If You Can: How Millennials Can Get Rich Slowly by William J. Bernstein (5/5)

A comprehensive primer on personal finance for young people. A good read, as well as reference book. It’s a 30min read that will inform your financial life going forward.

Recommended investment strategy

Takes fifteen minutes of work per year, outperforms 90 percent of finance professionals in the long run, and makes you a millionaire over time:

Start by saving 15% of your salary at age 25 into a 401(k) plan, an IRA, or a taxable account (or all three). Put equal amounts of that 15 percent into just three different mutual funds:

  • A U.S. total stock market index fund
  • An international total stock market index fund
  • A U.S. total bond market index fund

Over time, the three funds will grow at different rates, so once per year you’ll adjust their amounts so that they’re again equal. (That’s the fifteen minutes per year, assuming you’ve enrolled in an automatic savings plan.)

If you can follow this simple recipe throughout your working career, you will almost certainly beat out most professional investors. More importantly, you’ll likely accumulate enough savings to retire comfortably.

If you can, but there are five hurdles.

Hurdle one: People spend too much money.

Even if you can invest like Warren Buffett, if you can’t save, you’ll die poor.

A plumber making $100,000 per year was far more likely to be a millionaire than an attorney with the same income, because the latter’s peer group was far harder to keep up with.

Hurdle two: You’ll need an adequate understanding of what finance is all about.

Finance isn’t rocket science, but you’d better understand it clearly.

Stocks vs bonds

Stocks – ownership stake in a company

Bonds – loan to a company

From the investors’ perspective, an ownership stake (a stock) is much riskier than a loan to your business (a bond), and so the stock deserves a higher expected return than a bond.

  1. Bond ownership has no other upside beyond the full repayment of interest and principal, so it needs to be safe
  2. Stocks need to have their potentially unlimited upside to entice investors who must endure their high risk
  3. If stocks and bonds were equally risky, no one would own the bonds, with its limited upside; conversely, if stocks and bonds had the same return, no one would want to own the stocks, with their higher risk

This raises a more subtle point, and one that is often not well understood by even sophisticated investors, which is that the interests of the owners of stocks, who are willing to take considerable risks to get higher returns, and the owners of bonds (or, in the case of a small business, the folks loaning it money), who care only about safety, are very different, and it’s a company’s stock owners who get to vote, not the bond owners. For this reason, loans to businesses — corporate bonds — are in general a bad deal, and it is a good idea to confine your bond holdings to government offerings.

Is it possible to predict when such declines might occur, and so avoid them? Don’t even think about it: in the past 80 years, no one, and I mean no one, has ever done so reliably.

Is it possible to find a mutual fund manager or advisor who can beat the market? Again, no: several decades of careful research have shown that managers with superb prior performance usually fall flat on their faces going forward. (Over the past decade, even Warren Buffett has failed to beat the market by any significant margin.)

There are only two kinds of investors: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third kind: those who know they don’t know, but whose livelihoods depend on appearing to know.

If I had to summarize finance in one sentence, it would go something like this: if you want high returns, you’re going to occasionally have to endure ferocious losses with equanimity, and if you want safety, you’re going to have to endure low returns. At the end of the investing day, only two kinds of assets exist; risky ones (high returns and high risks, namely stocks), and what are known in finance as “riskless” ones (low risks and low returns, like T-bills, CDs, and money market funds). Job one for the investor is to figure out the appropriate mix of the two. For example, the three-fund portfolio presented at the beginning of this book consists of two thirds risky assets and one third riskless assets.

Hurdle three: Learning the basics of financial and market history.

Those who ignore financial history are condemned to repeat it.

There is no great cause of mischief to the small investor than the confusion between the health of the economy and stock returns. It’s natural for people to assume that when the economy is in good shape, future stock returns will be high, and vice versa.

The exact opposite is in fact true: market history shows that when there’s economic blue sky, future returns are low, and when the economy is on the skids, future returns are high; it is a truism in the market that the best fishing is done in the most stormy waters.

The biggest profits are made by buying at the lowest prices, and stocks only get cheap when bad economic news abounds; therefore, the highest returns are earned by buying when the economy is in the toilet, and vice versa.

Learning market history isn’t just about knowing the past pattern of returns (though that’s helpful). In addition, it’s about learning to recognize the market’s emotional environment, which also correlates with future returns.

When the shoeshine boys started offering him stock tips, he knew it was time to get out.

Why the correlation between popular interest and subsequent low returns? Simple: Driving the price of any asset higher requires the entry of new buyers, and when everyone is invested in stocks, real estate, or gold, there’s no one left to join the party; the entry of naive, inexperienced investors usually signals the end.

When all your friends are enthusiastic about stocks (or real estate, or any other investment), perhaps you shouldn’t be, and when they respond negatively to your investment strategy, that’s likely a god sign.

A working knowledge of market history reinforces this sort of profitable but highly counterintuitive behavior — i.e. to have seen the movie before.

The discipline of maintaining a fixed allocation, such as the 33/33/33 portfolio mentioned at the beginning of the book, is an easy and effective form of market timing, since it of necessity means that you will be buying more stocks after significant market falls, when pessimism reigns, and selling some stocks after prolonged and dramatic price rices, when the market seems to be making everyone rich. The real purpose of learning financial history is to give you the courage to do the selling at high prices and the buying at low ones mandated by the discipline of sticking to a fixed stock / bond allocation.

Hurdle four: Overcoming your biggest enemy – the face in the mirror – is a daunting task.

