EP 5: Making Money Simple (Part II)

by Peter Lazaroff | Jul 21, 2021 | Podcast

In the second installment of a three-part series, Peter walks through the investing chapters of Making Money Simple: The Complete Guide To Getting Your Financial House in Order and Keeping It That Way Forever.

The prior episode focuses on creating a system for financial success by making intentional, systematic choices with your money. With a good savings system in place, we can now turn our focus to investing.

Successful investing allows you to maximize the impact of the good savings habits by offering a higher compound rate of return. But how do you earn those higher compound rates of return?

Listen now and let Peter tell you how.

Episode

Outline

“Investing is a complex activity, but that doesn’t mean it requires a complex solution.”

That’s the opening sentence of chapter 5, which is titled Your Introduction To Investing.

In this episode, I’m going to walk through the investing chapters of my book Making Money Simple: The Complete Guide To Getting Your Financial House in Order and Keeping It That Way Forever.

In the last episode, I went through the first four chapters of the book, which focus on creating a system for financial success by making intentional, systematic choices with your money.

We saw how a good system will direct dollars to the things that matter most and keep you one track for reaching your end goals.
We also discussed how a systematic process can reduce or eliminate our human tendencies that lead to poor consumption choices as well as subpar saving and investing decisions.

With a good savings system in place, we can now turn our focus to investing.

Successful investing allows you to maximize the impact of the good savings habits you would have implemented in the first four chapters by offering a higher compound rate of return.
But how do you earn those higher compound rates of return?

As the opening quote suggests, most people think the answer must be a complex one. However, the best way to invest is elegantly simple.

You don’t need to be an investment expert of work harder than everyone else to be a successful investor.
I tell a story about Grace Groner to emphasize this point. Grace was in the news back in 2010 when, at her death, she left $7 million to a foundation benefiting Lake Forest College because she was a career secretary that never showed any signs of having that sort of wealth.
Grace’s success was simple. She bought stock early in her career and never sold it.
She didn’t panic when the stock market was down or try to avoid periods of heightened volatility.
She didn’t make frequent changes to her portfolio in hopes of profiting from current market trends.
She didn’t spend time trying to find the next Apple or Amazon of her day.
She didn’t move money back and forth between investment managers in hope of capturing the highest returns
NOPE: She simply reinvested the dividends from her initial investment and never sold. These simple actions allowed her to avoid the mistakes that plague most investors and fully benefit from decades of uninterrupted compound growth.

Most people think they need to be like Warren Buffett to grow their wealth, but even Buffet credits his financial success to minimizing mistakes and allowing the magic of compounding to work for multiple decades.

Some numbers I shared in the book: $80.7 of Buffett’s $81 billion net worth was accumulated after his 50^th birthday.
$78 billion of the $81 billion came after he qualified for Social Security in his mid-60s
When you see the thousands of articles and books written about Buffett, it’s easy to overlook how powerful the impact of time and compound interest has been on his net worth.

“Good investing isn’t necessarily about earning the highest returns. It’s about doing the same thing for decades on end.”

The problem for most investors is, unlike Warren Buffett and Grace Groner, they get in their own way.

I share some data in the book about why the average investor performs so poorly, but it basically boils down to poor behavior.

When people follow their natural instincts, they apply fault reasoning to investment decisions. Throughout our evolution as a species, we’ve developed cognitive shortcuts to evaluate evidence e that requires a great deal of mental energy.
Rather than think through a problem, particularly when it’s complicated or unclear, our brains prefer to take shortcuts.

These mental shortcuts are deeply ingrained into our DNA, which (you may not realize) remains very similar to the genetic building blocks our species developed during the Cognitive Revolution 70,000 years ago.

Now consider that it wasn’t until roughly 12,000 years ago that our species began trading in their hunting and gathering ways to live on cultivated land and farms.
Now consider that the Scientific Revolution began only 500 years ago, and that led to an explosion of innovation and advancement.
For most of human history, people spent very little of their time with the type of data and inputs often associated with investing

Decisions tended to be survival-based, and we carry those tendencies with us today. Unfortunately, survival-based logic usually results in poor investment behavior.

In my role as Chief Investment Officer, I see this play out time and again.
When the market goes down, our human fear instinct kicks in and makes us feel the need to do something.
When our ancient ancestors heard a rustle in the bushes, they ran out of fear. They didn’t have time to calculate the probability that the noise in the bushes was a lion. If it was, taking the time to think about it posed too much of a risk of being pounded on. Better to get away first and evaluate later.

