Praise for
Common Sense Investing
“Hide this book in a safe place because grossly overpaid investment advisors are burning every copy they can find.”
—Rick
Ferri, CFA, President, Portfolio Solutions LLC
Author: All
About Asset Allocation,
All About Index Funds, and
others.
“Common Sense Investing captures the core elements of the BogleheadsSM investment philosophy in terms any investor can easily understand and implement. Read it and reap!”
—Mel
Lindauer, Forbes columnist,
Co-author: The Bogleheads’ Guide
to Investing
“Here are 10 simple, easy to follow, and proven investing rules. Investing an hour reading this short book will make you a better investor.”
—Burton
G. Malkiel, Princeton University
Author: A Random Walk Down
Wall Street
“Rick has produced a masterful financial guide for beginning investors and old hands alike. If you want to get started investing the right way, this book provides the clarity and backbone to achieve your financial destiny.”
—Bill
Schultheis, Financial Adviser
Author: The New Coffeehouse Investor
“Rick has provided a great service. In terms that the novice investor can understand, he provides ten simple rules that provide the prescription for investment success. In fact, if you follow his rules you are virtually guaranteed to outperform the majority of investors, both individual and professionals alike.”
—Larry
Swedroe, Principal and Director of Research
Buckingham Family of
Financial Services
Author of eleven books on investing
Common Sense Investing:
Ten Simple Rules to Finance Your Dreams
or
Create a New Roadmap to Achieve Financial Independence.
By Rick Van Ness
Version 1.0
Copyright 2011 Rick Van Ness.
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Disclaimer
Limit of Liability/Disclaimer of Warranty: This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. Although the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
Comments and feedback welcomed and appreciated!
The author welcomes and appreciates all thoughts and suggestions. Reach him at: rick@financinglife.org.
Table of Contents
Rule #1: Develop a workable plan
Rule #2: Invest early and often
Rule #3: Never bear too much or too little risk
Rule #5: Never try to time the market
Rule #6: Use index funds when possible
Appendix A: Simple rules vs. human nature
Appendix B: Become a savvy buyer
Appendix C: Example startup portfolios
Appendix D: Dollar cost averaging
Appendix F: Low-cost mutual fund providers
Free high-definition streaming videos
Personal finance is a means to an end—living a rich and fulfilling life. It is not hard. It is not complicated. I write this to share simple truths I’ve learned from some very wise people.
—Rick Van Ness
Preface (a true story)
Our company had occasional luncheon speakers. I clearly remember the poster advertising one of these. It had the name of Vicki Robin’s book, but all I saw was Bla bla bla bla bla bla Achieving Financial Independence. I snuffed with the arrogance of an MBA from a top university on Wall Street (ink still wet): “What could they teach me about finances!” Instead, I worked during this lunchtime presentation at my desk and went down to grab a quick bite afterwards. The cafeteria was empty. I sat alone.
To my horror, the host brought the speakers over to my table and they joined me for lunch. I said hello but mostly listened. My ears were burning. I couldn’t believe what I was hearing. “Excuse me?” I asked Diane, the second of the two presenters. I then learned that Diane had worked at IBM for maybe a dozen years, saving most of what she earned, and was now living entirely off the investment dividends. “How could you do that?” They were making different kind of choices than most of us: clothing from thrift stores (I couldn’t tell), bartering for car repairs, etc. But they woke up every morning and did exactly what they wanted to do with their lives! They volunteered in some specific ways that were important to them. This was powerful! While I had thought their talk was about finances, it was really about achieving independence!
They hadn’t published their book Your Money or Your Life yet, but it was available on audio cassettes and they left a copy for our company library. I borrowed my young son’s bright red cassette player and listened to six cassettes on a flight to Chicago, and the remaining six on my flight home. They spoke about fulfillment in a personal and non-judgmental way, fully recognizing that it varies from one individual to the next. They spoke about “going to work” as trading “life energy” for money, which is both enlightening and extremely helpful for making purchase decisions: “How much life energy would I really want to trade for that Stuff?” They put into words what I knew to be true.
Ever since, I have been keenly aware and proudly frugal, and I have learned quite a bit more about common sense and investing.
Introduction
If you are like most of us, you are busy living your life and just not interested in becoming an expert in investing. My goal is to show you that it’s actually not hard to take control of your finances, save and invest wisely, and then get on with your life with a sound financial lifestyle that will support your dreams. You are going to learn how to correctly buy and hold a diversified portfolio of stocks and bonds for the long term.
Start by tuning out all the shows and newsletters trying to sell you something. For us, there is no better mentor than legendary mutual fund industry veteran John C. Bogle. We’ll also incorporate the work of a few Nobel Laureates and distinguished academics. Quite frankly, it is the advice I wish I heard when I was 25 years old. We’ll develop four general principles as 10 simple rules.
