I have been slowly working on this article because it is very important. The investment world is extremely confusing and complicated – and this is the reason why I started studying finance in the first place. With all the investment options and confusing information out there, can the everyday person win anymore?
Years ago, my wife and I had saved up a decent amount of cash in our savings account and I knew it was safe – but quickly losing value. I knew that inflation averages around 3% a year so my lump sum was worth 3% less each year I left it there. I knew I should invest it but I didn’t know how or who to trust.
I started my investment journey by searching Google. “What is the best way to invest this amount of money?” There were opinions – from putting it in the stock market, to investing in real estate, to starting a small business. I could put it in Treasury Bonds or Certificates of Deposits(CD). Current CD rates are 2.55% – 3.10% and Treasury Bonds are around 2.16% to 2.42%.
If I put my money in either of those, I may not keep up with inflation. My wife and I met with a financial adviser, but after a long conversation, we didn’t feel like we trusted the adviser. Due to my 14 years in law enforcement, I find it difficult to trust anyone – especially people with my money. So instead of blindly trusting someone, I decided to educate myself. I read dozens of finance and investment books and still continue to this day. I learned what works and what does not. I learned who I can trust, and who I can not.
Below are some of the main investments principles I have learned:
The First Principle –
Do not start investing unless you understand what you are investing in. In other words, don’t play unless you know the rules of the game. If you play without knowing the rules, you will end up funding your broker’s monthly yacht payment instead of your own.
The Second Principle –
People like you and I can still be successful in the stock market. By playing under a certain set of rules, we can minimize our losses, (yes they will happen) and maximize our profits.
The Third Principle –
You can not beat the market. I did not believe this at first, but the more research I did, the more I discovered this truth is intentionally covered up by actively managed mutual fund managers. The mutual fund industry is a 17 trillion dollar industry – yes that is trillion with a “T”. This is an industry that banks on you believing they can routinely beat the market – that is why people give them their money. Would you believe me if I told you that actively managed mutual funds rarely beat the market on a consistent basis? If you don’t, stand by – this information is rarely publicized in the financial industry. In reality, only 4-5% of mutual funds actually beat the market index consistently over a sustained period of time!¹ (A more detailed explanation follows) With approximately 9,511 mutual funds out there, good luck picking one of few!
The Fourth Principle –
If you invest correctly, you will not get rich quick. Get rich quick schemes are just that, schemes. For more on get rich quick schemes, check out my related post: Make $500,000 This Year*! To build up a healthy and lucrative retirement account, you must play the slow and steady game and rely on compound interest. Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t… pays it. Compound interest is the most powerful force in the universe.” If Albert Einstein agrees, who am I to disagree?
Market Terms Explained
What do I mean by, “the market”? The market is made up of a couple thousand companies who sell stock of their company. There are a couple of measures that identify themselves as “the market.” For instance, the S&P 500 (Standard & Poor’s 500 Index) is the culmination of the 500 largest U.S. publicly traded companies ranked by market value. This includes top companies such as Apple, Google, IBM, etc. Each company is weighted by the size they are in the stock market.
For example, Apple is the largest company in the S&P 500 and makes up a little more than 4% of the total index (500 companies). The second company is Microsoft, weighted at 3.46%, and then Amazon at 3.05%. The companies continue downward to the 500th company which is Mattel Inc. weighted at .02%.
When companies grow or shrink, their weight in the market moves accordingly. These companies fluctuate daily, but in general they remain close to the same in terms of ranking and percentage. How the companies within the index perform, determines whether the index as a whole, goes up or down in terms of value. When you hear of a market drop, that means the majority or top influential companies have lost value compared to the previous day. (People sold more stock than bought)
The S&P 500 is a common baseline for the market and most fund managers actively try to outperform this baseline. If they can’t beat the baseline, what’s the point? That is the point… 96% of them can’t beat it and charge you extra fees, yet we still invest with them…
For a reminder on stock market basics, please refer to my related article: Stock Market Basics.
What are Actively Managed Funds (aka Mutual Funds)?