Thankfully, most of us no longer need to worry about being hunted down by lions, but that instinct to react when we feel threatened remains.

Markets go up and down. Logically, we can no that in advance. But emotionally, we have a hard time staying calm and reasonable when markets behave in a way that makes us concerned about our wealth.
On the other hand, we also have a hard time staying calm and reasonable when the market (or a particular investment) gets us excited about increasing our wealth.
The point is that reacting to current market conditions – whether they are good or bad – leads to poor investment decisions.

In Chapter 5: I dive into the behavioral reasons that we tend to do silly things that ultimately lead to performance chasing or market timing.

The psychology of investing – and all financial decisions – is what interests me most about my profession. While I dive into a couple key concepts, it’s by no means comprehensive.
If you’re looking for some good behavioral finance books, I will share a link to my favorite books where I break out a section just on behavioral finance.

I wrap up Chapter 5 with a section on investment fees that I think can be summed up quite simply with this quote:

“…The less you pay, the more of a fund’s return you keep.”

Chapter 6: Harnessing the Power of Markets

This is maybe my favorite chapter in the book because I’m able to share a variety of narratives that distill complex investing topics into easily digestible lessons and make investing as a whole seem more approachable.

When people come to me for advice, they typically want to jump right to the “how,” but skipping the theory (skipping the why) is like playing a board game without ever learning the rules.

Learning the rules to the game gives you direction, which in turn makes you better equipped to deal with the inevitable adversity you face as an investor.
I can’t emphasize enough how important this can be to staying the course – to being a long-term investor.

The chapter leads off with a story about my father-in-law and the way he goes about buying cars that paints a really tangible picture of how markets work. I have a related blog post that I can link to in the show notes so that I won’t repeat that story here.

But understanding how markets work is one of the most important things a long-term investor can understand.

Markets are at work all around us. For example, when I go to the grocery store, I usually buy some kind of fruit depending on the prices. My favorite is raspberries, which (like everything else) vary in price throughout the year depending on supply.

In the winter, raspberry prices often rise to $5 because there is less supply. At that price, I usually opt for another type of fruit, but raspberries are obviously worth $5 to somebody (otherwise the grocery store wouldn’t price them that way).

If raspberry prices fall to $3 in the winter, then I’m probably going to buy.
And during those few magical weeks in the summer when raspberries sell for $1 per pint, I stockpile as many pints that I feel can be eaten before they spoil.

When I make my purchase decision, I never question whether the price is accurate.

Price is set according to supply and demand.
In the summer months when supply is high, price is low.
In the winter months when supply is low, the price tends to be higher.
If raspberries aren’t selling and the product is nearing the end of its shelf life, the grocery store marks down prices to entice buyers like myself to purchase them.
The daily price of raspberries varies based on buyer and seller expectations of market forces.

People tend to respect the power of supply and demand in markets in their everyday life, but that respect seems to break down when it comes to financial markets.

At one point or another, nearly every investor makes the mistake of trying to beat the market. Maybe they buy shares of an individual stock, like Amazon or Apple.
Maybe they sell a portion of their portfolio in anticipation of a market decline.
Maybe they wait to invest cash because they feel the market is overvalued.
Maybe they buy an actively managed mutual fund that promises to deliver above-average returns or protect against market declines.
These are all examples of competing with the market or trying to outsmart the market. Most investors that take this route underestimate the competition within financial markets and overestimate the opportunity for above average returns.

I go on to explain how competing against the collective knowledge of financial markets works using examples with cows, jelly beans, and (eventually) the stock market. I can link to a blog post called The Collective Knowledge of Financial Markets that covers this topic a bit, too.

Understanding this concept makes it much more clear why active management typically trails passive management and why the general objective of trying to outsmart the market is a loser’s game. The book uses both data and anecdotes to explain why this is the case.

As I’ve said before, I don’t want to sit hear reading every word of every chapter, but I will link to several blog posts in the show notes (Active vs Passive: The Wrong Debate and Market Prediction is Harder Than You Think) because these narratives are some of my favorite in the book.

So while this chapter tees up an investment philosophy, the next chapter focuses on designing and implementing a portfolio that meets your specific goals.

