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The Best (and easiest) Way To Build Wealth Thumbnail

The Best (and easiest) Way To Build Wealth

“Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.”

—Peter Lynch

The stock market is (and has been) the single biggest contributor to wealth over time. Stock returns have outpaced those of cash, bonds, real estate, commodities, and collectibles. It’s not even close.

What is a stock, and what does it mean to own a stock?

Quite simply, when you buy a stock, you own a piece of a company. If you buy shares of Apple, you are now a partial owner (shareholder). You can walk into an Apple store and watch people buying products from your company.

And as Apple grows as a company, your wealth grows along with it. Exciting, right? It gets even better because most large, well-established companies take part of their profits and give it back to shareholders in the form of a dividend. In other words, you get paid to own stocks.

The combination of capital appreciation and dividends is called an investor’s “total return.” Over a typical twenty-year period, total annual stock market returns have averaged anywhere between 8 and 10 percent. This translates into your money doubling every seven to ten years. Why? It’s due to the power of compounding. Don’t believe it? The math doesn’t lie.

The Power of Compounding

Let’s say you invest $100 and experience a 10 percent annualized return for the next seven years. At the end of year one, you’ll have $110 ($100 x .10 = $10, $100 + $10 = $110).

In year two, the stock market once again appreciates by 10 percent, but this time, you started with a base of $110. So, instead of earning $10, you earn $11 and end the year with $121 ($110 x .10 = $11, $110 + $11 = $121).

Year 3: 10 percent return on $121—end the year with $133.10.

Year 4: 10 percent return on $131.10—end the year with $146.41.

Year 5: 10 percent return on $146.41—end the year with $161.05.

Year 6: 10 percent return on $161.05—end the year with $177.16.

Year 7: 10 percent return on 177.16—end the year with $194.87.

In seven years, your initial investment of $100 almost doubled.

As a side note, the stock market does not provide a guaranteed or steady return of 8 to 10 percent. That’s just the average return over time. The stock market could be up 20 percent in year one, and down -10 percent in year two. More on this coming up.

Assuming a stock market return of 10 percent (based on historical returns), saying no to the daily latte and yes to investing $5 a day ($150 per month) in the stock market would result in over $950,000 in forty years. All it takes is $5 a day to experience this powerful wealth-building force. The stock market is not reserved for the rich. They are just the ones benefiting.

So, why aren’t people taking advantage?

It’s because we’re confused, intimidated, and time constrained. The investment industry and financial media want you to believe that investing in stocks is complex, and that you need to pay high fees for “sophisticated” advice. This is far from the truth.

When it comes to the stock market, the simplest approach almost always leads to the best outcomes. You just need to follow four simple rules:

  1. Diversify using low-cost index funds.
  2. Invest in consistent increments.
  3. Stay invested over the long run.
  4. Minimize fees and emotions.

Diversify Using Low-Cost Index Funds


Diversification can be summed up by the old saying: “Don’t put all your eggs in one basket.” Owning just one stock exposes you to the ups and downs of a single company—a company that may be hot today, but obsolete tomorrow. Hindsight is 20/20, and it’s easy to look back and rationalize how clear and obvious it was that Apple, Amazon, and Microsoft would go on to become such massive successes. Yet, it’s nearly impossible to decipher the next Amazon from the next Pets.com. Even the pros get it wrong. So, instead of owning just one stock, own many.

Don’t have time to research, trade, and manage such a big responsibility? Most of us don’t, but there’s a quick, easy, and effective approach that beats 90 percent of the pros.

Just buy and hold low-cost index funds.

What Is an Index Fund?

Let’s go all the way back to 1923. A publisher of financial reports and analysis, Standard & Poor’s, created a proxy for the US stock market. It started with just a small number of stocks but quickly expanded. Today, this proxy includes the largest five hundred stocks and is known as the S&P 500. It’s the industry proxy for the US stock market, and you can own all five hundred stocks in just a single purchase. How? By owning an S&P 500 Index Fund.

Popularized by the legendary mutual fund company Vanguard, index funds pool money from investors and buy shares in all five hundred stocks represented in the index. So, if you buy shares in an S&P 500 index fund, you are a partial owner of Apple, Facebook, Google, Microsoft, Proctor & Gamble, and the list goes on. Since the fund company takes a “passive” approach (all they must do is replicate the index), fees are typically low. Most S&P 500 index funds charge fees of one-tenth of a percent (.10 percent) or less: for every $100 invested, the fund charges $0.10.

Buying an S&P 500 index fund or exchange traded fund (ETFs are a close cousin to the index fund; index funds trade once per day, while ETFs trade intraday (multiple trades within a day) is an easy and cost-effective way to get diversified exposure to the US stock market. When you own an S&P 500 index fund, you are tied to the growth of the economy.