Start saving now, not later
The first two rules are all about getting started, and finding a way to save a portion of what you earn. If you can’t do this, the other eight rules are moot. There are some great tips in here, so I hope you’ll find these helpful.
Rule #1: Develop a workable plan
Rule #2: Invest early and often
Diversify your investments
If starting to save now is the most important habit you need to form, the way that you then allocate this to stocks and bonds is the most important decision you need to make. Diversify your investments. I know you think you know what this means, but most people actually don’t. These will be our next three rules. It’s not hard, but since this is all about risk management and it is so important, read up and make sure you grasp these simple concepts.
Rule #3: Never bear too much or too little risk
Rule #4: Diversify!
Rule #5: Never try to time the market
Minimize costs
Small percentages make a huge difference over the course of our lifetime. Our next three rules will show you how you can keep what you earn by not giving it away in unnecessary fees and taxes.
Rule #6: Use index funds when possible
Rule #7: Keep costs low
Rule #8: Minimize taxes
Stick to your Plan!
Our last rules will help you create a simple one-page written plan—and that very action will help give you the discipline to stick with these time proven rules that we’ll now explore individually in more detail.
Rule #9: Keep it simple
Rule #10: Stay the course
Each of these rules are a short chapter. You can read them from start to finish or skip ahead to any of particular interest.
Each of these rules is also a short explanatory video that may be viewed for free in high-definition streaming video at www.financinglife.org. This book complements the video series to read offline, to ponder a point, or for quick reference later.
Rule #1
Develop a workable plan
Some of our dreams need a little money. This list is where we begin.
We need to have some idea of how much we need to save and how we will save it.
There may be part of you rebelling already. Relax! Of course you don’t know the future! But it will serve you to imagine one scenario. The enemy of a good plan is the search for a perfect plan.
Make assumptions. Put them in writing.
Make assumptions, and then change them when you get better ideas or better information. Our goal is to enable these possibilities.
Let’s pause here and consider some simple arithmetic. Financing life is about all of your dreams, but for most of you, saving for retirement will be the biggest item—by far!
Hopefully you have a long time to save for retirement, so I want to share two guidelines so that you can choose an appropriate goal for your investment plan.
If you reach retirement age in good health, there’s a very good chance you, your spouse, or both of you, will enjoy 30 years of retirement. A good rule-of-thumb is that you’ll need 25 times what you’ll draw from your savings for 30 years of retirement. For example, you may wish to retire at age 65 on $60,000 a year. If you expect $20,000 a year from Social Security, then you’ll need $40,000 a year from your savings. That means you’ll need to save 25 x $40,000, or $1 million, to be fairly confident you won’t run out of money if you live to age 95.
You might want half this, or twice this. It’s a personal choice. This guideline does account for inflation and most stock market scenarios, but assumes your money is invested wisely, as we’ll describe in later chapters.
Invest money you’ll need soon very conservatively, like in a money market fund or a bank CD—definitely not the stock market. On the other hand, money you need beyond 10 years really should be invested in a portfolio of stocks and bonds, and that is what these ten rules will help you understand how to do correctly.
“But Rick,” you say, “the stock market is way too volatile.”
Correct! The next chart shows a history of annual returns of Large Company Stocks.
In any given year, the value might fall by half! Look what happened in 2008.
Now let’s look at the historical outcomes for holding stocks still longer. In the next chart, each bar represents the return after holding for 10 years.
Sometimes people lose money after holding 10 years! (like 2008!)
But, most of the time stocks outperform an even bigger risk: inflation.
Invest to beat inflation
Your risk of losing your investment in the stock market is small over a long holding period. Your risk of losing the value of your investment due to inflation is much larger! This is why you must invest and you need an investment return bigger than inflation.
Suppose you plan to retire in 30 years and inflation is just average—every $1,000 you save today will be worth only $410!
But wait, does this chart suggest we should own only stocks and hold them for a very long time—until you need that money? It’s true our investments would grow, but we can’t change the volatility of the stock market.
Remember, we saw that any given year your stock holdings might lose half of their value. We’ll see in Rule #3 that each year we will want to gradually convert some of our stocks to bonds so that we don’t hold too much risk by the time we need the money. One popular guideline we’ll discuss later is to “own your age in bonds.”
We’re going to continue working on this plan all the way through Rule #10. Right now it probably looks like you are going to need a lot of money.
OK. So how much do you need to save? Here a short answer that works for most young adults: 5% of your gross paycheck for those big ticket items, and another 10% for your retirement.
And if you haven’t already, you should use the very first money you save to establish a sound financial lifestyle before investing for the future. I have a separate video about this.
http://www.youtube.com/watch?v=ChUhTlNLhVI
Pay yourself first
If you get a paycheck, you already get a large slice withheld for various taxes. Here are some guidelines—details will vary state-to-state, individual-to-individual.