I start that process in the next chapter by explaining the trade-offs between risk and return.

Chapter 7: Building a Portfolio to Meet Your Goals

The primary driver of investment returns is risk. Investing is all about earning a return in exchange for accepting volatility, uncertainty, and the potential for permanent loss.

The key is to find the right balance of risk and return by dividing up your investment dollars among stocks, bonds, and cash.

This process, known as asset allocation, is the most important decision a long-term investor makes. In fact, the most commonly cited research on the topic determined that asset allocation explains 93.6% of variation in portfolio returns.

Your portfolio will always rise and fall with the overall market, but the specific mix of stocks and bonds dictates the range of possible outcomes.

Portfolios with a greater percentage of assets allocated to stocks have historically earned a higher return.
However, those same portfolios with the highest return also experienced the most years with a loss and the widest range of possible outcomes.

Losses are painful to experience as an investor, but trying to completely avoid losses exposes your portfolio to other risks.

One such risk is not generating high enough returns to meet your goals.
Portfolios that don’t take enough risk require an unrealistic savings rate relative to your cash flow, and very few people can simply save enough money in cash to meet all their financial goals.
A second risk of avoiding riskier assets like stocks is inflation, which may actually outweigh the risk of short-term market losses. A flat rate of 3 percent inflation will reduce a portfolio’s purchasing power by nearly 59 percent over a 30-year time horizon.

A quote I like and find myself saying fairly often in client interactions is:

“The goal of investing is to grow your savings faster than inflation without taking undue risks. “

You can accomplish this through choosing an asset allocation that appropriately blends risk and return.
So let’s unpack how stocks, bonds, and cash each play an important function in blending risk and return.

By investing in stocks and bonds, you provide financial capital to businesses that use that capital to produce goods or services they can sell for a profit.

As providers of these two types of financial capital, investors (that’s you) expect a return on their money.
Historically, investors earn a higher return for owning stocks versus bonds.
The higher expected return for stocks is compensation for accepting greater uncertainty and volatility in the price of the investment.
Over long periods of time, the equity premium translates into staggering wealth differentials.

Unfortunately, it isn’t as easy as saying: “I want higher returns, so I’ll just own more stocks.”

Stocks do have higher expected returns, but the day-to-day experience of earning those higher expected returns is far more stressful than it appears on paper.
Ignoring risk and focusing only on return increases the chance owning a portfolio that is more painful than you can tolerate.
That’s where bonds come in.

When stock markets experience a sharp fall, bonds act as a diversifier and reduce the overall volatility of the portfolio.

The relative lack of volatility is the primary reason to include some percentage of bond exposure in your portfolio.

As for cash, it’s one thing to have an emergency fund, but having too much cash in your portfolio can be problematic for now reasons:

Cash provides poor long-term returns (negative real, after-tax returns)!
Holding too much cash creates psychological mind games
- When stocks are going up, investors frequently tell themselves that they will wait for a market decline to use their cash to buy more stocks.
- But when the prices of stocks do start to fall, investors tend to wait for prices to fall even further before they act.
- In both cases, you must overcome the desire to invest at just the right time in order to invest your cash.

I have some cool graphics and data on each of these asset classes that perhaps is more focused on the “why,” but the “how” really comes in when we talk about determining the appropriate mix of stocks, bonds, and cash – which requires you to assess your ability and willingness to take risk.

I always tell clients that there is no such thing as a perfect portfolio and I think that’s important to keep in mind because…
Assessing your risk tolerance is all about finding the best portfolio for you—the one that you can stick with for decades at a time.
- Risk tolerance is a mix of measuring ability to tolerate risk, which is mostly objective process based on time horizon, human capital, liquidity needs relative to the size of your portfolio, flexibility of your goals, etc
- Willingness to tolerate risk is more subjective, so I share some exercises that I use with clients to help measure this aspect
I actually have an article I can link to in the show notes about this, too: Assessing Risk Tolerance

This is arguably the most important part of the chapter because building the perfect portfolio doesn’t matter one bit if it doesn’t align with your willingness and ability to take risk.

The way you divide up your investments between stocks and bonds will set the tone for the expected range of returns and overall volatility of your portfolio.
The more stocks you own, the higher you expect return and volatility to be.
Once you’ve determined the appropriate mix of stocks and bonds, the next step is globally diversifying to enhance your portfolio’s compound growth.

