Dr Tom Philips says it in fewer than 700 words!
My friend Tom Philips sent me a long email when he saw the post on being a normal person [https://donezra.com/114-being-normal-beats-being-a-theoretical-economic-person/ ]. He particularly liked Dr Meir Statman’s clear identification of our two goals: not to be poor, and to be rich. And he will weave it into a graduate level textbook on portfolio management that he’s in the midst of co-authoring. I’m delighted!
Tom, who teaches in the Department of Finance and Risk Engineering at NYU’s Tandon School of Engineering in New York, NY, also sent me a short note that he wrote for the next generation of his family on investing. I wish I could express myself as succinctly as he does (all you need to know in fewer than 700 words)! He has given me permission to reproduce the note here, and I do so with enthusiasm. By the way, Tom modestly calls his note “Most everything you need to know …” but I’ve taken the liberty of calling it “All you need to know …” And yes, you know and I know that I’m exaggerating – obviously. That’s why a graduate-level textbook is necessary, if you really want to know (almost) everything that’s relevant.
He calls this part “Theory and Beliefs” and has a second part that he calls “Actionable Advice” (for his US-based friends and relatives) which he has also allowed me to reproduce. (OK, it’s a touch over 800 words in total if you count these too, but regardless, it’s remarkable.) For my readers in other countries, of course you will take his recommendations as directional rather than specific, because you will need to find parallel solutions available in your own country (though it turns out that both he and I personally invest with Vanguard), and possibly hedged to your own currency – plus the fact that you may not have the same personal characteristics as Tom’s friends and relatives, to whom this is addressed. The Vanguard characteristics that particularly appeal to Tom are that it “was the pioneer of index fund investing and continues its long tradition of being exceptionally investor friendly – its costs are 80% lower than the industry average, and it has high ethical standards.”
You’ll see that the stuff I’ve written (if you remember it) is extremely consistent with Tom’s note – another reason I like it so much. (Which reminds me – this series of blog posts has become so long that I find it tough to find exactly where I’ve said something in the past. I must find a convenient way to compile an index of it all. For the future …)
Theory and Beliefs
- Investing is putting your savings at risk: no risk (e.g. cash under your mattress), no reward; good risk (e.g. stock and bonds), good rewards; bad risk (e.g. gambling), bad rewards. You’ll earn about 4% each year with moderate risk over the long term if you buy and hold a globally diversified portfolio of stocks and bonds. That’s about 2% better than inflation, which runs about 2% each year.
- If I knew how to earn 15% each year with no risk, I’d tell you; but I don’t, and neither do the charlatans who claim that they do.
- While financial markets offer investors a dizzying array of investments, and while salespeople routinely promise the sun, the moon and the stars, you’ll do just fine by ignoring them and investing in a globally diversified portfolio of stocks and bonds through exceptionally low cost mutual funds known as index funds, which simply buy and hold all the stocks or bonds in the market and don’t trade them.
- But isn’t it better to identify, and invest with, the next Warren Buffett? It absolutely is, if you can identify the next Warren Buffett! But it’s exceptionally hard to prospectively identify great investors, who are a rare breed. What about retaining a consultant who identifies great investors? Great idea if you can reliably identify great identifiers, but they, too, are a rare breed! In short, non-index investing is best left to the few investors who have a proven record of success – index funds work best for everyone else.
- The benefits of global diversification are vastly underestimated. You’ll do yourself a huge disservice by investing only in your home country and in a few stocks, as it’s incredibly hard to tell in advance which countries, regions, sectors and companies will do well and which will do poorly.
- The powers of disciplined saving and compounding are also vastly underestimated: If you save $1 for retirement in each year that you work, over half your retirement savings will come from contributions you made before you turned 40.
- With Social Security as a backup, you need to save approximately 1/6 of your income each year for retirement. Furthermore, you can spend about 3% of your savings each year once you retire.
- P.S. https://opensocialsecurity.com/ is a terrific resource, and it’s free – use it!
- Stocks generally outperform bonds over the long term, but are volatile. Don’t get starry eyed when they rise, don’t despair when they fall.
- You won’t go too far wrong by investing half your savings in stocks and half in bonds, half domestically (i.e. in your home country) and half internationally. If you live in a small country (say Iceland), invest less than half (say 1/4) domestically and the rest internationally.
- Avoid esoteric investments in real estate, private equity, hedge funds etc. Recall point 3 and tune out glamour, noise, and fees, all three of which usually go hand in hand.
- Stocks sometimes get overvalued (e.g. during the Internet bubble in 2000), so it then makes sense to keep less than half your savings (say 1/3) in stocks. At other times (e.g. at the depth of the crisis in early 2009), they get undervalued, so it makes sense to have more than half your savings (say 2/3) in stocks.
- P.S. it’s incredibly hard to tell if stocks are going to rise or fall in the short term, and most periods of overvaluation and undervaluation are obvious only in hindsight.
- Invest at the lowest possible cost – your earnings rightly belong to you, not to someone else. If you are paying more than 0.2% of your assets in fees each year, you are paying much too much. Ditto for sales charges of any kind – they benefit salespeople, not you.
- Finally, never, ever, burn with envy because someone you know claims to have effortlessly made a fortune – virtually all such stories are the product of an active imagination aided by a selective memory.
Actionable Advice (remember: for US investors)
- If you want to invest in one single fund that will work well for the rest of your life regardless of your age, put all your savings into something like Vanguard’s LifeStrategy Moderate Growth Fund, which has 40% in US stocks, 25% in international stocks, 25% in US bonds and 10% in international bonds.
- If you are willing to invest in two funds, put 85% of your savings into Vanguard’s LifeStrategy Growth Fund, and 15% into Vanguard’s Total International Bond Index Fund. This prioritizes domestic stocks over international stocks, but equalizes your exposure to domestic and international bonds.
- If you are willing to invest in 3 funds, put half your savings into the Vanguard Total World Stock Index Fund, one-fourth into the Vanguard Total Bond Market Index Fund and the remaining one-fourth into the Vanguard International Bond Index Fund. To adjust your exposure to stocks, scale these numbers up or down proportionately, e.g. (2/3, 1/6, 1/6) or (1/3, 1/3, 1/3).
Tom adds: “Solution 3 is, in essence, what I do with my own savings. I think the first solution is good, the second is better, and the third is the best, but you’ll be happy with any of them. And if you find investing intimidating, just use the first option: you can’t beat it for simplicity, and you’ll be happy with the results.”
Thanks very much, Tom!
My friend Tom Philips helps you to keep both the principles behind lifetime investing and their implementation simple.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.