Our human behavior is that if we don’t see it, we don’t miss it. So a time-proven strategy for saving is to pay yourself first with that 15% automatically deposited.
Here’s a balanced budget that works for many people. See how this works for you. It applies 45% of your gross income to your essential expenses that you need, and 15% to discretionary, or fun stuff.
This example budget saves 5% of gross income for near-term big-ticket items, and 10% for retirement. Initially, you might be thinking that you need everything you spend money on. Use these questions to get at your true foundation expenses:
1. Could you live in safety and dignity without this purchase?
2. If you lost your job, would you keep spending money on this?
3. Could you live without this purchase for six months?
If you withhold money from your paycheck to pay your taxes, and you pay yourself first with an automatic deposit for your long-term savings, then you don’t need a complicated budget. You simply spend what you have left: one dollar for fun expenses for every three dollars you spend on the essentials you need.
Some of you might be thinking, “Hey, you’re only young once. Maybe I should save 10% for big-ticket items, and only 5% for retirement.” This is a tradeoff that only you can make.
Time is your friend. You’ll see by example in our next rule how you can harness the power of compound interest by starting to save early.
Chapter Footnotes
Find this and other explanatory videos, smart tips, and links to useful resources at www.FinancingLife.org.
The story about risk and inflation is adapted from The New Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get on with Your Life by Bill Schultheis, 2009.
The budgeting basics are adapted from On My Own Two Feet by Manisha Thakor and Sharon Kedar, 2007.
Rule #2
Invest early and often
Example: two women, two stories
To illustrate the miracle of compound interest and the importance of starting to save early, I’d like you to consider two women, Tabitha and Tonya.
Tabitha graduated from college at age 22 and took a job with a starting salary of $35,000. Right away she began saving $5,000 a year for her retirement. She kept up this routine for ten years, saving a total of $50,000 out of her own pocket. Then, at age 32, she decided to quit her job and become a full-time mother. While she did not contribute another dollar to her savings, her existing savings continued to grow until she retired at age 65.
Tonya, by contrast, took a lower paying job in an expensive part of the country. Her early years were a struggle and she saved nothing. But her career advanced with constant promotions. At age 40, she was a vice president making $75,000 a year. She finally felt that she was able to start saving for retirement, so she began putting away $10,000 a year. Tonya did this for ten years, saving a total of $100,000 out of her own pocket. At age 50, when her parents became very ill, she decided to quit her job to help take care of them so she stopped saving. Tonya’s existing nest egg only got to grow for fifteen more years before she turned age 65.
The million dollar difference!
While both women’s investments grew at 10 percent per year, their nest eggs at age 65 were very different sizes. While Tabitha saved only half as much as Tonya out of her own pocket, she ended up with over $1 million more in her retirement.
The benefits of starting to save and invest early are simply enormous. Having time on your side and investing your hard-earned savings in a smart manner is the classic recipe for financial success.
Chapter Footnotes
Find this and other explanatory videos, smart tips, and links to useful resources at www.FinancingLife.org.
This storyline for this chapter is from On My Own Two Feet, by Manisha Thakor and Sharon Kedar, 2007, www.adamsmedia.com, pp 6-7, and is used with permission.
Rule #3
Never bear too much or too little risk
This chapter is about your most important decision—how much of your investment should be in stocks, and how much should be in bonds. This is all about managing risk. How much risk should you take? And how, exactly, do you go about that?
Variability measures risk
There are safe places to put your money and it might grow like this.
After-taxes, it’s not likely to keep up with inflation. You have many choices to earn a higher return but all are less predictable, which means that the money might not be there when you need it. So variability of the return is one good measure of risk.
Expect higher returns for riskier investments
If we plot that risk, or variability, with the return on investment, our risk-free alternatives go on the left. Treasury bonds are not risk-free because their value varies with the current interest rate. Stocks have a high risk and return.
Distilled to its essence, investing is about earning a return in exchange for shouldering risk. Here’s the catch that many investors miss: this is only true for diversified portfolios.
Dilute specific-company risk
For instance, you could buy the S&P 500 which is a low-cost benchmark index of the 500 largest companies. But if you were to pick any one company, your risk would be far greater—even any five of them, or ten, or twenty. Examples of this specific company risk that can be diversified away might be the departure of a key executive, the outcome of an important court case, or employees going on strike.
Your total risk includes market-risk (events that move the whole market) plus specific-company risk (like we described above). Specific-company risk can be eliminated by using mutual funds which own many companies. Market-risk cannot.
It is usually unwise to speculate in specific companies unless you have exceptional information about what you are investing in (rare). If you wish a higher expected return than the S&P 500 largest companies, choose an index fund in an asset class which has both higher risk and higher expected return—like small company stocks.