I should probably explain some of the terminology I am using. In the market, you can either buy single stocks yourself – such as a share of Amazon or another company, or you can buy a fund that has a bunch of different companies within it. Buying a single company stock is risky because you are putting all your eggs (money) in one basket. For instance, if you buy only Amazon stock, you are relying on Amazon to continue going up. If it goes down, so does your entire investment.
Mutual fund managers buy many different companies and put them inside a single portfolio (fund) based on the mangers belief of which are more stable or will return the most profit. Managers also actively sell when they feel a company is going to do poorly in the future. Constant buying and selling in an attempt to get the most profit is the basic strategy of an actively managed mutual fund. Mutual funds have many different company stock within one fund so if one stock loses value, the hope is that another company within the fund will increase in value to offset the loss – also known as “Diversification”. Diversification is a good thing, it protects you from putting all your money in a boom or bust scenario.
Stock Market Fees
When you buy a stock in the market, you pay a fee to a broker. There are fees in the market associated with trading. Say you feel Apple is going to go down so you want to sell it and buy Amazon instead. There are fees you pay to make that trade. Trading, buying, and selling is not free. This is the main problem with actively managed funds. Actively manged funds buy and sell on a regular basis and incur fees for doing this which impacts your bottom line. These fees are also not always disclosed as part of the “expense ratio” but may be hidden in the lengthy prospectus that no one reads.
Mutual funds, in addition to the buying and selling fees that may be charged behind the scenes, also charge a management fee. This is a yearly fee that can take on different names such as “expense ratio,” and other names that may be confusing as to what they mean. This is not by accident. Would a normal person understand “expense ratio” to mean, annual fee charged? The mutual fund industry has lobbied aggressively to hide as many fees as they can from the investor. There are many other fees that are charged by mutual funds to include: Hiring costs, Distribution and service fees, account fees, other expenses, sales loads, redemption fees, and purchase fees. Not all of these fees are disclosed on the front page of your statement. Many are hidden within the pages of paperwork that you receive, never read, and promptly shred. Some of these fees are also not disclosed unless you specifically request them from the company…
What Are Index Funds?
Index funds are my favorite funds. I am a long term investor – because slow and steady wins the race. Why are index funds my favorite? Simply because they beat (outperform) mutual funds 96% of the time over the long term, and they charge extremely small fees. These are not actively managed funds – they mirror the indexes and are referred to as “passively managed.” There are several different indexes to choose from but I invest most of my money in the S&P 500 index. I get charged .04% annually by the fund to invest with it while the other actively managed funds charge up around .8% to 1% or more. When you take into account that most actively managed funds don’t beat the index and they charge higher fees, it’s no wonder the investors are not winning like they should be in the stock market. In addition, the difference between .8% and .04% may not seem like much but with compound interest over time, that can mean hundreds of thousands of dollars you are giving away in fees…
This is just the beginning of several investment articles. The truth is, only 4-5% of mutual funds beat the market baseline for any sustained period of time and the trillion dollar industry knows this. They hide their fees from you and do not want you educated on how their industry works. There is a reason all the yachts in the harbor are owned by the brokers and not the investors…..
In upcoming articles I will discuss how we can start investing on our own. Before you do, start gathering information on your employer sponsored retirement plan. Many of these plans can work to your benefit and offer you free money in the form of a match. They also have tax benefits and you can invest pre-tax rather than using your post tax money. (The benefits of post-tax Roth IRAs will be discussed later) As stated earlier, if you don’t understand what you are investing in, don’t do it! Educate yourself to avoid becoming a broke victim.
In a future post I will go over my employer sponsored retirement plan and how to decipher the terminology.
If you found this article helpful please share it across social media. If you have any comments or questions about mutual funds please comment below, I would love to give you further insight! Since I have several investment articles coming in the future, make sure to subscribe below with your email address so you don’t miss any of my new articles! Thank you again for reading and keep at it – you work too hard to be this broke!
¹Robbins,T. (2014) Money Master The Game. NY, New York: Simon & Schuster