We’ve all heard the stories about how everyday people we know, or a friend of a friend has gotten rich. Maybe not filthy rich like the billionaires in pop culture. Most of the billionaires have similar stories to each other, in that they created a company which in turn sold a product or service that millions of people want or need. While these stories are inspirational, we intuitively understand that they’re not reproducible. You or I will not be the next Bill Gates, Elon Musk, or Jeff Bezos.
So it’s with a fond ear that we listen to tales of people with “regular jobs” just like us who became comfortably wealthy. Millionaires at the very least. Maybe they’re a lawyer, or an accountant, or a carpenter, or an engineer. Either way, the general trend of these stories seems to be that they turned a small trickle of savings from their day job into a respectable pile of cash through their investment savvy.
You know the stories that I’m talking about. Your uncle, who bought a vacation home in the Jersey Shore for $80k a few decades ago, and recently sold it for over a million dollars. Your brother-in-law, who was smart enough to buy Apple stock in the mid-90’s with all the money to his name and made 2,000 times his initial investment. That coworker who follows some fancy “seasonal investment strategy” in his 401k, and is always bragging about his 20% returns.
But you know what? These stories are useless too. None of them are reproducible either. Most of those people just got lucky on a one-off event. And worse, for every “big winner” you hear about, there’s a loser whose story you never heard. What if your uncle bought in Detroit, and his home was now worth pennies on the dollar? What if your brother-in-law invested in GT Advanced Technologies in 2014 instead and lost everything when they went bankrupt, just like these poor souls? What if your coworker only tells you about his winning 401k trades, and actually has less money than if he just followed a buy and hold strategy, never making a single trade?
How would one define the best investment strategy for getting rich then?
For me, the answer is easy. It would be the most reliable, reproducible path. Consider the following: I offer you an investment opportunity. I have a special fund that will produce the same rate of return, steadily, forever. The only catch is that if you accept the offer, you have to invest your life savings into it, and you cannot ever invest your money in any other way. I offer a choice of one of these options:
- A guaranteed 10% annual return.
- A coin flip… If heads, you get 20% annual returns, but if tails, you get a 0% return, forever. (Interestingly, the average performance among the group of people who choose this option is still 10%, but that says nothing about their individual performance.)
I’d wager most people would choose the first option. Sure, you won’t perform the best, like anyone who was lucky enough to get the 20% return. But you’re also guaranteed to not perform the worst, like half of the people who chose option 2, who are cursed for the rest of their life to have a return lower than that of my savings account. What’s more, this strategy is reproducible. If I told a friend about it, all they’d have to do to replicate my results is to choose the first option, and not be arrogant and try to beat the odds of the coin. To just accept the average, because it’s good enough to meet their goals, and recognize that trying to outperform simply isn’t worth it when there’s an equal chance that you perform commensurately worse.
So why, then, do so many people not apply this same logic to their real investment portfolios? One is hypothetical, and one is your hard-earned cash that you traded your labor and finite time for. The analogy here is certainly appropriate. Don’t believe me? Let’s take it from Nobel Prize winning economist William Sharpe:
Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights. Each passive manager will obtain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.
WILLIAM F. SHARPE, THE ARITHMETIC OF ACTIVE MANAGEMENT (1991)
I encourage you to read the whole (short) article by clicking the title in the citation above. It is a complete logical proof behind the quote above, which is absolutely a truth. Conflate our prior example with this new knowledge, and we now have the following choices:
- Be a passive investor. Invest in globally diversified, low-cost index funds and receive exactly the average stock market return minus a small fee (0.15% or less).
- Be an active investor. Individually return more or less than the average stock market return. On average, this group will receive exactly the average stock market return minus a medium to large fee. For active fund investors, these fees are typically between 0.50-1.50% depending on the fund. For self-managed retail portfolios, these fees are trading costs plus any additional tax drag incurred while implementing their strategy.
If you choose active investing, the deck is already stacked against you! Active funds have high fees. Or if your strategy involves trading frequently, holding positions for less than a year incurs much higher short-term capital gains tax rates (at least in the US). So it’s not even a 50/50 chance for you to beat the market, since you also have to account for these additional costs just to get back to even with the market return.
