Last Updated on April 26, 2022 by Rational thinking
Summary and introduction:
Research shows that the majority of investors underperform the broad market indices. The most likely reason is due to frequent buying/selling and behavioral mistakes. When you are trying to “outsmart” the markets, you most likely end up losing to the market.
To successfully invest you actually need to do as little as possible. What is required of you is more or less nothing. No analysis, no research, no forecast, no reading of news and research, no tinkering and no re-balancing. No intelligence whatsoever is required. No study of Warren Buffett or other marvelous investors (which you will never manage to clone anyway).
What you need to do is the following:
Set up an automatic monthly withdrawal from your bank account to buy shares or units in passive mutual funds or ETFs (or several funds/ETS, perhaps some active funds as well). Then forget about it and continue your ordinary life. Don’t do any tinkering. This method is called dollar-cost averaging (DCA). It can’t get any simpler than that! If you do that for 2-4 decades you most likely build a decent wealth and crush the majority of the “experts” along the way.
At the end of the article, we give you an example of how to dollar-cost average. Even saving only 100 a month gets you a long way if you are patient and let your capital compound.
Warren Buffett has always advised “unprofessional” investors to simply invest in the S&P 500 index (or another passive index). That is cheap and easy and gives you the same return as the index minus a small cost. This advice makes a lot of sense, but of course, is rather boring for a lot of aspiring investors.
When you retire you simply do the opposite: withdraw a certain amount or percentage every month from your assets. Don’t waste your time looking for dividend stocks to pay for your retirement. Most dividend investors have it all wrong.
All you need is a steady job/income, time and delayed gratification. DGA is the hardcore version of Charlie Munger’s “sit on your ass” investing.
Pessimism and opportunity costs: It pays off to be an optimist in the stock market
Mainstream and social media bombard us constantly with news, commentaries and opinions about the stock market and the economy. At any time there are a zillion reasons for the stock market to drop x%, and very often you need a leap of faith to hang on to your stocks. Reading about the markets at regular intervals makes it just worse.
Being bearish is a huge opportunity cost in the long run. Dimson, Marsh and Staunton published in 2001 a brilliant book called Triumph Of The Optimists that elegantly shows the superior returns in stocks versus other asset classes. Optimism is an underrated asset, given of course you can control your emotions. You just have to tolerate some potential pain when the market drops, but this of course you avoid by ignoring the news and not following your positions.
The less time you spend on calculating your assets, the better. Just make sure you have a daily margin of safety to continue your ordinary life, and your wealth will highly likely take care of itself.
Most stocks do poorly – stick to mutual funds:
Statistics show that most stocks perform very poorly. According to the famous study by Hendrik Bessembinder the median stock “survives” only seven years, and only 27.6% of the listed stocks manage to beat treasury bills. Thus, the median stocks have returned less than treasury bills even though the averages have performed so well (read here for an explanation of averages and median).
How are you going to pick those few good stocks? It’s extremely unlikely. Research shows small retail investors underperform both the market and mutual funds. By investing directly in the stock market you highly likely fail and end up trailing the market averages.
Then how come the stock market has been such a good asset class over time?
The outliers make the averages perform well:
A very small group of stocks make the stock market outperform: the outliers. The above-mentioned book by Elroy, Dimson and Marsh didn’t look at the individual stocks that make up the market. They simply looked at the wealth created by all stocks. Sadly, just a tiny few drive the majority of the performance. Bessembinder concluded that only 4% of the stocks made the averages beat treasury bills, and only 0.33% make half of all wealth creation. This means you have to be pretty good at picking stocks to make it worthwhile! These few stocks compensate for the poor performance of all the other stocks. Missing the best stocks obviously leads to dramatic underperformance.
As a retail investor the conclusion is pretty simple: stick to mutual funds or ETFs. Much less can go wrong.
Marshmallows and delayed gratification:
Most people and investors can’t delay gratification. Saving for the future requires discipline that most of us don’t possess: we don’t pass the marshmallow test. We would rather eat one marshmallow today than have two in the future. Saving for the future faces the same problem: the gratification of spending is immediate while saving is delayed gratification. You might have to wait for decades to get enjoyment from that money. There are many studies that show a correlation between the ability to delay gratification and subsequent success in adulthood and life.
To avoid delayed gratification you can invest a “small” amount every month which doesn’t feel like a big sacrifice. Furthermore, compounding means it’s better to start saving small early than more later. This method leads to dollar-cost averaging:
Dollar-cost averaging (DCA):
Dollar-cost averaging is an investment plan where you invest at regular or irregular intervals to build wealth over time. This, of course, can’t protect you from the risk of declining market prices, but it ultimately lets you invest in potential future prosperity by investing a small amount for example every month. This way you invest in both bull and bear markets. When the markets go down you keep on saving and thus lower your investment cost, thus the name dollar-cost averaging.
The advantages of a monthly investment plan are obvious:
- No waste of time predicting future stock market prices.
- No waste of time predicting the future economy.
- You will not risk your capital at investing outside your circle of competence.
- No behavioral mistakes.
You simply make your monthly withdrawal and forget about it. This plan is extremely simple and thus much less can go wrong. You remove emotions and potential behavioral mistakes. No ill-timed buying or selling. In Chapter 5 of Benjamin Graham’s The Intelligent Investor Graham refers to a study conducted by Lucile Tomlinson on DGA. Her concluding remark reads like this:
No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.
A dollar-cost averaging example: the snowball effect
By saving regularly you can capture the snowball effect, which I described in this article. Below is a practical example that shows how 100 invested monthly compounds over time:
The assumptions are like this:
- S&P 500 is represented by SPY (ETF).
- 100 invested at end of January 2000 and monthly thereafter until May 2020.
- To keep up the savings rate with inflation, the monthly savings rate increases by 0.25% per month. Thus, the first withdrawal is 100 in January 2020 and the last in May 2020 is 185.
- Dividends are reinvested.
This is all there is to it. It can’t get any simpler than that!
All in all, you save 34 114 and have a portfolio worth 90 799 per 5th of June 2020. Not bad! Interestingly, visually both the financial crisis of 2008/09 and the corona mess in 2020 are just minor hiccups along the way.
The chart shows how compounding works with time: The first ten years produced just a wealth of 16 000, while the last ten years produced about 75 000 including the monthly savings. Of course, the stock market performed much better in the last ten years, but it illustrates why Warren Buffett presumably has made 99% of his wealth after he turned 50.
The simpler you make it, the more likely you are to continue saving and investing. The less time you spend on your investments, the less likely you are to tinker and make foolish mistakes. The longer you wait and keep on saving, the more it snowballs.
This is why it makes a lot of sense with a monthly savings plan and dollar-cost averaging. Make sure you make it as hassle-free and easy as you can.
Good luck investing!
Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.