It doesn’t end with the S&P 500. There are thousands of stock market index funds (and ETFs) ranging from funds that provide exposure to non-US developed economies such as Europe, Australia, and the Far East, to emerging market economies. There are sector-specific index funds (index funds that just focus on technology stocks) and trend-focused funds (funds that invest in companies that are popular with Millennials). To keep it simple, just focus on index funds that are linked to the S&P 500 for US stocks, MSCI EAFE (Europe, Australia, and the Far East) for non-US stocks, and funds that are managed by well-known investment companies (Vanguard, Fidelity, and iShares by Blackrock).

Passive Index Funds versus Active Funds

Can it really be this easy? Just buy and hold low-cost index funds? There must be a way to get an “edge,” right?

Well, when you look at the numbers, the “less is more” path to investing yields the best results.

Each year, Standard & Poor’s releases a report on how active managers do against their passive benchmarks. The results aren’t good.

In 2018, 64.5 percent of active (professional) large cap managers lagged the S&P 500.

Extend the time period out ten years, and it gets worse with a projected 85.1 percent of active large cap managers lagging the S&P 500.

Extend out fifteen years, and 91.6 percent of active large cap managers will likely lag the S&P 500.[1]

The average person can save time, energy, and money by just investing in passive, low-cost index funds. You can go on with your life and beat more than 90 percent of the investing pros in the process.

Invest in Consistent Increments


Is it better to invest now or wait for a better entry point? Yes, and yes.

How?

By investing today, and again in a month, and again the month after. It’s a process called Dollar Cost Averaging. Dollar Cost Averaging spreads out timing risk, builds good saving habits, and takes the thought and emotion out of the investing process. Does this sound familiar? Well, if you participate in a 401(k) plan, it’s the exact same concept.

Building wealth through the stock market is a process. It’s a series of steps. The stock market is not a get-rich-quick scheme. There are ups and downs, and the rewards go to those who ignore the noise and stick to the process. Actually, it’s a lot like travel.

Have you ever traveled to a far destination? Perhaps you took a flight to another continent or went on a cross-country road trip. Remember the experience?

Traveling is almost always rewarding and enlightening, but getting there can be a hassle. Traveling takes time, patience, planning, and commitment, but you can embrace the process in a positive way. 

Think about the process of traveling overseas. After months of planning, the day finally arrives. You pack a suitcase and head to the airport only to find long security lines and potential delays. Next, you board a plane and sit in a confined space for hours. After you land, you claim your stuff, catch a cab/bus/train to your destination, and check in to your lodging accommodations. Hours later, you’re experiencing the true joy of travel; the process and pain it took to arrive is long forgotten.

Building wealth is no different. It’s just a series of steps. At first, it will appear as if you’re running in place. Just keep moving and trust the process. Your plane will eventually land, and you will arrive at your destination. Let’s run through a scenario.

Case Study: Jody, the Young Investor

Jody started her wealth-building journey in July 2006. She knew nothing about the stock market, so she kept it simple by investing in a low-cost S&P 500 index fund and made a commitment to investing $500 at the end of each month. She ignored all stock market news and stuck with the process.

How much did she have on June 30, 2019? Let’s look back at her journey. After year one, her balance was $6,469. Good, but not life changing.

Year two? Her balance was $11,072, but after total contributions of $12,000.

Year three? It was $14,112, but after total contributions of $18,000. It’s kind of like being excited to travel out of the country only to be hit with a three-hour delay. Frustrated and going nowhere.

Fast forward to year six with a balance of $43,303. Making progress.

Year ten? $101,332.

After thirteen years, and contributions of $78,000, her account value is over $171,000. Not enough to retire on, but a strong foundation. All from just a simple process—investing in low-cost index funds, and a $500 contribution at the end of each month. So, why aren’t more people doing this? Let’s look at some common excuses.

“This is great for the person who was smart enough to start at age twenty-two. I’m thirty-five and have no savings. I’m already far behind! Feels like I’ll never catch up!” 

If this is you, you’re not alone, but if you’re kicking yourself for not starting thirteen years ago, how do you think you’ll feel in thirteen years if you don’t start today? Think you’ll look back at thirty-five-year-old you and say, “Good thing you didn’t start at thirty-five since you were already behind.” No! You’ll say, “I really should have started when I had the chance at thirty-five!” If you start today, Future You will be thanking Present Day You. It doesn’t matter if you’re late to the journey. You may never fully catch up to the person who started at age twenty-two, but it doesn’t matter. Just start the process and create your own benchmarks. You won’t be rich overnight, and you will certainly experience delays and bumps along the way, but the destination will be more than worth it.

