So you are responsibly living below your means, you have conscientiously built up an emergency fund of cash for 3-6 months’ living expenses, you have no ‘bad’ debt, and you’ve even taken care of other basic financial housekeeping, like adequate insurance and a will. Congratulations! You are probably ready to face the risks and rewards of investing 101.
The first myth I had to dispel in myself when I began investing is that “Investing is only for rich people.” (In fact, a good friend of mine just wrote me email to that effect a few weeks ago!) Not true. Investing is for people who are living below their means, have a little extra cash each month, and are prepared to sacrifice a little cash today for potential rewards tomorrow.
It does not take a lot of cash to start investing. If you’re in a big hurry to jump in, you can start with just $100. Personally I think a few thousand dollars to start will be more helpful, and I’ll explain why in a minute. Much more important than how much money you have to invest is (a) you can spare that money from immediate needs and (b) you are willing to take a long view (at least 5 years and preferably a 10 to 30 year time frame).
Why the long term?
Unless one has perfect knowledge of future events (including tsunamis, wars, inventions and innovations, shifts in popular culture and taste, political developments, the discovery or exhaustion of natural resources, climate change, and the personal lives and doings of thousands of executives running thousands of companies), you cannot predict the movements of the financial markets on a day-to-day or even year-to-year basis. Anyone who tells you different is a huge egomaniac, or a pathological liar, and probably both.
But over the long term, the total U.S. stock market has returned about 10.4% a year since 1926. This does not mean that you will earn about 10.4% each year on your investments in the U.S. or other stock markets. There will be some up years, and some down years. It also doesn’t mean you will earn about 10.4% a year even over the long term: some very smart researchers point out that the 20th century is called “the American Century” for a reason”America was gaining massive economic, military, and political power globally. This will probably not continue. The average stock market return for most industrialized nations since 1900 has been more like 7 to 9% a year (before inflation).
But earning 7 to 9% before inflation still isn’t too shabby. And since 1900, stock markets have always performed better over the long term than bond markets (about 4 to 5% a year before inflation) and much better than cash savings (where in general you will lose money over time because inflation each year is nearly always more than the interest you can earn).
So my view, shared by nearly all financial professionals, is that over the long term, the stock market is the best place for investing as long as you don’t need the money right away. It is important to realize that stock markets can turn negative for quite a long time (i.e., you are losing money each year) like the U.S. stock market after 1929. And if you sell during those down turns, you will lose a lot of money, because you bought those stocks at higher prices, and you are selling them for low prices. But if you take the long view, for as long as we have records history has shown that the stock markets are the place to be to increase your assets.
OK, I want to invest in the stock market
Great! But there are expensive and inexpensive ways to do this. Unless you are a licensed broker, you cannot buy stocks directly yourself. You need to go through an individual broker, or an investment company, and they will charge you money. The more they charge you, the less your investments will earn for you, right?
Individual brokers and investment companies frequently charge “loads” when they sell you stocks. The term “load” is a code word for “sales fee” or “commission.” It is often right around 5.75% of your purchase. And I say this is ridiculous. Well, actually it’s great for the broker, because s/he is getting rich off you. But it’s terrible for you. So first off, we want no “loads” in our investments.
A different way brokers make money off you is an annual fee. Sometimes they charge this on top of the initial load or sales fee! These annual fees can range from 0.1% to 2% or more. Perhaps you think a few percentage points make no difference. But it sure does over time. I’ll show you how.
Let’s say you have saved up $10,000 to invest. And you have found a terrific mutual fund that will actually earn you 10% returns (before tax or inflation) every year for 40 years. If you are paying 0.1% in annual fees, your $10,000 will grow like this:
5 years: $16,032
10 years: $25,703
20 years: $66,062
30 years: $169,797
40 years: $436,423
But if you are paying your investment company 2% annual fees to manage your money, your $10,000 grows like this:
5 years: $14,693
10 years: $21,589
20 years: $46,610
30 years: $100,627
40 years: $217,245
After 40 years of paying 2% annual fees, you will have almost exactly half the money from your investments you would have had paying 0.1% annual fees. In fact, while the U.S. stock market has returned about 12.2% a year between 1984 and 2002 (before inflation and taxes), most investors have actually seen only about 2.6% annual returns.
That’s because most investors pay too much in sales fees and annual fees, and most investors panic when the stock market turns negative and they sell their assets when prices are low. But you are armed and dangerous, and you won’t make those mistakes.
So how can I invest for the long term with no loads and low fees?
Now that’s the right attitude! I personally much prefer mutual funds (a collection of stocks from many companies) over individual stocks, because I don’t have time to research the approximately 5000 publicly traded companies in the U.S. and decide which ones to buy.
And among mutual funds, index funds have the lowest annual fees and generally no loads (sales fees). Index funds require no day-to-day management; they are built to simply follow whatever the broad stock market is doing, whether it goes up or down. Believe it or not, these cheap index funds perform better than other funds anyway 99.9% of the time.
The S&P 500 Index is my favorite index because it is easy to get information about what it’s doing (try the evening news) and it represents 75% of the total U.S. stock market. (The other 25% of the market is composed of small companies and it is more expensive to buy their stocks and harder to get information on what they are up to.)
I have three suggestions for inexpensive S&P 500 index funds from absolutely trustworthy companies.
My favorite (because it requires the smallest minimum investment) is Vanguard’s S&P Index mutual fund. Annual fees are 0.18%, you can start with as little as $3000, and you can invest as little as $100 more at a time afterward (perfect for monthly contributions).
E*Trade’s S&P Index mutual fund is cheaper (just 0.09% annual fees) but you need a minimum of $5000 to get started. You can afterward add as little as $100 at a time through automatic deductions.
Finally, Fidelity’s S&P Index mutual fund is only 0.10% in annual fees but requires $10,000 minimum investment, and a minimum of $500 in additional contributions.
I haven’t really addressed taxes, inflation, and other costs yet, but stay tuned for the next installment of Investing 101: Minimizing Risk, Maximizing Returns.