Wednesday, July 15, 2015

KISS (Keep It Simple, Stupid) Investing Is Essential for Successful Long Term Individual Investors ... Harvard Economics Professor Offers Some Bad Advice

Things that at first appear complicated, once the fundamentals are understood, become simple. And so it is with individuals investing for the long haul in order to achieve financial security and independence for themselves and their families.

But occasionally even Harvard economics professors fail to internalize the basics and get it wrong. Then they spread bad advice to all those listening.

As you will see below, the Harvard professor believes investing for individuals is too complicated. He then opines that the solution for these incapable individual investors is to practice 'robo' investing by putting their money in target date funds which automatically rotate into more bonds and less stocks as the investor ages.

In my view, he's wrong on both counts: (1) successful long term investing for individuals doesn't have to be hard, and (2) owning bonds is neither a good idea now nor for the foreseeable future.

Now let's briefly examine how and why the KISS method works.

If I earn $100 and spend $150, I need to borrow $50. That not only leaves me with nothing for saving and investing but requires that I spend less in the future in order to service my debt. In other words, the future required interest and principal payments will reduce my future opportunities for spending, saving and investing by much more than $50.

On the other hand, if I earn $100 and spend $50, that means I can save and invest $50 for my future wants and needs, including retirement. In addition, that $50 invested over the next 40 years at a compound growth rate of 9% will become $1,600. $1,600 is greater than zero, so the decision to spend and borrow NOW or save and invest for the FUTURE, if made logically, is an easy one.

And if I know that a portfolio of diversified blue chip and dividend growing individual stocks has historically earned 9% annually over a long period of time, then I also know the KISS way to get that 9% annualized average return on my investment in stocks. And if I don't want to invest in individual stocks at the outset or even later, I can choose a low cost S&P 500 index fund instead. Either way works although the individual stock route works better for those who make the effort to know what's going on with the shares of the companies they choose to 'own' over time.

And that's just a simple fact of life which I will know once I understand and internalize the mathematical rule of 72 --- that 9% X 8 years will double my initial investment and that after 40 years my money will have doubled 5 times.

$50 to $100 to $200 to $400 to $800 to $1,600 after 40 years at 9% annually. There's nothing hard about the simple math. And after 48 years it would likely have doubled again to $3,200. Not a bad return on an initial investment of $50.

So why is a Harvard economics professor having trouble understanding the simple stuff described above? Beats me.

Why Investing Is So Complicated, and How to Make It Simpler is worthwhile reading, even if it is written by a somewhat confused and mistaken Harvard economics professor. In his own words, here goes:

