How to Invest to Develop Wealth

Cash is Trash - Stocks Investment - Outperforming the Market - Fees - Inflation

Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.

Check out some of my popular posts:

Intelligent CEO

The Impact of the Highly Improbable

Surviving Capitalism with Competitive Moats

Subscribe to receive actionable advice on company building👇

Once one achieves a sound financial lifestyle, the question arises about how to invest for a comfortable retirement. It's a question of preserving and developing wealth over a long period. It's not an easy task. There are endless possibilities of investment, and losing money is, alas, all too common. What to do in a world where almost every investment is one click away?

Staying in cash isn't an option because it loses value over time. According to Warren Buffet: "the worst investment you can have is cash." The consumer price index shows a 155% increase in inflation since 1982 in the US. This leads to thinking that "cash is trash," as Ray Dalio says. This is an unfortunate yet prevalent situation. Historian Niall Ferguson in his book, The Ascent of Money, points out that, throughout the ages, governments always debase their currency, especially when there is much debt in the economyPrivate and public debt has never been so high, so we can expect a lot of money printing. To sum up, it's better to have something else than cash!

Investors today can access a wide range of assets such as stocks, bonds, real estate, commodities, crypto, art, jewelry, etc. The best performing asset class over the past century is stocks. Stocks provide investors with a share of the profits generated by publicly-owned companies. Over time, stock prices roughly follow the trend of the economy, which is to grow. It may not seem as simple as that to invest in stocks. Investors regularly face a long list of questions regarding which companies to buy, from which sectors or geography, when to buy etc. The bible of stock investing is the book The Intelligent Investor. The author, Benjamin Graham, was a genius who graduated from Columbia at 20 and was offered tenure positions in three different departments. The investing legend describes the mechanism to find stocks that are trading for less than their intrinsic value while preserving a margin of safety for the investor. The book does warn, however, that most investors will lose their money by underperforming the market.

Decades of data show that the large majority of investors underperform the S&P500 over the long run. Even recently, after ten years, 85 percent of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index. According to Buffet, that's even worse for traders who use options and other derivatives that are "financial weapons of mass destruction." Under-performance isn't visible right away. As Nassim Nicholas Taleb points out in his book Black Swan, traders usually beat the market for a while and then lose everything in a matter of days when a rare, unpredictable, and high-impact event happens. Some studies indicate that, before costs, some managers possess stock selection skills, but first, it's almost impossible to beat the market for several years and, second, the performance is insufficient to overcome their fees.

Managing money is a fees business in which the compensation is 2% fees per year plus 20% of carried interest. A great book starts with an amusing story: a tourist visits New York and admires the yachts of the money managers and brokers; naively, he asked, "Where are all the customers' yachts?" Of course, none of the customers could afford yachts, even though they dutifully followed their advisers' advice. This anecdote sums up the situation perfectly. As Warren Buffet said: "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsize profits, not the clients." Fees kill profits. If investors pay 2.5% fees out of a high 5% annual returns, fees eat up 50% of the performance. Worse, there is a tyranny of compounding fees that can eat 80% of your retirement funds, according to John Bogle, Vanguard's founder. What is astonishing is that these high fees keep rising. It's the long and sordid history of high fees for low returnsPaying that much money to underperform the market seems a terrible choice.

The best option then is to invest in a low-cost index fund that tracks the market. The average return of the stock market will outperform every money manager out there. As a striking example, a hedge fund manager challenged Warren Buffet in a $1m bet, saying that the best hedge funds will outperform the market over the next decade. After ten years, the selected hedge funds' return was 22% against 85.4% for the index. Buffet politely commented that "the results for their investors were dismal – really dismal". In Berkshire Hathaway's 2013 Shareholder Letter, Warren Buffet noted that his last will and testament requires trust assets for his wife's benefit to be invested as follows: 10% in short-term government bonds and the remaining 90% in a very low-cost S&P 500 Index fund. The average annual return of the S&P500 from 1957 through 2018 is an astonishing 8%. At the same time, index fund fees fell fast, and today the total expense ratio for the Vanguard S&P500 is 0.03%. What a great combo to develop wealth over time: great return and low fees.

The main drawbacks of stocks are their risk. In the worst crisis, stocks can lose half of their value, as we experienced in 2008. Although stocks do rise in the long run, investors usually balance their portfolio with a bond allocation to reduce their portfolio volatility. The legendary John Bogle recommends "roughly your age in bonds" mainly because you have less time to recover from a market crash as older as you get. Asset allocation is key for your long-term return. For instance, if stock returns 8%, bond returns 4,5% and inflation is 3% per year, your cumulative return after inflation will be 52% for a 80% stock / 20% bond portfolio and 24% for a 20% stock / 80% bond portfolio after 10 years. Benjamin Graham recommends that "the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.Selecting the appropriate asset allocation depends on the investor's ability, willingness, and need to take the risk.

It's easy to set up such a portfolio. If investors want broader diversification, it's even possible to buy a Total World Stock Market Index Fund and Total World Bond Market Index Fund. Both own almost every stock and bond globally, so investors are merely betting that humanity will continue to create value over time. Investors abound their portfolio every month regardless of the asset's price, which is great peace of mind. It allows investors to spend more time with family and friends and less time managing their finances. The only thing that needs to be mastered is the investor's psychology.

The hardest part with this winning strategy is to control one's psychology. The investor's first instinct is to attempt to time the market by predicting its movements and buying and selling accordingly. Studies show that it's impossible because the market moves randomly. It requires tremendous humility to acknowledge that you can't do anything. In the words of Bogle: "don't do something, just stand here." Time is your ally, emotions your enemy. The system is designed for you to do something and lose. For instance, every brokerage site has prominently featured news feeds and live alerts to create fear of missing out so intelligent investors will deviate from their strategy. These stimulations are bad, and investors need a plan to survive the information overloadUseless and disturbing news is part of the explanation why investors buy high and sell low. In his book Irrational Exuberance, the Nobel prize winner Robert J. Shiller recalls that investors invested a net total of only $18 billion in 1990 when stocks were cheap, but $420 billion in 1999 and 2000, when stocks were substantially overvalued. Better be careful with our own actions!

In summary, the winning strategy is to save a lot, select an asset allocation containing both stock and bond asset classes, buy low-cost and diversified funds and never deviate from the initial strategy. I love how simple, powerful, and yet highly contrarian this method is. The long-term returns are high, but for that, you need the psychological strength to oppose the majority.

Anonymous survey: What would have made this article more helpful?

If you found this article valuable, please consider sharing it 🙌