Tuesday, April 18, 2017

Lessons On Investing

I gave a presentation on achieving financial success to a hundred or so graduating college engineering students two weeks ago.

For this audience, my primary message was simple and straightforward.

You have the greatest asset in the world for financial success---your youth.
Live beneath your means. Save and invest. Start when you are young and stay with it.
Compound returns will guarantee that you become wealthy.
It is no more complicated than that. 

Despite the fact that the formula is simple, very few people seem to be able to follow it.

Consider these statistics from the Economic Policy Institute (data as of 2013).

Nearly half of all families have no retirement savings at all.

The average retirement savings account holds $95,776.

However, that number is pumped up by the few that have saved a lot. When you take account of the many that have nothing, the median is just $5,000.

Even for those ages 56-61 nearing retirement, the median retirement savings is just $17,000.

Besides failing to save in the first place, many fail to achieve financial success because they can't keep their hands off of their savings, they lose too much to taxes or they make poor investment decisions with their money.

You see all three of these working together when someone borrows from their 401(k) account. On average, about 20% of participants in a 401(k) plan have a current loan from their 401(k). Almost 40% of plan participants have taken a loan out over the last five years.

There are many reasons why taking a loan from your 401(k) is a bad idea but the biggest reason is that the loan terms effectively make the loan fully callable if your employment ceases with that employer. Could there be anything worse financially for anyone than to lose their job which then becomes the trigger for a loan being called?

It is probably not a surprise that 86% of those with a 401(k) loan that leave their employer, default on the loan. This then triggers full taxation of the loan amount and a 10% penalty. A sure-fire way to end up with little or no retirement savings.

One of the other big messages I conveyed to the college students was to "watch their pennies." People tend to think that pennies are not important. That is why I seem to find so many laying on sidewalks. I never ignore a penny on the sidewalk.

You understand this when you see what a penny's difference can make when it is compounded over time.

Take the example of a graduating college student who receives a $2,000 gift at graduation from her grandparents. Her grandparents tell her to invest it in a retirement account and to add $2,000 to the fund each year for the next 45 years as a tribute to them. She does just that.

That money, compounded monthly at an 8% annual return, will give her almost $1 million at age 67. However, if she only earns 7% (a mere penny on the dollar less per year), she accumulates only $682,000. If she earns 9%, her retirement nest egg becomes $1,356,475.

An extra 1% in extra investment return per year makes a huge difference over a lifetime. The same goes for an extra 1% in investment management or advisor fees that reduces your investment return. Those fees can be well worth the money if Warren Buffett is picking stocks for you or managing your investments. However, the fact is that only 19% of active investment fund managers around the world are doing better than their benchmark index according to a recent Bank of America study.  However, those active managers are charging premium fees even though they may be delivering sub-par returns.

Why is it hard to beat index investing?

The easy answer is that the benchmark index has no fees. For a manager to beat the index they have to deliver outsized returns at least equal to their fee. That is not an easy task.

New research provides the answer as to why this is so hard. The reality is that stock market index performance is heavily skewed to a handful of stocks each year. A few stocks typically drive annual stock index performance while 70% of stocks will perform worse than a Treasury bill according to a study by J.B Heaton, Nick Polson and Jan Hendrik Witte.

A few quotes from the Bloomberg Markets article on the research.

The distribution of returns in the stock market is bizarrely lopsided. Often, equity benchmarks are so reliant on gigantic gains in just a handful of stocks that missing them—as most managers do—consigns the majority to futility. 
A concentration of outsize gains in a minority of index members is tantamount to a death sentence for anyone who gets paid for beating a benchmark. It’s a pattern of returns that virtually ensures everyone outside of an indexer owns mostly deadbeat stocks.
By itself, the observation that you need to pick winners to beat the benchmark isn’t news. What else are fund managers paid for? The point of this vein of research is that the contours of the market itself make the odds against picking winners prohibitively long. 

Lessons worth remembering whether you are a college student, a 401(k) participant or an active investment manager.

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