Oct 2020
“Even fans of actively managed funds often concede that most other investors would be better off in index funds.”
– Paul Samuelson, Nobel Laureate
“He who buys what he does not need, steals from himself.”
– Swedish Proverb
It’s well documented how bad young people are with money. That typically within a generation of making it or inheriting it, young people have lost it. Some estimates even put the number as high as 90% of all generational wealth transitions are squandered. Why is that? It’s quite simple really, it’s because they spend it.
Articles that talk about people losing large amounts of money use very interesting vocabulary. Like the word lost, as if the money is misplaced and they just need to go searching for it. But the truth is it isn’t misplaced, it’s been spent. It’s never coming back. When money is spent, it’s never coming back. So when people lose money, it’s actually because they’ve spent it all.
So the first way of not losing your money is to just not spend it. To try really hard not to spend it on dumb stuff or inessential items. That’s something that seems really obvious and straight forward but was eye opening for me as a kid. That if I spend less money, then I’ll have more of it. But having more money is only one side of the equation. The other is making the money you do have, become worth more.
How do you make your money, make money? This also has a simple answer. By investing it. But generally people are bad investors who make bad investment decisions. Even professional money investors typically make bad investment decisions. Studies of the stock market show that over time 80 percent lose, 10 percent break even and 10 percent make money consistently.
Which is really bad. Why do people make bad decisions about where to keep their money? I think it’s because generally people aren’t taught how to do money. Nobody sits them down and says, here’s an education in finance and some basic money wisdom that will be the difference in your life between generating wealth and reducing wealth.
Part of that difference is because young people are also not living in a period of job security and seemingly perpetual growth like our parents generation largely did. Young people today live in a more uncertain world where truisms like; a good degree translating to a good job aren’t correct assumptions anymore.
Which makes it all the more important for basic financial education to be commonplace since young people can’t rely on other avenues for wealth creation anymore. So where is the place that people should keep their money? If you had asked me when I was a kid, I would have said a bank account. But it turns out that’s the wrong answer and the second biggest mistake people make. They keep all their money in a bank account.
I never realised that keeping money in a bank account was a bad idea. I was always taught growing up that a bank account was a safe place to put money. That it was even a good thing because the bank paid you interest. That smart people saved their money and kept it in a bank account. But within this lesson that was taught to me by my parents and internalised was also its undoing.
Now that I’m older, I know better. A bank account is a bad place to keep money. It’s a good place to keep small amounts of money for day to day spending but a bad place to keep large amounts of money. The reason? Because a bank account doesn’t make money for you with your money. Your money becomes less valuable over time when it’s in a bank account. And more than likely it’ll just get spent.
The reason is because of something called inflation. Which is a process where money becomes worth less over time. But it’s not actually the money that is becoming worth less, it’s just that everything else is becoming more expensive. When my Dad was in school a meat pie was $1. Today a meat pie is $5. That’s inflation.
So if you just keep money in a bank account, it becomes worth less and less every year as the world gets more expensive. How much less? The average is about 2%. The amount that you can buy with money reduces by 2% every year. That’s why bank accounts are bad. Because if your money doesn’t increase, the world becomes more expensive around it and the amount you can buy with the same amount of money decreases.
So where is the best place to keep your money? It turns out it’s in something called a stock market index. But the main ones such as the S&P 500 or ASX 200 are basically a list of the top companies in a country. So instead of owning shares in a couple of companies which is risky if they do badly, you own a smaller piece of a much larger group of companies. Usually the best companies in the country.
When you buy an index of the top companies in America or Australia you are buying the stock market as a whole and what is essentially the growth prospects of that country. And countries, especially Western countries, generally do well over time. Because of straight forward reasons like their populations are growing so the companies need to make more things for more people. The annualised returns of the top 200 index for each country is anywhere from 5% – 8% per year. With the S&P 500 it’s a bit higher at 10.5% per year.
When is the best time to buy the index? Apparently it doesn’t matter. Everytime is the best time. It is time in the market, not timing the market that is important. How do you buy an index? This was a confusing one for me. It turns out that most indexes are in fact themselves a stock that is traded on the stock market.
There are companies out there that create a pool of funds that track a stock market index like the S&P 500 and ASX200. Then they take that fund and list it itself on the stock market as a share that you can buy. There are literally dozens and this is called an exchange traded fund, more commonly known as an ETF. Buying these are the easiest way of investing in a stock market index.
So to invest in an index is as simple as picking a company that has an index, then buying that share. And you buy as many shares as money you want to invest in the index. When you want the money again, you just sell the shares. So buying and selling that share is how you invest and divest in an index.
Which company’s index? The highest recommended one appears to be Vanguard because they charge the lowest fees. The less they charge in fees, the more money you get to keep. What Vanguard does is basically handle all the paperwork of transferring dividends and making sure you are always owning only the top 200 or top 500 companies.
So if one company does badly and falls out of the top companies, they are sold and whatever replaces them get bought. For doing that Vanguard charge something like 0.1% fees, which sounds pretty good. It means for every $1,000 invested you pay $1 in fees. In Australia the Vanguard index fund is share sticker VAS. In America, the Vanguard index fund is share sticker VOO. When you buy VAS you effectively have a holding of the top 200 companies in Australia but without having to go out and buy all 200 companies separately.
To invest and devest in the Vanguard index is to buy and sell shares of VAS or VOO. This was the mental hurdle I had to overcome. After I had read about the benefits of an index, it took me a long time to figure out how to actually invest in and own one. The 5% – 8% return then manifests as the dividends paid and also any increase in the price of the share when you sell it.
So practically, you basically treat the index fund as if it’s a bank account. So buying individual stocks is bad. But buying the stock market as a whole is good. Keeping money in a bank account is bad. The story that really hit home why is something I had to think about with a thought experiment and explains why most inherited wealth is spent.
If you spend $50k per year annually and you inherit $1 million dollars. If you keep that million in a bank account, it will take you 20 years to spend it all. But if you keep that million dollars in an index where it grows at 5%. It is earning roughly $50k per year. So you can spend the same $50k per year and then after 20 years you still have that million dollars.
That’s the difference between keeping your money in a stock index versus in a bank account. It makes very little practical difference to your life but has an enormous impact on your net wealth. You are depleting money from a bank account when you spend it. But you are spending only the earnings on your money if it’s in an index fund.
So I think essentially all financial advice can be diluted into one axiom. This is the highest order bit of financial education that will produce the greatest returns in a person’s life with the least amount of effort.
“Spend as little money as you can. Don’t keep all your money in a bank account. Invest it in a stock market index.”
It just about guarantees that you’ll make money by passively investing. If you start to get more complicated however and choose to actively invest, then that is another essay. But it’s important to know that most of the people who try that lose money.