“I have the worst timing and I just know if I put my money in the stock market today, it’s going to drop. I think I should wait.”

While market corrections and bear markets are painful, they’re part of the process. Accept it and keep moving. Don’t cancel your trip over a three-hour delay. Jody started in 2006, right before the financial crisis. She didn’t wait for the financial crisis to pass. She didn’t stop the process when things got tough. She ignored the noise, and her patience and commitment were rewarded. There were times when she contributed $500 right before a stock market rally, and times when she contributed $500 right before a sell-off. In the end, it all evened out.

What if she experienced nothing but bad timing? What if she had the worst luck? Let’s run through an alternative scenario, but this time, instead of investing $500 at the end of each month, she’ll contribute a lump sum of $6,000 once a year at the worst possible time.

  • $6,000 in September 2007—The peak before the bear market caused by the Great Recession. The stock market would drop another 40-plus percent.
  • $6,000 in August 2008—Two weeks before the collapse of Lehman Brothers.
  • $6,000 in March 2010—At the start of the Eurozone debt crisis.
  • $6,000 in April 2011—Three months before the debt ceiling debate that pushed the stock market into correction territory.

And so on. The top of the stock market for each twelve-month period. The worst security line, the only flight that experienced delays, bad cab drivers, etc.

How much does she have after thirteen years of terrible timing?

$153,000! 

There were certainly more bumps and setbacks along the way, but this is still a solid base to build on.

Every journey is a series of steps. Ignore the distance, embrace the process, and have faith that even the most distant destinations get closer with every step. By investing in consistent increments, you spread out your timing risk, continually build on your existing base, and develop healthy saving and investing habits that add up over time. This brings us to our next rule: stay invested.

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Stay Invested Over the Long Term


There are two times when the value of the stock market matters: when you buy and when you sell. Other than that, the day-to-day fluctuations are just noise.

Picture something of value you own (a house, valuable art, or ownership in a small business) and imagine someone yelling out different prices into a megaphone for six and a half hours a day. Would you panic and sell when the person yelled out a lower price? Would you rush to buy when the when the person yelled out a higher price? No! To the extent possible, you would ignore this lunatic and tell them to get off your lawn.

Well, this is the stock market. Between the hours of 9:30 a.m. to 4:00 p.m. EDT, traders yell out the prices of public companies. It’s a lot of noise, and for a long-term investor these prices hold zero significance. Down days are just paper losses. If you don’t sell into the noise, you don’t lose anything.

The best thing you can do during times of market panic is turn off the TV, ignore the news, and do something fun and productive. Play with your kids or pets, go for a walk or run, go fishing, or whatever else you can do to avoid getting wrapped up in the noise and panic.

Yes, the stock market comes with risk, but over time the odds are in your favor. Just look at these statistics:

1. The stock market is up more than it’s down. 

From 1950 to 2018, the stock market has been up fifty-four out of sixty-nine years (78 percent of calendar years)[2] and gains have been significant. A $1,000 investment made at the start of 1950 would be worth close to $1,500,000 at the end of 2018. All for doing nothing. You get rewarded for patience. 

On a given day, the stock market is up about 53 percent of the time. Extend the time period out to three months, and the stock market is up around 66 percent of the time, and over a rolling twelve-month period, 75 percent of the time. So, if you’re a long-term investor, make no mistake about it, you will experience some down days, weeks, months, and years. If you stay invested for the long term, you’ll experience more up days than down days. You just need to be patient.

2. Be prepared for short-term losses. On average, the stock market experiences a peak-to-trough loss of greater than 10 percent every one to two years.

Over the last sixty-nine years, the stock market has dropped more than 10 percent on thirty-seven different occasions.[3] Translation: expect a peak-to-trough decline of more than 10 percent to happen within the next two years. Your wealth journey will experience delays and setbacks. Don’t sell into the panic. Instead, thank the market for the 10 percent drop. Why? Because it’s the reason you get paid over time. Volatility weeds out the weak from the strong, and the strong get rewarded.

3. Losses are made up quickly.

Since 1950, the average time to recovery for a loss of greater than 10 percent is six months.[4]

Minimize Fees and Emotions


It’s not what you earn, but what you keep that matters. The areas that erode the most wealth over time are fees and emotions.

When it comes to having a relationship with a financial advisor, it’s common to pay two layers of fees. The first layer is for advice. This fee is for the planning, coaching, and expertise surrounding their investment strategy and asset allocation. Fees are paid by the hour, a flat monthly fee, or as a percentage of assets. The most common fee is a percentage of assets. For this fee structure, the first fee layer ranges from .25 percent to 2 percent. The second fee layer goes to the mutual fund company (or outside manager) the advisor selects on your behalf. These fees range from as low as .03 percent for passive funds to as high as 2 percent for actively managed funds.