I also spend some time on the importance of diversification, which may seem obvious, but many investors believe they are well-diversified when, in fact, they’re not.

I share some examples of different types of false diversification that I commonly see, so hopefully you are able to identify if you are in a similar situation.
Diversification has obvious appeal from a risk tolerance standpoint, but the real jaw dropping, “aha ha” moment for most people comes when I show how diversification allows your portfolio to compound returns more effectively.
Again I revert back into a little theory because understanding the theory makes it easier to stay the course when markets make it difficult to want to do so.
Most people would agree that they ought to be diversified, but they don’t really understand the math behind it. The math behind this will really blow your mind.
The example I show is year-by-year returns on two portfolios, with identical average returns, but different levels of volatility. The portfolio with lower volatility ends up with more money because of the impact volatility has on compound interest.

At this point in the chapter, we’ve learned that setting an asset allocation that is aligned with your ability and willingness to take risk is the first step of portfolio construction. Making sure that you are properly diversified within that asset allocation is the next step. The final piece of the portfolio construction is a process to maintain these initial portfolio exposures. That process is rebalancing.

Throughout the chapter, the examples make it clear that periods of higher returns in any given market are often followed by periods of lower returns. Rebalancing takes advantage of this trend by selling asset classes that have done well and buying those that have done poorly—in other words, rebalancing ensures you buy low and sell high.

To better understand the benefit of rebalancing, I simply compare a portfolio that is rebalanced once a year versus a portfolio that is not. Spoiler alert: the annually rebalanced portfolio ended up with more money. As an added emotional bonus, losses during the worst-performing periods for the annually rebalanced portfolio weren’t quite as bad as the portfolio that was never rebalanced.

There’s no guarantee that rebalancing will enhance performance, but the biggest benefit of rebalancing is keeping your risk exposure in line with your risk tolerance. If you set out to invest in a portfolio with 70 percent stocks because it meets your needs, then you don’t want to let that portfolio drift to 80 percent stocks as the result of a rising market and become riskier than you are willing or able to tolerate.

Onto Chapter 8!

Chapter 8: How and Where to Invest Your Savings

With a good foundation of investment theory in place, Chapter 8 focuses on implementing a systematic approach to investing that will ensure your financial plan fully benefits from the power of compounding.

If you build a draft financial plan as you’re reading the book, you should have several things in place by this point.

You should have goals with an expected value and completion date. These goals should also rank retirement savings and an emergency as your top priorities.
You should have a handle on your current financial situation, including what assets and liabilities you have.
You should have a good idea of how much cash flow you have available each month to direct toward your goals.
You should have all savings, bills, and debt payments set up to be made automatically.

Assuming you have done all this work, it’s time to begin dollar cost averaging in your investment accounts.

Dollar cost averaging means contributing a set amount to your portfolio on a regular schedule over time.
Automating your dollar cost averaging plan removes the need for determining the best time to invest and helps you avoid many of the errors we highlighted in Chapter 5.
Dollar cost averaging is also the simplest way to invest paycheck by paycheck with the planned savings from your reverse budget.
You don’t have to do anything beyond setting up automated monthly contributions to your investment accounts. In fact, you’re already dollar cost averaging if you have regularly scheduled automatic investment contributions going to your employer-sponsored retirement plan.

While dollar cost averaging is the best way to systematically invest your savings, it doesn’t address a common situation of deciding how to invest a large sum of cash. Nobody wants to invest at the wrong time, but you must remember that market timing is a game that nobody can win.

The probabilities suggest that investing a large sum of cash that has built up over time or is the result of a windfall, inheritance, stock options vesting, divorce, whatever…the probabilities suggest you are likely to have a better return by investing all at once rather than DCA.
But for ongoing savings, DCA is the best approach.

Here’s a quote within that discussion that I like:

“It’s tempting to think about the possibility of buying at just the right moment. But here’s a dirty little secret that most of the investment industry doesn’t want you to know: time is more important than timing.”

There are several examples in the chapter that show why Investment success is more about time in the market than correctly timing market movements.

I also share some case studies to show why focusing on your savings rate rather than your rate of return.

Finally, the chapter focuses on reducing your tax bill to maximize your investment return.and accelerate your progress toward your goals.

