SIMPLE WEALTH, INEVITABLE WEALTH
By Nick Murray
This book was an easy and enjoyable read. The book helps to develop an investor mindset and a strategy for creating long-term wealth. I am sharing my notes, chapter by chapter, here.
Nick Murray, author of this book, began his career in the financial advisory profession in 1967. He has written eight books for financial services professional since 1987. Simple Wealth, Inevitable Wealth is his only books for the individual investor.
Finding Your Coach
Do you have the time, temperament and expertise to do your own investing? If your answer is No, you need a coach. The value of a financial advisor or coach in investing lies in incremental return, in mistakes not made, in time and stress you take in trying to do it yourself.
Wealth is not determined by investment performance, but investor behaviour. Therefore, some behavioural questions to ponder are:
Do you know how much it will take to make your financial dreams a reality?
Do you know how to make a lifetime investment plan which reasonably assures the achievement of your goals?
Do you fund that plan with the right kinds of investments (as opposed to the illusion of “the best” mutual funds)?
Do you discipline yourself not to switch funds into whatever’s “hot” at the moment?
Do you never lose faith in the plan, regardless of the bear market/sky is falling/apocalypse du jour?
These are behavioral questions and you are more likely to behave appropriately with the help of a knowledgeable and caring coach. This is exactly the same as how working with a personal trainer makes it is much more probable that you’ll stick to your diet, remain faithful to your exercise plan, and gain the desired outcome.
Trust and mutual respect; empathy and a shared sense of mission; those are the ingredients of your relationship with the lifetime coach who is right for you. Then, and only then, comes competence. Do not care for what they know until you know that they care for.
There will be times when you’ll watch large percentages of your net worth disappear during a long bear market. What may save you from a panicky decision to see is your advisor’s faith in the future and your trust in this judgment. Hence, it is important to have an advisor whose technical capabilities you respect, but far more important whom you trust.
While it may cost you 1% of your lifetime return but remember, the value of a high-quality financial advisor is a multiple of what he costs. That’s all that matters.
Some sources of referral to your coach could be your successful friends/neighbors/colleagues or professional like accountants and attorneys. After that, organizations of advisors - who hold their members to very high standards - are smart places to look. Interview at least 5-6 advisors and by then you will get a very good idea of who you should work with. Once you have made a decision, relax as you are not alone anymore
An Owner, Not a Loaner
Equity - common stock - is a share in the ownership of a business. When you invest in stocks, you’re an owner of businesses. And, your common sense and your life experience will tell you that it is the owner of good businesses who achieve real wealth and lasting financial independence.
When you invest in bonds, you lend money to the government and organization. In return, you get fixed or floatable interest and/or your capital gets appreciated by a little if bought on discount and kept until maturity.
Over the seventy-eight-year period (1926-2003), just to use as a kind of proxy for the idea of “long term”, real returns to the owner, net of inflation have been upwards of three times what the loaner got.
Lending money has limited upside, owning business has unlimited. However, you have to know and accept the idea of unknowability of the future. But, remember, in the past, owning businesses have turned out to be a real wealth generator.
What the Risk Isn't
People tend to overestimate the long-term risk of owning stocks and underestimate the long-term risk of NOT owning stocks. The long return of equities is so much greater than bonds. Hence, holding bond is irrational for the true wealth seeker. The great financial risk isn't loss of principal, but erosion of purchasing power.
Stocks are too volatile over short periods, therefore you must only invest money in equities that you won't need for at least five years.
When you buy fewer stocks, you have greater chances of outperforming or underperforming the market as a whole. But when you buy the index funds or broader market, the risk falls sharply as the marketplaces ultimately heals itself. The market goes down from time to time but it has never stayed down. The advance is permanent, decline is temporary.
Even though there is a great amount of historical evidence that the stock market or stocks as an asset class has generated good positive returns over time, most people give in to fear when the market declines. The issue is not how the market is doing, but how we are reacting to what the market is doing. It is human nature to react disproportionately to falling markets as opposed to rising markets.
"Losing money feels twice as bad as making money feels good."
-- Richard Thaler
"Fear has a greater grasp on human action than does the impressive weight of historical evidence."
-- Professor Jeremy Siegel
People have a hard time making a critical distinction between volatility and loss. You don't lose when the market declines unless you sell it. Wealth is the product of long term equity investing but giving it to fear is the greatest obstacle. It's important that you have faith in the future.
"Volatility is temporary, advance is permanent."
What the Real Risk is?
