Investing Reality – It’s So Simple A Caveman Can Do It

My last post about investing misconceptions was admittedly quite scary. In fact, it flies right in the face of what I had described in my earlier posts about using your savings to grow your investments. Why on earth would you work super hard to pay off your debt, save money and then lose it all in the stock market? I also said that I was going to present you a different view on the stock market. The investing reality is that is very simple.

Long Term Trend Of The Stock Market

The chart above is for the S&P 500 from the 1980-2022. There is one aspect about the chart that you should notice – its long-term trend is always in the upward direction. Included are all major events in that time-frame. Wars, natural disasters, political upheavals, oil embargoes, economic collapses, sovereign debt crises, global pandemics, etc. Yet, despite all those events, the S&P 500 has moved higher and higher. Why is that?

In his 2007 book, “The Little Book of Common Sense Investing”, the late John Bogle laid it out clearly. Over the past hundred years US corporations, because of their growth, productivity, resourcefulness and innovation, have been able to achieve a return on capital of 6.5% per year (after adjusting for inflation). That means, $1 invested turns to $1.88 in 10 years, $3.52 in 20 years, $6.61 in 30 years, $12.42 in 40 years and $23.31 in 50 years, after adjusting for inflation. The compounding of the returns over the years is nothing short of a miracle. The stock market (or more accurately the value of the S&P 500) reflects that growth. You must acknowledge and internalize this investing reality if you want to become financially independent.

The S&P 500 index is simply a value of the 500 largest companies by market value listed on the New York Stock Exchange or NASDAQ. The company’s market capitalization (which is a product of the number of shares and price) determines its size in the index. As we all know, some individual companies compete with one another and gain and lose market share all the time. This is another outstanding feature of the S&P 500 index. It re-balances four times a year to make sure that the only 500 of the largest and best-performing companies remain in the index.

Investing Reality – Simplicity Of Index Investing

John Bogle’s investing philosophy is based on this principle. It is known as index investing (or passive, lazy investing). It is simply based on investing in the stock market as a whole, doing nothing else, simply sitting back and letting the power of compounding work for you. See the investing reality? How easy it is.

It would be surprising for you to know that the first index fund was launched in 1975. However, the idea never really got much traction in the mainstream media. The reason is obvious – there is not much viewership (and consequentially advertising revenue) you can attract by having a pundit sit in front of the TV and advise people to put their money into a boring index fund.

However, a lot has changed in the last 10 years and index investing has entered the mainstream. I believe there are two major reasons for this change:

1. Outspoken support of index investing by Warren Buffett – there is no doubt that the Oracle of Omaha, a well-known supporter of John Bogle, has vocally pushed back against actively managed funds. Buffett’s success is well-known but then again it is not easy to replicate his approach. In 2008, at the height of the housing crisis, Buffett made a $1M bet that a low-cost, S&P500 index fund over a period of 10 years would outperform a collection of actively managed hedge funds led by the “best of the best” on Wall Street. At the end of 2017, the results came in – the index fund had a 7.1% return while the actively managed fund had a meagre 2.2% return.

2. Growth of social media and online content – A lot of people, especially millennials and Generation Z, consume a lot of online content through various social media networks. As such, there is wide range of information sources available (assuming one is willing to dig in and search for the right answer). The days when people used to get their information from a TV broadcast have disappeared.

What About Costs?

When investing in a fund, whether it is an index, mutual or a hedge fund, you will hear the term management expense ratio (MER). The textbook definition is quite simple – it is the administrative cost of running the fund. However, for most people, this definition is confusing. When someone mentions a cost, you would naturally expect them to quote a dollar figure. But instead they quote you a percentage.

Huh?

The quoted cost is a percentage of the fund’s return. If a fund has a MER of 2.5%, then a $10 return will give $9.75 to the shareholders. You do not have to pay the costs in a bill at the end of the month. The costs are baked in the cake. It is taken out of the investments, in stealth fashion. But then again, you are still getting the lion’s share, aren’t you? Who cares about that 2.5%? Right?

Wrong.

In the earlier part of this post, I talked about how returns compound over time. $1 after 10 years turns to $1.88 (a return of 88%) and the same $1 turns to $3.52 after 20 years (a return of 252%). This is the miracle of compounding at play – the longer time you invest for, the higher your returns. Unfortunately, the miracle works against you when it comes to costs. Over a long period of time, the costs become huge as well, which then vastly diminishes your returns.

Here is an excellent article that explains the compounding effect of costs with the aid of simple example. An investment of $100,000, $5000 annual contribution and a 5% annual return is modeled with different MERs over different timeframes. Over a period of 25 years, a 0.20% MER will result in a total cost of $14,457.94 while a 2.5% MER will result in a total cost of $182,909.94 (which happens to be more than the initial investment of $100,000!).

Costs matter. Index funds only charge between 0.05%-0.30% fees while actively managed funds charge between 1-2%. Hedge funds are the worst. They charge 20% fees on top of the MERs as well.

So Where Do We Stand?

In this post and the last one, I have presented two views on the stock market. The first one is related to investing misconceptions and the second one is about investing reality.

Hopefully, with the information I provided, the answers to the four most common questions should make it clear.

1. What do I invest in? Low-cost index funds
2. How do I know if it is right? Your net returns, after taxes and costs, are the highest when you use index funds over a long period of time.
3. Stocks are risky – what if I lose all my money? It is true only when you try to beat the market.
4. What if the stock market crashes and burns? Temporary setbacks will come in the way but over a long period of time, the stock market will go higher.