Most of us are very bad investors. We put very little effort into deciding what kinds of things we should invest in. We don’t pay much attention to the tax consequences of our investments. We often let ourselves get sold products that primarily serve to enrich the person selling said products to us. We buy high. We sell low. The results are disastrous. A recent article indicated that while the S&P 500 index has average 9.22% over the last 20 years, the average individual investor in equity funds has only gotten 54% of those returns (a 5.02% average return). Ouch.
Why do we have such a hard time getting even the “average” returns offered by an S&P 500 index fund?
Greed causes us to look for a bigger better deal. We hear about a brand new IPO and think we should get in early on a stock. We hear about a hot sector and are tempted to move our money there. A financial advisor knocks on our door and promises a bigger better return. We hear about a hot new asset allocation strategy that promises maximum returns and minimal risk.
We want better returns, so we set any previous planning we did along with healthy skepticism aside with the eye on having more money down the road. Unfortunately, this rarely works out. By the time you’ve heard about a hot new stock or investment, it’s probably too late to get in at a good price. After your shiny new investment fails to get the big promised returns, you sell it for the next big thing. You end up buying high and selling low over and over again, which decimates your returns.
We fear volatility and risk. Many people overstate their willingness to take on risk in favor of potentially larger returns down the road. They think they can handle the ups and downs of the market, but sell whenever there’s a minor correction. We think we’re making a smart move to sell when the market goes down to avoid losses. However, by the time you sell, the market likely has already taken much of its losses. By the time you get back in, you’ll probably have missed a lot of the recovery. Again, you’re buying high and selling low.
We pay too much in fees. People generally have a very little understanding of how much they’re actually paying for their investments. If you have an investment advisor that charges a 1% annual account fee, you’ll be losing out on 24% of your total returns if you invested over a 30-year period. You also need to pay close attention to what the underlying management fees of the mutual funds you’re invested in. I’m a big fan of the low-cost mutual funds offered by Vanguard and Fidelity.
Getting Good Investment Returns is Surprisingly Easy (With a Little Research)
Like losing weight, getting solid investment returns over the long haul isn’t rocket science. If you’re willing to do a basic amount of research, you don’t even need a financial advisor (whose fees will also reduce your returns). You just need to spend a few hours every year reviewing your strategy and making minor adjustments.
- Identify Your Account Type. The first to getting consistently good returns is to understand what account type will serve you best for taxes. A Roth IRA is usually the best type of account to open if you’re saving for retirement. After that, you can work on maximizing any employer-sponsored retirement plans such as a 401K or 403B plan. If you’re self-employed, you can open a Simplified Employee Pension Plan (SEP) or an Individual 401K plan. Here’s a basic guide that provides more details common types retirement accounts. If you run out of tax-advantaged savings options, you can look at a low-turnover or tax-managed mutual funds like those offered by Vanguard.
- Determine Your Asset Allocation. Different types of investments (stocks, bonds, real estate, cash, commodities, etc.) perform differently during different economic conditions. They have different average returns and different levels of risk. For this reason, it’s good to have a variety of types of investments at a set percentage of your allocation. There are a lot of tools that will help you determine what you should invest in online based on your age and savings goals. Wealthfront has a tax-aware asset allocation tool that I like. Vanguard has an asset allocation tool for its funds that’s also good. Charles Schwab has a resource about asset allocation that’s also worth checking out. You can also learn about target date retirement funds that will automatically set an asset allocation for you based on your age.
- Pick Your Mutual Fund Provider. Next, you have to figure out who you’re going to put your money with. Radio host Clark Howard recommends that you invest with one of three low-cost mutual fund providers, Fidelity, T. Rowe Price or Vanguard. The bulk of my personal investments are done through Vanguard, since they have some of the most affordable fees in the industry. I also have a Wealthfront account, which lets you invest in Vanguard ETFs and provides a few other services for a nominal management fee (0.25%).
- Put Your Investments on Auto Pilot. After you’ve figured out what you’re going to invest in and where you’re going to invest, setup an automatic monthly deposit into your investment account. The standard recommendation is that you should be putting 15% of your income into retirement accounts. If you can’t do that, it’s better to start at a lower percentage than no percentage at all. After you’ve setup the automatic investment plan, let it run, forget about it and pay no attention to the financial media (like CNBC).
- Extra Credit: Rebalance Once Every Year. If you want to go above and beyond, make sure that you’re still at your desired asset allocation mix once each year. By rebalancing, you’ll be selling a portion of your investments that are performing well and buying investments that are undervalued, increasing your returns over the long term. Learn more about rebalancing here. If you invest in a target-date retirement fund or use a robo-advisor (like WealthFront), this is done for you automatically.
If you want to invest in single stocks, gold or angel deals…
Some people have caught a bug that causes them to want to pick single stocks or throw money at new companies by way of angel investing. Others want to own precious metals like gold and silver. Yet others want to invest in fine art or collectibles. If this is you, it’s okay to do some of these things, but recognize that it’s going to be tough for you to get the same kind of returns you’re getting from the basic investment strategy listed above. You should also make sure that no more than 10% of your portfolio is invested in these creative and hands-on investments. I’ve personally invested in a few angel investment deals, but they represent only about 7% of my investment portfolio.
A quick note about real-estate
There’s nothing wrong about owning rental real-estate (homes, apartments, commercial space) as part of your investment portfolio. You can get returns similar to that of the stock market with less volatility, but there’s much more work involved to maintain your investment. If you want to consider rental real-estate as an investment, do a ton of research and meet with a few people that have been in the business for a while before diving in head first.
Getting good investment returns doesn’t have to be hard or take a ton of time. If you’re willing to do a bit of basic research up front (5 hours or less) and setup an automatic investment plan, you’ll be well on your way to establishing a secure financial future.