S. businesses, for example, is by holding the total stock market portfolio.
Before delving into the basics of index funds, such as mutual funds that invest in the entire U.S. stock market and maintain their holdings indefinitely, it is crucial to understand the workings of the stock market.
It is worth noting that many mutual fund investors have an inflated perception of their capabilities. They select funds based on the recent or long-term performance of fund managers and engage advisers to assist in this process. However, advisers often achieve even less success.
Unaware of the impact of costs, fund investors willingly pay substantial sales loads and bear excessive fund fees and expenses. Furthermore, they are unknowingly subjected to significant, hidden transaction costs due to the high portfolio turnover of funds. Fund investors mistakenly believe they can effortlessly identify superior fund managers.
On the other hand, those who invest and subsequently abstain from incurring unnecessary costs enjoy remarkably favourable odds of success. The reason is simple: these investors own businesses that earn substantial returns on their capital and distribute dividends to their owners.
However, it is essential to acknowledge that many individual companies do fail. Firms with unsound ideas, inflexible strategies, and weak management ultimately succumb to the creative destruction that characterizes competitive capitalism, only to be replaced by others.
As you pursue investment success, it is essential to acknowledge that we can never predict the returns stocks and bonds will yield in the coming years, nor can we foresee the potential returns of alternatives to the index portfolio.
However, do not be disheartened. Despite the inherent uncertainty and the ever-present haze enveloping the investment world, there is still a wealth of knowledge at our disposal.
Thank you all so much for reading, have a great day, and I'll see you in the next one.