And in fact, this was Mr. Sharpe’s main point. As he explains much more eloquently, “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” So again, why do so many people invest in this manner if, on average, they would be better served by holding a passive index fund?
People might just not know any better.
Clearly the most forgivable reason, as you simply don’t know what you don’t know! Personally, I think the glorification of stock investing in the media is to blame for this one. The talking heads on cable news are always going on about which stock skyrocketed during the day’s trading session, and they always talk about it in a manner as if there was some sort of methodology to see it coming. Ironically, when a company beats expectations so well that their stock pops, this is a direct result of the average market participant not seeing that coming. The big move is the market pricing in the new information.
Financial news on the internet is just as bad. Every stock market movement has a reason assigned to it in the headlines. We’ve all seen articles like “Dow Jones SURGES on Positive Jobs Report” or “Stocks Continue to Crater on Coronavirus Fears”. It’s sensationalist journalism at its worst. The stock market is such a complex thing that (with a few exceptions) it’s laughable to try and boil the day’s events down to a headline, much less a single article. If stuff like this is a person’s main exposure and education on the market, it’s no wonder they’d be misguided.
Going back to our earlier real estate example, you’ll often hear “so-and-so bought their house 30 years ago for [small number], and today it’s worth [really big number]!” It’s a super simplified statement that has a wow factor, but is completely useless when determining how good of an investment their house really was. There’s so many factors that need to be considered to make an accurate analysis, like:
- Adjusting for inflation
- Total interest paid on the mortgage
- Total amount of property tax paid
- Total cost of maintenance
- The opportunity cost of your down payment, i.e. how much money did you miss out on by not investing that money into stocks
- Imputed rent, i.e. how much did you save by living in your house compared to renting elsewhere
All of the above but the last one are factors that cost the homeowner money, and would reduce their claimed return to a much smaller number. So take such stories with a grain of salt, because many times the person telling them doesn’t even know that they need to consider such factors to make a fair evaluation of their home’s performance as an investment.
Add to this list the people that have positive returns from picking stocks or trading, but they don’t know how to benchmark their returns to an appropriate index. For example, if you’re attempting to pick winners among large cap US stocks while reinvesting your dividends for maximum growth, the S&P 500 is likely an appropriate benchmark. If during June 2020, this person brags that their portfolio has had a return of 200% over the past decade, that certainly sounds impressive — they’ve tripled their money! However, when we compare to their benchmark index over the same period, we’ll see that the S&P 500 actually returned 250%. The index investor had higher returns, likely with less risk, and certainly with less time spent managing their portfolio!
They know the odds, but still think they’re smarter than the market.
This one seems very common among engineers, computer scientists and programmers, and people in other math-based fields. They typically think that they can discern a pattern of behavior from the stock market (after all it’s just numbers, right), and develop some sort of “system” to exploit it and beat the market. I’ll be the first to admit that I used to think this way. I spent several years in college trading Forex (i.e. trading currencies on the foreign exchange market). I was convinced that if I spent enough time studying the markets, I could eventually learn — either intuitively or through a technical indicator system — how to exploit them for insanely high returns.
It’s undeniable that some people like Warren Buffett have outperformed the market consistently for decades. It’s up for debate the degree to which raw skill, sheer luck and survivorship bias, insider advantage, or some combination of those played a role in their results. Regardless, most people don’t seem to realize exactly what they’re up against when they embark on the quest to become the next Buffett.
Remember, when you move your chips into the active management pile, more dollars (not necessarily people) playing this game will lose than win, if losing is defined as under-performing the average market return. Who else is entering the ring with you? Multi-billion dollar hedge fund managers. The legions of Ivy League PhD students, people much smarter than you or I, in their employ. Market analysts who spend their entire 60 hour work week following every move of a small selection of companies. People trading unfairly with insider information who might never get caught.