The real risk you face is that you’ll be flattened by modern life’s financial elephant: the failure to maintain strict long-term discipline in saving and investing.

We have met the enemy and he is us.

Long-term planning, of course, is what investing is all about, and it’s a predisposition that our maker most definitely did not endow us with.

Ninety-five percent of what happens in finance is random noise, yet investors constantly convince themselves that they see patterns in market activity.

Runs of 4 or more heads or tails are perceived as a nonrandom pattern, when in fact they are the rule in random sequences, not the exception. Stock market participants frequently make this mistake, and an entirely bogus field of finance known as “technical analysis” is devoted to finding patterns in random financial data.

Hurdle five: As an investor, you must recognize the monsters that populate the financial industry.

The financial services industry wants to make you poor and stupid.

To be avoided at all costs are: any stock brokers or “full-service” brokerage firm; any newsletter; any advisor who purchases individual securities; any hedge fund. Most mutual fund companies spew more toxic waste into the investment environment than a third-world refinery. Most financial advisors can’t invest their way out of a paper bag.

A ready routine for deflecting approaches from friends and relations in the finance industry is an essential survival skill.

Still, you’ll need to exert extreme care with mutual funds. Except the Vanguard Group, a mutual fund or brokerage company has two sets of masters: the clients who purchase the mutual funds or stocks and bonds in the funds and brokerage accounts, and the shareholders who own the stock of the brokerage or fund company itself. Every company’s goal is to maximize the bottom line of the latter — its real owners — and mutual fund and brokerage firms can only do this at the expense of their clients — that is, you.

Act as if every broker, insurance salesman, mutual fund salesperson, and financial advisor you encounter is a hardened criminal, and stick to low-cost index funds, and you’ll do just fine.

Nuts and bolts

  1. Get out of debt; until that point, the only investing you should be doing is with the minimum 401(k) or other defined contribution savings required to “max out” your employer match
  2. Emergency fund placed in T-bills, CDs, or money market accounts — this should be enough for six months of living expenses, and should be in a taxable account (Putting your emergency money in a 401(k) or IRA is a terrible idea, since if you need it, you’ll almost certainly have to pay a substantial tax penalty to get it out.)
  3. Then, and only then, can you start to save seriously for retirement. For most young people, this will mean some mix of an employer-based plan, such as a 401(k), individual IRA accounts, and taxable accounts. Ideal strategy for most young people —
  • Max out 401(k) match
  • Contribute the maximum to a Roth IRA (assuming they’re not making too much money to qualify for the Roth, approximately $200,000 for a married couple and $120,000 for a single person)
  • Save in a taxable account on top of that

Two kinds of IRA accounts: Traditional and Roth

  • Traditional – you get a tax deduction on the contributions, and pay taxes when the money is withdrawn, generally after age 59.5
  • Roth – you contribute money you’ve already paid taxes on, but pay no taxes on withdrawals in retirement

In general, the Roth is a better deal than a traditional IRA, since not only can you contribute “more” to the Roth (since $5,500 — the current annual contribution limit — of after-tax dollars is worth a lot more than $5,500 in pre-tax dollars), but also you’re hopefully in a higher tax bracket when you retire.

Your goal, as mentioned, is to save at least 15% of your salary in some combination of 401(k) / IRA / taxable savings. But in reality, the best strategy is to save as much as you can, and don’t stop doing so until the day you die.

A frequent problem with 401(k) plans is the quality of the fund offerings. You should look carefully at the fund expenses offered in your employer’s plan.

  • If its expense ratios are in general more than 1.0%, then you have a lousy one, and you should contribute only up to the match.
  • If its expenses are in general lower than 0.5%, and particularly if it includes Vanguard’s index funds or Fidelity’s Spartan-class funds (which have fees as low as Vanguard’s), then you might consider making significant voluntary contributions in excess of the match limits.

Example of kinds of index funds you’ll want to use.

  • If your 401(k) is lucky enough to have Vanguard funds, look for, respectively
    • The (U.S.) Total Stock Market Index Fund
    • Total International Stock Index Fund, and
    • Either the Short-term Bond Index or Total Bond Market Index Fund
  • The Fidelity Spartan series is also excellent: the Total Market Index, International Index, and U.S. Bond Index (or Short-Term Treasury Bond Index) funds

Recommended Reading

  1. The millionaire next door by Thomas Stanley and William Danko — the most important book you’ll ever read, because it emphasizes the point that there’s an inverse correlation between spending and savings. Dissects the the corrosive effects of our consumer-oriented society on both personal and societal well being in a lucid way
  2. Common Sense on Mutual Funds by John Bogle — perhaps the best introduction to basic finance that’s ever been written
  3. Devil take the hindmost by Edward Chancellor — a compendium of stock market manias. The lives of most investors encompass the two different kinds of markets described in these books (Devil Take the Hindmost and The Great Depression), and they will provide a beacon that will guide you through both the best of times and the worst of times
  4. The great depression by Benjamin Roth — a portrait of how things look at the bottom. The lives of most investors encompass the two different kinds of markets described in these books (Devil Take the Hindmost and The Great Depression), and they will provide a beacon that will guide you through both the best of times and the worst of times
  5. Your money and your brain by Jason Zweig — if Jason can’t save you from yourself, then no one can
  6. How a second grader beats wall street by Allan Roth — nuts and bolts
  7. All about asset allocation by Rick Ferri — nuts and bolts

Spreadsheet showing effects of varying returns rates and saving rates in terms of real, accumulated assets after 20, 30, and 40 years