The real long-term risk is not owning equities. Achieving wealth is not possible without owning equity. However, the idea of owning equity vs bonds is counter-cultural and thus hard to accept emotionally. 3% inflation compounding for thirty years would mean the price will rise about two and a half times. In other words, your money will lose 60% of its purchasing power. In order to stay ahead of inflation and rely on income from your investment and leaving wealth for heirs, not owning equity is not a valid choice.
There are three reasons why many people over-stress on words like, safety, income and yield, and not invest in equities:
We unconsciously assume something closer to our parents’ life expectancy than our own.
Fear of loss is much greater than hope for gain
Psychological /economic events of the last centuries - great depression, stock market crash, etc.
The culture of overusing these seven words which have shaped our perception: money, risk, safety, income, yield, conservative and speculative.
In the long run, the only sane definition of “money” is “purchasing power”. The inflation (rising living cost) erodes the purchasing power. Therefore, in order to create wealth, your money must grow faster than inflation.
Behaving Your Way to Wealth
In equity investment, your behavior, not the relative performance, is the only variable that will govern your financial success and your behavior is the only thing you can control. Most people focus on things they can’t control, i.e. market volatility, or when large company growth outperforms its peers, to name two.
Before you embark on a long term investment journey, make sure your life and income are adequately insured and your debt situation is under control. The only debt you can ideally have is mortgage. Since emotions are a huge factor in equity investing, the peace of mind that comes from reducing debt is priceless.
Four behavior tactics will have a decisive effect on the quality of your later life:
Behavior # 1: Set Specific dollar/time goals
What do you want, when you want and what’s it going to cost?
For example, your goal is retirement income of 50,000 a year at the age of 62 onward.
Let’s assume your income on your total investment will be 6% at the age 62 and onward.
That would mean you need $833,333 worth of investments. 6% of $833,333 will be $50,000 which you can use every year.
Once you know the total capital you need at the age of 62, there are three questions to answer:
How much capital have you got now?
How much time do you have from now until 62?
How much money do you need to invest every month from now to your retirement date, at some realistic rate of return, in order to close the gap?
Behavior # 2: Make a specific plan for closing the gap
Let’s say you just turned 40, want to retire at 62 with the $833,333 cited above, and have $100,000 right now.
First step is to know if you invest your existing $100,000, assuming you will get 7% return, what will it turn into or future value after 22 years.
Formula to calculate future value is:
$100,000 x (1 + .07)^22 = $443,040
Second step is to close the gap between $833,333 and 443,040, which is $390,000. Hence, you now need to know how much you need to invest every month to get $390,000 after 22 years.
Formula to calculate monthly payment is:
P = Monthly payment (we’ll calculate)
FV = Future Value (in this case, our FV is $390,000)
I = interest rate (we’ll assume 6% — divide by 12 as it’s monthly. (.06 / 12 = .005 or .5%)
N = Number of months (12 x 22 = 264)
Plug the number into the formula:
P = (390,000 x .005) / ((1 + .005)264 — 1)
The answer you’ll get is $714. This is the amount you need to save and invest each month which, after the compounding effect on your return, will give you $390,000 after 22 years.
Your plan must be carried out in monthly investments, for psychological even more than for financial reasons. Don't tell yourself you are going to do it on the high chunk out of your annual bonus, because you won’t.
As the time goes by, you will notice that you are not getting 6% return every year - your returns will be volatile. We assume that whatever stocks/funds you choose, you’ll stick with it regardless and your average will be 6% in 22 years.
The best thing you can do is to concentrate on your behavioral responses you can control: increasing your monthly investment, planning to work a year or two longer, trimming, postponing the start of your withdrawal, etc.
Behavior # 3: Invest the same amounts monthly, in the same funds, so as to harness the power of dollar-cost averaging
Compounding and dollar-cost averaging are the two most powerful wealth creating engines. In the last behavior, we understood and calculated the power of compounding. The other engine Dollar-Cost averaging eliminates the need to time the market.
The idea behind dollar-cost averaging is that by investing the same dollar amount every month, you buy larger and larger numbers of fund shares when the market declines. You buy, in other words, more and more aggressively when the share prices get cheaper and cheaper. When markets rise again, your same dollar investment buys fewer and fewer shares as they become progressively higher priced. Logically, you buy the largest numbers of shares precisely at panic-induced market bottoms, and the fewest shares at euphoric market tops - which is, of course, exactly the opposite of what most investors do.
You end up with a below-average cost, because so many of your fund shares purchased at relatively low prices and so few were bought at high prices. And below-average costs lead to above-average returns. The genius of DCA is that, when you abandon any hope of timing markets/investments and simply toss in the same number of dollars every month, your “timing” becomes close to perfect.