They’re all acting with the singular purpose to try and make sure that they end up on the winning side of that bet. I’d say it’s unlikely that a retail investor who probably only spends a few hours per week managing their portfolio after working their full-time job would emerge from the ring victorious. If you’re lucky, you’ll just get a few bruises like when I was trying to play the Forex market. I didn’t have much money to throw around then, so I think I only lost about $500 total before learning my lesson.
Or maybe you’ll just under-perform by 1-2% per year. After all, not everybody that loses the active bet goes completely broke. It’s not total financial destruction and you’re still making money, but over the long-term, that would certainly compound into a huge lost opportunity cost compared to just accepting the average market return.
Seriously, even the pros can’t do it.
The above figure comes from S&P Dow Jones Indices, “the de facto scorekeeper of the active versus passive debate.” Their Scorecard report is full of tables and tables of data comparing the results of active funds in many different categories of US stocks, international stocks, and bonds to their respective appropriate benchmarks. They even account for survivorship bias in the data set, as many of these active funds close due to poor performance, sometimes in an attempt to mislead investors. If you open 10 funds and close the worst half after a decade, purging them from your catalog of fund offerings, your track record will certainly look more impressive.
The track record of these active funds on average is nothing short of abysmal. After 10 years, over 80% of active funds which invest in either large cap, mid cap, or small cap US stocks have under-performed their respective benchmarks after accounting for fees. At the 15 year mark, it’s close to 90% under-performance across the board!
Of the 10% or so who do beat the market, there’s no guarantee that they will be able to sustain that performance in the future. Would you rather…
- Have your personal portfolio beat the long-term performance of nearly 90% of paid, professional active money managers by doing almost no work.
- Do the research of identifying those fund managers who have outperformed in the past, and accept the risk that they’ll be one of the big losers in the next SPIVA Scorecard report.
What if accepting the so-called average… actually made you above average?
It may sound counter-intuitive, but as we can see from the evidence presented thus far, it’s clearly true! As long as there is some pool of actively managed money in the stock market — and thus bringing down the average return across the pool of all invested money, net of fees — all that you have to do to be an above average investor is to invest passively, with minimal fees.
So what kind of stock index funds do I buy then?
“Successful investing is about owning businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s – and, for that matter, the world’s – corporations.
JOHN C. BOGLE, FOUNDER OF THE VANGUARD GROUP AND “FATHER OF THE INDEX FUND”
This is actually the easy part, because we’ve already laid out all the groundwork. We’ve already concluded that active management and picking stocks is a loser’s game. It then stands to reason that picking individual sectors, or even countries also qualifies as active management. What is the most passive portfolio that one can have? I’d imagine it would own a small chunk of every company in the world. Since that’s not technically possible, as some companies are privately owned, the next-best thing in my eyes would be to own a chunk of every publicly-traded company in the world.
Thankfully, there’s index funds that do just that! Take for example, the Vanguard Total World Stock Index Fund (VTWAX). This fund holds market cap weighted stocks in over 8,000 companies, all for a low 0.10% expense ratio. VTWAX is my preferred equity investment. I think this fund is so good, that it should be the default stock fund recommended to all investors. The only reason that my stock holdings aren’t 100% in this fund is because it isn’t offered in my 401k, but I do try to emulate it as closely as possible using other low-cost funds in the appropriate ratios.
If your brokerage doesn’t offer a similar fund, you can emulate a total world stock portfolio by holding 60% of your equities in a Total US Stock Market Fund (like VTSAX at Vanguard) and 40% of your equities in a Total International Stock Market Fund (like VTIAX at Vanguard). Note that the market capitalizations of countries change over time, so while this is accurate as of an update in April 2022 it may be prudent to double-check these market caps if you happen upon this article in the future.
What about bonds?
Many investors like to add a portion of bonds to their portfolio for capital preservation and to help smooth out stock market volatility. Make no mistake that historically, stocks have been the true engine of portfolio growth over the long-term, and that the relative security of bonds has come with the commensurate trade-off of lower returns. However, don’t confuse that with thinking bonds are bad, as they certainly have their place.
