Saturday, August 6, 2011

Reading: How a Second Grader Beat Wall Street

I often feel a disconnect when reading or writing about investing. Managing money soundly in order to live comfortably in retirement and make the most of your assets seems important, but also doable. Yet there are so many options, with such complicated structures and payment schedules that my head is left spinning. My intuition that investing, making sure to diversify and thus reduce risk, is straightforward, contradicts the many products I read about in Money Magazine. However, this book (while somewhat gimmicky) is in accord with my thoughts. The basic math of investing is as follows: Take whatever you earn, then subtract your costs (management, trading fees), and that gives you your REAL earnings.

There are funds called Index Funds, and what they do is allow you to own hundreds of funds, at an extremely low cost (approx. .02%). Because this fund is diversified, meaning it owns bits of many many companies and stocks, it’s a bit like averaging the market. The advantage to this is that you would not have huge losses due to any few companies underperforming as you would if you had fewer stocks. Index funds have low costs because they are not being managed actively by an individual, which often comes with a hefty price tag. The less money you are paying others, the more of it you get to keep. In this book, the author’s second grader constructs a simple portfolio of Index Funds (60% US stocks, 30% International stocks, and 10% bonds), and it has consistently been beating most actively managed funds.

The (to some) shocking truth is that past performance of a manager does not predict future performance, that often experts armed with data and analysis do worse than the market on average. If this is the case, why pay them money? Why not keep it for yourself and invest in an index fund? I read an article about the rise in young adults who keep their money in CDs or savings accounts rather than investing it, having seen their parents and peers lose so much money in the market in recent years. This is unfortunate because we rely on the compounding of our assets in the stock market in order to outpace inflation and grow it to an amount that will allow us to retire comfortably. The facts are, in any substantial stretch of time (say, 40 years), average market growth outpaces inflation significantly. By investing in index funds, you keep your risk low, while increasing your money. I think we can all agree that this is favorable to keeping it all under your pillow (or your savings account—same thing).

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