The longer and/or more frequent the bear market, the better it is for your long term return as you will be able to buy more and more at less prices. This is contrary to what most people do.
In the US, for example, the market goes up nearly four out of five times. Therefore, it is important, in order for dollar-averaging cost to work, you have a longer time horizon with monthly investment. The idea of dollar cost averaging for 2 to 3 years with a lump sum investment today would be emotional and irrational. It may not help you get the fruits of DCA.
Behavior # 4: Systematically withdraw no more than 6% of your equity account balance at retirement. Historically, this should leave lots of room for income, and your heirs’ patrimony, to keep on growing.
The annual average total return of S&P has been 10% for the last seventy-eight year. Considering there is a high possibility of average return around 10% for the next many years, if you withdraw 6% a year, your money will still be growing and heirs are going to be fine.
There is no such thing as absolute certainty of return and no risk in equity investment. There will be a few years when you have less than 6%. If you are worried about that, you might want to set aside some funds into money markets so you could withdraw when your return is less than 6%. Or you may consider reducing your withdrawal if you can survive without it.
If your fund portfolio marches merrily along throughout your retirement - providing an income stream for you while continuing to build up your legacy to your children - when do you sell? You don’t. Why will you sell if your fund is growing and providing an income stream at the same time? Why would you not leave your portfolio for your children to benefit from?
The right time to buy equity is always when you have the money. The only time to sell them is when you need the money. Otherwise, let it grow.
Steering Clear of the Big Mistake
The first five chapters discussed the immense idea of four essential ideas: faith (in the future, and in equities), patience, discipline, and empathetic and competent advisor/coach.
“Indeed if I had to mail to you a summary of the first 131 pages of this book on the back of the postcard, it would say:”
Studies conducted by two financial research organizations DALBAR, Inc and the Bogle Investment Center found that the average equity mutual fund investor earned an average annual return (again, with dividends reinvested) of only 2.7%. Whereas, the average return of equity funds was more than 9%. The reason is not the portfolio selection but the eight great mistakes one needs to steer clear from.
Mutual funds discussed here are a proxy for all managed/pooled investments: separately managed accounts, the sub-accounts of variable annuities and variable universal life insurance contracts, and so forth.
You might ask why l pick diversified/managed/pooled investments as opposed to picking individual stocks. In fact, Warren Buffett, the greatest stock-picker of all time, dismisses the idea of diversification as “protection against ignorance”. But you and I are not Warren Buffet and many superb companies stop being superb after a while, and you often won’t know this until after the stocks are way down. Examples are IBM, Xerox, Polaroid, Kodak, Control Data and Wang Laboratories. Finding individual companies is also likely to lead to many psychological pitfalls of investing, but you are less likely to get your egos and identities tangled up in mutual funds.
In order to diversify across major equity sectors, dollar-cost average by investing the same amount in each of the following sectors every month:
Growth and value tend to move counter-cyclically to each other, and end up in about the same place in terms of overall long term return. Foreign markets tend to do their own things at their own times irrespective of local markets.
One approach could be to invest in index funds which should give us the index return less the expenses of running the fund. An index, bet it the S&P 500, the Nasdaq Composite, or the Russell 2000 - tells you the average return of all the money that’s invested in all the stocks in that index. More specifically, it is better to look for actively managed funds that follow a long-term, buy-and-hold, low-turnover investment strategy, and which therefore have relatively low expenses.
When looking for the funds to invest in, your rule of thumb should be ‘not to pick any fund based on less than 5 years of performance’. When looking for fund managers, you must seek out who:
are disciplined enough to stick to what they are good at
have a significant body of experience
have a low turnover (not trading stocks frequently) which leads to low expense ratio
In the end, stay away from the eight great mistakes:
Overdiversfiication - Invest and trust in your five core funds mentioned above. There is no limit to diversification. A few funds is all you need.
Under-diversification - Thinking that you can identify one or two good companies to invest for your future is a highly risky business.
Euphoria - Most people are concerned about being outperformed by someone else. The prudent approach is to think of the principal risk in the rising market. Don't be greedy in the bull market.
Panic - Markets will go down every few years; crisis is inevitable. Panic is a big mistake and panic always rationalizes itself. You can’t deal effectively with panic until you acknowledge you are panicking. It’s never, never OK to act on the fear.
Speculating when you think you are still investing and not realizing that you have crossed the line - it’s important to know the difference between speculating and investing. Doing what others are doing and not understanding it is a speculation
Investing for yield instead of for Total Return - You need to focus on total return (yield + capital appreciation)
Leverage - borrowing money to buy the wrong idea at the wrong time is the worst mistake you will ever make. It can wipe you out completely.
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