So, how do you build wealth?
Contrary to what you may have heard, picking the best stocks and market timing really does not work. In this month’s article, we are going to explore 6 timeless strategies backed by financial science that can assist in your wealth accumulation journey.
Savings Rate & Where To Save
How you save, the amount you save, and where you save, if done correctly, are the greatest creators of long-term wealth. There are so many investment choices and the reality is, many can help you get from point A to B. But what gets you to point B faster- the frequency at which you save and the consistency.
What’s even more interesting, is that your long-term savings rate matters even more than your investment return! As Data Points illustrates: if two individuals start saving at the same time, but one saves 10% more, they will accumulate wealth at a rate close to 3 times the amount of the other individual at the end of a 30-year period. Even if the individual saving the lesser amount has a 2.5% greater rate of return, the individual saving more consistently will still accumulate more wealth over time. In short, focus on your long-term savings rate. Down markets, up markets, flat markets, it doesn’t matter, the approach is a timeless one.
As to where you save, this is a conversation on tax planning. Roth IRA, 401(k), Investment Account, etc. — each account is taxed differently. Because of this, consider placing the least efficient investment from a tax perspective to the most tax-efficient investment account. This is a more advanced concept called asset location. For example, this may mean placing income-producing assets like bonds in a tax-sheltered account like an IRA.
Time Horizon
Perhaps the greatest defense to a recession is to diversify your assets by time. This means choosing where to invest based on when you will need the money. For example, funds in a 401(k) for a 30-year old young professional will most likely not be used for living expenses until retirement. This could mean a time horizon of 30+ years. With a time horizon that long, your portfolio should care very little about current market conditions. That portfolio will go through so many ups and downs that you’ll lose count. However, if history is any testament to the resiliency of long-term investing, the global stock market has survived two world wars, a depression, a global financial crisis and yet, still averages approximately 10% as an annualized rate of return. This means for a young professional who has a long-time horizon, consider allocating primarily towards more aggressive investments i.e greater percentage of equities versus bonds.
Be mindful of your time horizon as a 10% return is an average and not guaranteed for any particular year. For example, certain years like 2008 yielded returns of - 40%. Any money that you potentially need within a 5-year window should stay clear of the stock market. Cash needs within 5-years should be invested in safe, liquid investments.
Global Diversification
For long-term investments, a good benchmark is to focus on owning the entire world. While the U.S markets receive all the media attention, it is still only 52% of the global market.
The benefit of global diversification is that it increases your probability to capture all returns. For example, from 2000-2009, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9.1%. However, globally diversified investors were in a position to enjoy positive returns elsewhere in the world.
Applying Financial Science
As Nobel Laureate, Eugene Fama and acclaimed financial researcher, Kenneth French discovered, there are three important factors that determine investment returns. They found that small companies tend to outperform large companies, value companies tend to outperform growth companies, and stocks usually outperform bonds. These three factors are the basis for the renowned investment company, Dimensional Fund Advisors. The above chart is not about picking winners or losers, but it serves to illustrate the power of incorporating a factor-based investment approach.
All major asset classes still serve a purpose in a diversified portfolio. Choosing how much to invest in what asset class depends entirely on your goals, risk tolerance, tax situation, and time horizon. When building portfolios for my clients, we incorporate much of this academic research into how we invest.
Forget About Timing & Individual Stocks
It’s tough, if not impossible, to know which market segments will outperform from period to period. Market timing and other unnecessary changes to a portfolio can be costly. Allowing emotions or opinions about short-term market conditions to impact long-term investment decisions can lead to disappointing results. For example, studies have shown that a hypothetical $1,000 turns into $138,908 from 1970 through the end of August 2019. Miss the market’s 5 best days and that’s down to $90,171. Miss the 25 best days and the return dwindles to $32,763. There’s no proven way to time the market so a prudent option is to stay put and rebalance occasionally through good times and bad. Remember, for investors to have a shot at successfully timing the market, they must make the call to buy or sell stocks correctly not just once, but twice.
Thinking about picking individual stocks? Think again. Research has shown that even professional investors have difficulty beating the market consistently through stock picking. Over the last 20 years, 77% of equity fund managers failed to survive and outperform their index benchmarks after costs. Millions of market participants buy and sell stocks every day, and the real-time information they bring helps set prices. Investors who attempt to chose winners are pitting their knowledge against the collective wisdom of all market participants. Instead, a proven approach to build wealth is to let the markets work for you through low-cost funds incorporating academic research.
Have A Coach
Putting all these pieces together over the course of several decades through life events and transitions is a challenge. Many people also struggle to separate their emotions from investing. Markets naturally go up and down.
Working closely with a Certified Financial Planner can offer expertise and coaching to help you create a better investment experience. In fact, Vanguard estimates working with a financial planner can add nearly 3% annually to your portfolio value - other studies from Russell Investments have estimated 4.4%.
Interested in applying these wealth accumulation principles to your situation? Feel free to schedule a complimentary consultation.
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