some perspective on investment choices

99% of the time, when people talk about investing, they talk about investment choices. What are you investing in? What do you buy or sell, and when? Have you found the next Apple or Google? It’s fun to talk about — a co-worker of mine recently told me about how he invested in copper mining companies in anticipation of the Beijing Olympics — but I’d like to offer some numbers, and some perspective.

To keep things simple, let’s say you’ve got a retirement investment portfolio that returns 10%, year-on-year. Of course, no portfolio is actually going to do that — anything returning 10% is going to carry a lot of risk, and thus, will vary quite a bit from year to year — but that’s okay for what we’re looking at. For this imaginary portfolio, if you invested $200 every month — $2400 a year — after 30 years, you’d have $452,098. (Edit: of course, the assumption that you’re investing a constant amount for thirty years, rather than increasing your investment as your income increases, is also unrealistic (not to mention unwise!). But again, this is okay for our purposes.)

Not too shabby, but most people I know would want more in their retirement accounts before they’d feel comfortable calling in rich. The first thing people generally think about is how to increase that return rate. Maybe you have an awesome hedge fund, or a killer advisor, or the perfect asset allocation, or you consistently pick more good stocks than bad every year for thirty years. If they’re really, really good, maybe you’ll get an extra 2%, net of fees (whether they’re charged by the hedge fund, your advisor, or your brokerage for all those trades). Now, that may not sound like much, but don’t be fooled — that extra 2% will get you $689,993, almost $250,000 more than (over 1.5x) what you would have gotten otherwise. (For the rest of this illustration, though, let’s assume you didn’t get lucky and are earning 10%.)

But wait — we forgot about taxes. If this is after-tax money in a Roth IRA, then our illustration still stands. But what if it’s in a normal brokerage account? Well, at current capital gains rates, 15% of your returns would go to Uncle Sam every year, bringing our nominal 10% rate down to 8.5%. (Edit: to be fair, this is an unrealistically worst-case scenario. By letting your money compound for as long as possible before selling, you can reduce this hit significantly.) Suddenly, your ending portfolio goes down to $330,141; you’ve lost over $120,000, almost a quarter of that bundle.

OK, so we definitely want to take taxes into careful consideration. But what if we go a step further and boost our savings rate — maybe we invest in a 401(k) with a company match, or simply max out our allowable IRA contributions? Well, if we upped that $200 to $400/month, we’d end up with $904,195. (Yes, that is exactly twice the $200/month number — the distributive property in action.)

Alright, that’s almost a million dollars, and it’s all in tax-advantaged accounts. But there’s one more thing we can do — what if instead of increasing our savings, we had just started investing earlier. Thirty years represents a 35-year-old waking up one day and saying, “hey, if I want to retire at 65, I better get a move on” — what if we started saving $100/month right out of college? After 44 years, you would have one million, eight hundred ninety-five thousand, five hundred and three dollars.

I can’t make the point any clearer: start saving for retirement now. Even if you can only go with $50 or even $25 a month — start with the basic advice here, and refine your investing strategy as you go. Yes, investment choices, taxes, and putting a lot away are all important, but they all pale in comparison to starting as soon as you can (and gradually increasing your contributions over time).

Photo by Journey Photographic.


the academic and the businessman: two views on investing

In case there was every any doubt: investing is not an exact science. After all, it depends quite literally on predicting the future, and as the Galbraith quote goes: “The only function of economic forecasting is to make astrology look respectable.” So it’s no surprise that there are as many ideas on investing as there are people, which can make for a lot of confusion. Let’s take a look at two of them: what I’ll call the Academic and the Businessman.

The Academic looks at investing in a very abstract sense. His main goal is to balance risk versus reward, using his knowledge of Modern Portfolio Theory. He knows that the two often go hand-in-hand, but that diversification is key, which will greatly reduce the risk while still keeping a good reward over time.

The Businessman, however, knows that owning stock is like owning a business. He does a good deal of research on each purchase he makes, and he makes sure to understand the business model of each company he invests in.

When purchasing a stock, a Businessman will often look at the “fundamentals”, aspects of the company such as earnings, cash flow, debt, assets, and dividends. The Businessman is especially interested in stocks that are priced lower than they should be — either because the company is out of favor (e.g. Ford during late 2008), or because its growth is even higher than expected (e.g. Apple, starting at around the same time). They look down on “di-worsification”, buying stocks in companies without a rock-solid reason for each purchase.

An Academic, however, rarely purchases an individual stock. He concerns himself more with the proportion of various asset classes (large and small, domestic and international, “value” and “growth”, and most importantly, stock and bond) in his quest to balance risk and reward. He believes that in this modern era of free-flowing information, picking an individual stock that significantly outperforms its current price is generally due to luck, and thus that consistently doing so is nearly impossible.

If you’re looking at investing sites on online, you’ll find a lot of Businessmen in the “Motley Fool” community, as well as in the sizable group of those who look to Warren Buffett for their investing inspiration. Meanwhile, the community known as the “Bogleheads” (after Jack Bogle, founder of Vanguard) fall firmly the Academic camp, along with academic researchers exemplified by Eugene Fama and Kenneth French.

Me? I’m an Academic…mostly. The research is compelling, and I trust it more than I do Wall Street or most financial publications. That said, I keep a small part of my portfolio set aside for specific companies to scratch the Businessman itch!

How about you? Are you an Academic, a Businessman, both, or neither?