Personally I hold no bonds due to several reasons. My portfolio size is small, so I’m comfortable with the unfettered day-to-day volatility of the stock market. I believe that I could act rationally and not sell during the occasional large market crash. I’m still over a decade from early retirement, so I don’t need to start preparing yet to mitigate sequence of returns risk (the risk that a few bad years of stock returns right at the start of your retirement may drastically reduce portfolio survivability).
Based on my prior research, I’m inclined to suggest that during portfolio accumulation in your working years, anywhere from 0 – 40% of your total portfolio value held in bonds would be reasonable. During the years leading up to and through early retirement, I’d suggest 10 – 40% as a reasonable range. That is, early retirees should have at least a small chunk of bonds for liability matching and to mitigate sequence of returns risk. However, stocks will provide the long-term growth that enables your portfolio to sustain withdrawals (and thus provide you income) for decades to come, so it’s a balancing act to find the sweet spot between all of these factors.
As far as fund recommendations for bonds, my top choice is the Vanguard Total World Bond ETF (BNDW), with a 0.06% expense ratio. Similar to how we chose a stock fund, this recommendation is based on simplicity and broad diversification at a low cost. VBTLX holds nearly 16,000 different bonds and aims to track the global investment-grade bond market, while being currency hedged to the US dollar to reduce foreign exchange risk. Currently BNDW is not available as a mutual fund, but I believe that Vanguard will add one soon given that their Total World Stock Market Fund was previously only offered as an ETF, and a mutual fund was recently created to track that fund based on popular demand.
This article is already pretty long, so I’m thinking we’ll get more into bonds and their benefits at a later time, especially as I consider adding them to my personal portfolio as my net worth grows. Bond allocation is a highly personal decision based on one’s own risk tolerance and needs, so there is no one right answer for what percentage of bonds to hold.
Don’t even worry about bonds early in your journey.
If you’re early along on your journey, the majority of your portfolio growth will be due to contributions rather than investment growth, so your asset allocation isn’t super important. Similarly, any stock market volatility will be smoothed out by your regular additions to your portfolio. I’d posit that such an investor actually doesn’t need bonds at all, and can direct all of their investments towards a fund like Vanguard’s Total World Stock Index Fund (VTWAX).
Everyone has a different savings rate, so I’ve come up with a handy rule of thumb to give you a frame of reference as to whether you should consider starting to add bonds to your portfolio!
As your portfolio grows, your MGFC will become smaller over time. Mine is a little over 3% at the time of writing this article. Let’s consider a 2% MGFC; at this point you’re still growing your portfolio by 24% per year just by contributions, which goes a long way towards recovering to your peak value after a market crash. I think only the most risk-averse investors should consider adding bonds this early.
Conversely, a 1% MGFC seems like a good time for even the most aggressive investors to start adding some bonds to their portfolio. At this point you’re approaching the rate where average nominal returns on your portfolio will soon eclipse your contributions. An investor who describes their risk tolerance as “moderate” may then want to take the midpoint of the prior two guidelines, and start adding some bonds around 1.5% MGFC.
That’s it. Two funds is all you need.
It’s my strong opinion that the most reliable method to get rich is to invest the majority of your assets in a diversified, low-cost equity index fund like Vanguard’s Total World Stock Index Fund (VTWAX). Learn to accept the (historical) average annual return of 8.5% nominal, because by doing so you are guaranteed to be an above average investor.
Knowing that trying to beat the market is a losing game, tweak the variables that are within your direct control instead. Pay yourself first. Live below your means, so you can spend less and save more. Always focus on improving your frugality. Pursue long-term strategies like increasing your income.
Stocks alone are enough to ensure you get rich. However, once you’re well on your way to building a respectable nest egg, slowly adding a second fund like the Vanguard Total World Bond ETF (BNDW) using the guidelines a couple paragraphs above is recommended. The ultimate goal is to slowly shift your portfolio from an aggressive growth model, to one that is optimized for sustaining withdrawals to provide you with income for the rest of your life. Expect articles that explore bonds and withdrawal optimization in more detail in the future!