Put the two layers together, and fees are all across the board—from .28 percent on the low side to 4 percent on the high side. Most fees are somewhere between 1 to 2 percent of assets under management. To be clear, there’s nothing nefarious about charging two layers of fees. It’s the industry standard, and it’s in the client’s best interest for their advisor to allocate funds to outside investment managers. Doing so provides your advisor more time to work with you on planning and coaching. That said, it’s important for clients to be aware of the layers and to ask for the total “all-in fee” (the fee that includes all fee layers) at the start of the relationship. The more you pay, the less you keep.

Let’s look at an example using an all-in fee of 2 percent. If a client starts with $50,000, contributes $1,000 each month, and earns an after-fee return of 5 percent per year (compounded monthly), they would have $1,890,000 at the end of forty years.

How would this look if they worked with an advisor that employed the same investment strategy, but with an all-in fee of 1 percent? The client would have $2,540,000 at the end of forty years. That’s $650,000 more!

Does this mean you need to avoid financial advisors? If you are organized with your money, know your goals and are good about holding yourself accountable to meet those goals, comfortable implementing and managing an investment strategy, aware of the different savings and investment vehicles; familiar with insurance options, and have the discipline to stick with the investment strategy during challenging market environments, then yes, you are wasting money with a financial advisor.

But investing is emotional and when it comes to making money, emotions are our worst enemy. Each year, the financial consulting firm DALBAR releases the investing results for the “average investor,” and the results aren’t good. Instead of following the old adage of “buy low and sell high,” the average investor does the opposite. The average investor tends to get excited during good times and buys more stocks (buy high) and panics during stock market corrections and sells (sell low). Over time, emotions have been the biggest destroyer of wealth, and we can see it in the data.

According to the 2017 DALBAR Study,[5] in 2016, the stock market returned 11.96 percent, but the average stock market investor returned 7.26 percent. Extend the time period out ten years, and we see a similar story. At the end of 2016, the ten-year annualized return of the stock market was 6.95 percent, but the average investor returned a dismal 3.64 percent. Extend the time period out twenty years, and the average investor loses out again. The twenty-year annualized return of the stock market was 7.68 percent, but the average investor returned just 4.79 percent. Finally, extend the time period out thirty years, and we see a recurring theme. The thirty-year annualized return of the stock market was 10.1 percent, but the average investor returned 3.98 percent.

Translated into actual dollars, the gap is truly alarming. If you invested $100,000 in the S&P 500 on 12/31/1986 and did nothing for thirty years, you would have $1,820,000 at the end of 2016. But if you were the average investor, you would end the thirty-year period with just $322,000. That’s $1.5 million less! If you are comfortable investing on your own, just be mindful of the biggest threat of all—your emotions.

The stock market gets a bad reputation for being risky, confusing, and exclusive, but this is far from the truth.

To recap, the stock market is an inclusive and powerful force for building wealth, and you can beat 90 percent of the pros by following just four simple rules:

  1. Diversify using low-cost index funds.
  2. Invest in consistent increments.
  3. Stay invested over the long run.
  4. Minimize fees and emotions.

It’s that easy.

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[1] S&P Dow Jones Indices. https://us.spindices.com/spiva/#/reports.

[2] Aswath Damodaran, “Annual Returns on Stock, T. Bonds, and T. Bills: 1928–Current, New York University Stern School of Business, January 5, 2019, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html.

[3] Edward Yardeni, Joe Abbott, and Mali Quintana, Market Briefing: S&P 500 Bull & Bear Markets & Corrections, Yardeni Research, Inc., December 18, 2019, https://www.yardeni.com/pub/sp500corrbear.pdf.

[4] Yardeni, Abbot, and Quintana, https://www.yardeni.com/pub/sp500corrbear.pdf.

[5] “Quantitative Analysis of Investor Behavior,” DALBAR, https://www.dalbar.com/QAIB/Index; Lance Roberts, “Dalbar 2017: Investors Suck at Investing & Tips for Advisors, RIA: Real Investment Advice, September 25, 2017, https://realinvestmentadvice.com/dalbar-2017-investors-suck-at-investing-tips-for-advisors/.

Future You Wealth, LLC is an Investment Advisor registered with the State of New York. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions.  Please contact us at 917-515-4470 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions.  Additionally, we recommend you compare any account reports from FYW with the account statements from your Custodian.  Please notify us if you do not receive statements from your Custodian on at least a quarterly basis.  Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.futureyouweatlh.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.