Don’t put all your eggs in one basket is the popular cliché. You simply don’t get rewarded for the risk you are taking. It moves you from investing, to speculating. Author William Bernstein noted: “Concentrating your portfolio in a few stocks maximizes your chances of getting rich. Unfortunately, it also maximizes your chance of becoming poor.”1
Bonds are the other essential ingredient because they behave differently than stocks. So you need to learn about both of these. The ratio of stocks to bonds you own is your key lever that controls your risk.
Ability, willingness, and need for risk
There is no “right” portfolio, but there is one that is best for you—one that carries the appropriate level of risk. In order to determine what that is, investing expert Larry Swedroe encourages you to consider your ability, willingness, and need to take risk.2
Your ability to take risk is determined by your investment horizon and the stability of your income. At the beginning of this series, you considered how much money you needed for your goals and when. The longer you have, the better you can weather the inevitable market downturns. If you need the money in a few years, you should keep it out of the stock market. Money that you won’t need for 10 or 20 years might be best in stocks. Also, the more stable your job, the greater your ability to handle the risks of owning stocks.
Nick is a 30 year-old who’s been saving aggressively for eight years. He is saving half of his money for a new house in a few years and the other half is for his retirement. It is important for him to keep the risk out of his money that he might need in the short-term. His retirement investments might be primarily in the stock market—depending on these other considerations.
Next, consider your willingness to take risk. As we saw before, the stock market has high long-term returns, but in the short term it is very volatile. Any year your stock could lose half its value. The key thing is how you will behave during the next recession. If you sell when the market is low—you do yourself a real disservice. You are better off starting with a number you can live with and then stick to it!
Finally, your need to take risk is determined by your financial goals and what rate of return is required to achieve them.
Now, if you are 40 years old, very risk averse and haven’t started to save for your retirement yet, then your willingness to take risk might conflict with your financial needs. You will need to earn more, save more, retire later, acquire the temperament to carry more risk (more stocks), or some combination.
Own your age in bonds?
If you are having trouble choosing what level is right for you, I will tell you that I think a good starting place is the advice to own your age in bonds. So, a 25-year old might own 25% bonds and 75% stocks, gradually changing these by 1% every birthday.
In this example, your portfolio value increases with age, and the percentage of the portfolio value invested in bonds increases by 1% every birthday (age 25 = 25%). Surprisingly, the distinction between these two is much less important than choosing something appropriate and then sticking to it.
Once the stocks and bonds decision is made, you can move on to the decision on what types of mutual funds you’ll want to own.
Chapter Footnotes
Find this and other explanatory videos, smart tips, and links to useful resources at www.FinancingLife.org.
(1) The Four Pillars of Investing: Lessons for Building a Winning Portfolio, William Bernstein, 2002, p.101.
(2) An excellent discussion about ability, willingness, and need to take risk is in The Successful Investor Today: 14 Simple Truths You Must Know When You Invest, by Larry E. Swedroe, 2003, pp 222-225.
Rule #4
Diversify
Previously, we saw how owning many stocks eliminated “specific company risk.” Now we are going to see that it is not enough to simply own hundreds of companies. You’ll learn the great advantage of owning poorly correlated assets. This part is truly cool! Magical.
Low correlation provides a “free lunch”
To show you, let’s imagine two companies: Bathing Suits Inc. and National Umbrella Company. A rainy year means sales at the Bathing Suit company fall but the umbrella company does well. In a sunny year, the bathing suit company does well and the sales of umbrellas fall.
The price of these company stocks move in opposite directions so they are negatively correlated. The Bathing Suit company is more volatile because the total annual return has an average value of 7.0% but varies by plus or minus 1.0%. This is both higher return and higher risk than the umbrella company which has an average return of 3.5% plus or minus 0.5%.
This is the magical part. Look what happens if you invest 2/3 of your money in the umbrella company and 1/3 in the bathing suit company. WOW! Adding some of the more volatile company to your portfolio not only increases the average return, but it lowers the variability (or risk). Pretty much a free lunch!
Next, see what it looks like on a risk-return chart. The Bathing Suit Company is in the upper right with twice the expected risk and return as the umbrella company. If you owned 100% of the umbrella company you’d be left and lower (less risk, less return). Now if you gradually invest part of your portfolio in the more risky Bathing Suit Company, your returns increase as you expected, but your risk, as measured by the variability of that return, actually decreases. Owning both is superior to only owning either of the companies.
This is an important, and surprising, point. In the previous rule, we saw how different types of investments are distributed along a line that extends up to the right on a Risk-Return chart. This is because investors demand higher expected-returns in exchange for shouldering more risk. But now we see that when you can combine poorly correlated assets, you get the desirable situation where adding a more volatile asset can increase expected returns and lower risk.