While taxes are an inevitable part of earning money, there are two ways to minimize taxes and supercharge your investment returns: tax-deferred investment accounts and asset location.

In covering tax-deferred, I cover IRAs, Roth IRAs, Employer Sponsored-Retirement Plans (401k, 403b, 457, Simple IRAs, SEP IRAs, etc) – I also cover the best order to leverage these accounts to save for retirement. I’ll share a link to a blog post in the show notes that does the same thing: Where To Save For Retirement.

Finally, I wrap up the tax-deferred accounts discussion with a relatively high level overview of the basics of 529 plans, but I go into greater detail on those in Chapter 10, which covers Family Finance topics.

Chapter 9: Facing the Realties of Market Downturns

Whew! Final chapter of the investment section. At this point you now have everything you need to build to invest your savings and meet your goals. The investment plan laid out focuses on things within your control: investment costs, asset allocation, savings rates, and your own behavior. Now you simply must have discipline to stay the course no matter what.

This is arguably the most challenging part of investing, particularly when markets are falling.

So in the final investing chapter of this section, we turn our attention to strategies for staying the course when things don’t seem to be going according to plan.

Mike Tyson once said, “Everyone has a plan until they get punched in the mouth.” Knowing that you are going to get punched in the face, literally or figuratively, isn’t fun. But it does allow us to mentally prepare ourselves to better decisions after taking a right hook from Mr. Market.

One of the first things to accept as an investor is that you’ll occasionally lose money—sometimes a lot of money—on the way to earning a decent return.

This is part of the risk you bear in exchange for higher expected returns on your investments.
The market will take twists and turns throughout your lifetime.
The financial media will dramatize everything along the way making it even harder to stay calm and rational.
Meanwhile, the Internet has made access to stock market data and real-time portfolio values increasingly easy, which is problematic because it causes investors to lose sight of the big picture.

We already know that loss aversion makes losses hurt about twice as much as a similar sized gain makes us feel good—the result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss.

I find that the more prepared someone is for losses, the less likely they are to succumb to the bad behaviors associated with trying to avoid it.

We never know when or why the next market downturn will happen. What we do know is that market downturns happen on a regular basis.

There’s a graph that shows the worst drawdowns for the S&P 500 every year dating back to 1926.
Double-digit losses occur in 65 percent of calendar years and nearly a quarter of the time losses are greater than 20 percent.
Despite the frequent losses, the S&P 500 earned an average annual return of 10.16 percent over this period.

Another stat I share frequently with clients is that the S&P 500 has historically had a 10% decline about once every 12 months, a 20% decline about once every 3.5 years, and a 30% or greater decline about once a decade.

Remember, risk and return are closely related. Losses are the price you pay in exchange for higher expected returns.

There is no such thing as a riskless, high return investment (you should run away as fast as possible from anyone suggesting otherwise).
The good news is that you can reduce the chance of permanent loss by staying invested over a long period of time.
In fact, overall market losses can present a huge advantage to investors who dollar cost average because market downturns allow them to buy stocks at lower prices.

I share several graphics to drive home this point to familiarize readers with the normalcy of losses.

This is a specific instance where a picture is worth well more than a thousand words. This is a picture heavy chapter that I can’t possibly do justice by voice.
But I will link to a page that I reference in the audiobook that shares every chart from the book.

I think the primary takeaway from the chapter can be summed up with this passage:

Volatility is not the enemy. It’s only the cost of higher returns in the long run.

When you accept that the market is very good at incorporating information into prices, you’ll see there’s no way for people to reasonably predict when and why downturns occur.
But we can reasonably expect downturns to continue occurring with a similar degree of frequency in the future.
That means we can plan for them—and you’re better off planning on downturns occurring regularly than trying to predict when stocks will take a tumble.

Investing is not easy, but good investment behavior is crucial to capturing the market’s long-term returns.

In the next episode, I’ll cover the final three chapters of the book that are focused on big decisions you only make once or maybe a couple of times, but that have giant financial ramifications – so it’s important to get these decisions right!

Conclusion

For show notes, free resources, and a place to submit questions – please visit TheLongTermInvestor.com. If you enjoy the show, you can subscribe wherever you listen to podcasts, and please leave me a review. I read every single one and appreciate you taking the time to let me know what you think.

Until next time, to long-term investing!

About the Podcast

Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.

Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.

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