Making a Difference

Jonathan Clements

TRYING TO BEAT THE market isn’t just a risky endeavor that will almost certainly end in failure. It’s also unnecessary and, arguably, an astonishing waste of money and time.

As I grow older, the clock ticks ever more loudly in my head. I hate to be kept waiting. I keep chores to a minimum. I try to eliminate activities from my day that bring little pleasure and have no purpose. I think hard before acquiring new possessions, because I know many will turn into a burden, as they require maintenance and repairs.

It’s also the reason I’m trying to train myself to look at the financial markets less frequently during the trading day. So often, it’s just information without insight. Similarly, it’s the reason I ignore commentary about individual stocks, hot funds and the market’s short-term direction. It isn’t simply that these folks will be wrong half the time. It’s also a huge distraction from what’s important.

So what is important—at least when it comes to investing? It is the markets themselves. They are wonderful wealth creation machines. Data for MSCI’s All World stock index goes back to year-end 1969. In the 48 years since, the index has climbed 8.9% a year, enough to turn $10,000 into almost $600,000.

Let’s imagine you wanted to do even better than that $600,000. To that end, you hire a top-notch money management firm, which charges 1% of assets a year and incurs another 0.5% annually in trading costs, for a total of 1.5%.

If things go well, the money management firm might pick stocks that outpace the market averages by two percentage points a year. That would be a remarkable achievement. Equally remarkable: The money manager, along with other financial firms, would effectively pocket three-quarters of that gain, thanks to the 1.5% in total costs.

Still, instead of earning 8.9% a year, you would clock 9.4%. That’s nothing to sniff at—beating the market by 0.5 percentage point a year over 48 years—and you would be richly rewarded, with your $10,000 growing to almost $750,000.

“If our goal is to amass ever more money, we’ll likely never be satisfied—because we could always have more.”

Problem is, if there’s the chance to earn two percentage points a year more than the market averages, there’s also a risk you’ll lag by that amount. In that scenario, Wall Street still gets its 1.5%. Funny how that works, isn’t it?

Result: Instead of outpacing the market by 0.5 percentage point a year after costs, you might lag by 3.5 percentage points, thanks to the double whammy of two percentage points lost to lousy stock picks and 1.5% of assets devoured by investment costs. You’re now making 5.4% a year, rather than the market’s 8.9%, and your $10,000 grows to a less exciting $125,000. Factor in inflation, which ran at 4% a year over this 48-year stretch, and the purchasing power of your $10,000 would grow to a mere $19,000.

The undeniable lesson: It’s the markets that will make you rich. Active management is more likely to subtract, than add, to those riches—which is why you should save yourself time and money by ignoring all the beat-the-market nonsense and instead sit quietly with a few low-cost index funds.

Admittedly, this conclusion will be unsatisfying to many. There’s far more pleasure in action than inaction. Surely there are steps we can take to improve our financial chances?

Indeed, there are. But for many, it’ll require a change in mindset. Consider these five seemingly self-evident truths, and the reality of how we can best add value to our financial lives:

1. Conventional wisdom: If we want higher returns, we need to pick market-beating stocks, bonds and mutual funds. Reality: If we want higher returns, we should forget trying to outguess the market—and instead focus on taking sensible risk, holding down investment costs and minimizing taxes. That brings us back to indexing. But it also means settling on the right asset allocation and diversification strategy, maxing out our retirement accounts and buying tax-efficient investments in our taxable accounts. These are all aspects of our investment strategy that are entirely within our control—and where a little effort can pay big dividends.

2. Conventional wisdom: Investing is where the big money is made. Reality: While our investment performance is a big potential contributor to our wealth, we’ll likely help our financial situation far more if we devote our energies to improving other areas of our financial lives. That means minimizing our borrowing costs, holding down insurance premiums, buying the right-size home, raising money-smart kids—and, most important, saving diligently.

3. Conventional wisdom: There’s retirement, insurance, college, houses, estate planning and more. Reality: All these things are connected. Our financial lives are a battleground of competing demands, with a broad array of expenses and goals laying claiming to our limited income and assets. To make smart decisions about our money—including how much to save, what portfolio to hold, what goals to pursue, what insurance to buy and how much debt is prudent—we need to look at our overall financial picture.

Often, the key organizing principle is our human capital—our income-earning ability—or the lack thereof. As I discussed in an earlier article, our regular paycheck drives our insurance needs, allows us to take on debt, provides the savings needed for retirement and frees us up to invest in stocks. But as we approach retirement and the last of our paychecks, we should aim to pay off all debt and boost our holdings of bonds.

4. Conventional wisdom: Money buys happiness. Reality: Money can buy happiness, but it sure isn’t guaranteed, because we’re really bad at figuring out what we truly want. Instead of blindly acquiring ever more stuff, and likely wasting a heap of money along the way, we should focus on being as thoughtful as possible in how we spend.

That means inserting time between when a potential purchase pops into our head—and when we pull the trigger and actually buy it. During that time, we should ponder other potential uses for the money. One trick: Draw up a wish list of major expenditures you might make in the years ahead. That’ll give you the chance to weigh the new living room furniture against the exotic vacation, or the home remodeling project against the shiny new car, so you figure out which will bring you greatest happiness.

5. Conventional wisdom: The goal is to be rich. Reality: If our goal is to amass ever more money, we’ll likely never be satisfied—because we could always have more. No, the goal isn’t to get rich. Rather, the goal is to have enough.

That means figuring out what sort of life we want to lead and what it’ll cost. This takes substantial thought. Where would we ultimately like to live and what size house do we want? How would we like to spend our days? How much financial help do we want to give the kids? All this drives how much wealth we need to amass during our working years.

Here’s the back-of-the-envelope calculation: Add together the cost of your desired home and the financial help you want to provide your children. To that amount, add a sum equal to 25 times the annual income you want from your portfolio. What we’re talking about here is the income you’ll need, once retired or semi-retired, to supplement what you receive from Social Security, any pension you’re entitled to and whatever you’re earning at that stage in your life.

Let’s say you want a $300,000 home and to provide $100,000 in financial help to your children. On top of that, you want $30,000 a year from savings. Multiply that $30,000 by 25. Result: You would need $750,000 to generate this income. Add it all up, and you’re looking at amassing $1.15 million over your life. That’s the price of your financial freedom—because that, you have decided, would be enough.

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