"I finally faced up to something I had been dreading.
After years of procrastinating, I logged on to my retirement account. . . . once I started to examine my portfolio, I began to feel anxious. Some of my money was in mutual funds, but I had no sense of how I chose them. And the rest of my money was in cash, earning virtually nothing; how had I let it sit there for so long? . . .
I seemed to have fallen into a recurrent nightmare, one in which I am taking a final exam in a class I never attended and a subject I don’t understand. This was even more embarrassing: I am, after all, a trained economist. When new acquaintances learn what I do for a living, they routinely ask, “So how should I invest my money?” I wish I knew.
Can’t the market fix things? If individuals are forced to choose their investments, why doesn’t the market make these choices easier?
By all accounts, the world of mutual funds, which is the basis for many retirement investments, is a competitive market. At the end of 2014, there were more than 20,000 mutual funds. On top of that, there are hundreds of exchange-traded funds. While many of these funds sit in a few big-name companies, one would hardly call this a monopolized industry. We’ve got plenty of choices.
The market seems to work well for consumers in other industries. The producers of smartphones, for example, compete fiercely to make simple and elegant user interfaces. If they can make it a breeze to interact with billions of lines of code, why can’t somebody simplify the alchemy of finance?
What distinguishes the market for investments is our inability to judge whether we have chosen well. Once I’ve used a phone for a few weeks, I can tell whether it was worth the money. By contrast, I may not know for decades (if ever) whether an investment was wise or foolish. Does a low return signal a prudent choice or a missed opportunity? And by the time the answer becomes clear, it’s already too late. You’ve got to live with your bad choice.
What’s more, the invisible hand of competition does not do well by consumers with limited understanding. Rather than eliminating biases, markets often cater to them. For example, many consumers choose a mutual fund by looking at last year’s returns, despite warnings that they should not do so. This creates a winner-take-all situation with the highest-performing funds getting most of the investors. You might think this encourages funds to produce higher returns, and that might seem to be a good thing.
But what it actually produces is a perverse incentive for fund companies to take risks. That’s because investors often choose what to do with their money once, and leave it there for a long time. Faced with that reality, the most profitable strategy for a mutual fund company can be to simply take risks in the hope of gaining high short-term returns. Win this high-return lottery and you can draw many investors from whom you will earn fees for decades. Big families of funds can start new funds regularly, each with a different risk strategy. For the companies, it’s like buying many lottery tickets.
It doesn’t matter for the company if many of the funds are clunkers as long as they end up with a few near the top of the performance rankings. For consumers of these funds, though, it’s a losing proposition.
Educating consumers to be better purchasers seems a sensible idea, but an example from recent history illustrates the problem with that. For a long time, the simple investment advice given to consumers has been “buy an index fund.” Index funds are such standardized products — mirroring the Standard & Poor’s 500-stock index does not require much management — that just about all of them were initially low cost while offering wonderful diversification.
Consumers have been buying index funds, and the market has responded by providing hundreds of them. Nearly all E.T.F.s are index funds.
But the market has also responded by charging high fees for this standardized product. In 2004, Ali Hortacsu and Chad Syverson, economists at the University of Chicago, found that index funds had as much variability in fees as their more labor-intensive actively managed counterparts. And these fees are nothing to be scoffed at — paying 1 percent more every single year in fees can compound over a lifetime to noticeably lower returns. . . .

Even if we receive good financial advice, following it can be hard: Saving more and consuming less is on par with going to the gym more and eating less. Some people can do it easily. Many can’t. . . .

What’s to be done now? You are on your own, unfortunately.

But I can tell you what I did. I chose a target retirement fund. With these funds, you simply decide on a target retirement year. As you age — and move closer to the target date — these funds automatically shift their holdings from riskier stocks to less risky bonds. . . .

The biggest lesson, I realized, was one that faces me all of the time: The biggest cost of fear is paralysis.
It is easy to make a mistake in choosing investments. But in an effort to avoid an error, I had been making an even bigger error. As I procrastinated, my money was uninvested and earning zero returns.
That, surely, is not the path to a happy retirement."
1- The good professor makes several good points --- especially the last one about delay and paralysis by analysis.

We don't have to make doing something that is simple hard. But as adults and individual investors we do need to get started early and keep going through the muck and the mud, thereby letting time work for instead of against our long term financial security and welfare.

2- But he also did an 'unsmart' thing with his own money by investing in a target date fund. That's because the future won't look the same as the past when it comes to fixed income returns. {NOTE: The bond portion is the 'unsmart' thing as I explained in the July 12 post 'Individual Investors Should Stay Away From Bonds . . . .'}
3- And in addition to that unforced error by buying bonds, he's also wrong when he says that investing is so complicated that the average person can't learn the basics and then apply them by properly managing his own account.

He just has to be willing to take the time and make the effort to apply the KISS methodology and invest in a diversified portfolio consisting of the shares of diversified blue chip dividend growing companies --- either that or invest in a low cost passive S&P 500 index fund from Vanguard or Fidelity.
Summing UP

The KISS method of investing means this for individual savers and investors --- it all begins with the common sense understanding that long term personal financial security depends on living within our means and that our family's long term financial well is vastly more important than which car we buy when we're young --- and that borrowing to excess prevents saving and investing --- and that unnecessary borrowing at an early age can be harmful in a game changing and lasting way to our family's long term financial health.
As a result, taking the necessary time to understand and internalize the benefits of saving and investing in stocks for the long haul is worth everyone's while.
And with sustained effort will come valuable knowledge which will turn into financial security and assets to last a lifetime.
Thanks. Bob.

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