In my post Start Now! Don’t Let Procrastination Cost You a Fortune!, I talked about the importance of avoiding procrastination in getting started on an investment program. While this is sound advice, it is not as easy as it sounds for most people. Many investors simply don’t know where to start, or they fear having large losses. This fear prevents people from taking the actions that they know that they should be taking. It’s natural to procrastinate when you don’t know what to do. I’m going to share with you a very simple strategy that should help put your mind at ease and that will very likely allow your investment portfolio to outperform the vast majority of professionals over the long run. If it sounds too good to be true, it’s not. As I will explain in more detail, while the strategy is simple, takes almost no time or effort, and has a very high probability of success, it still might not be easy to implement, depending on your individual temperament.
The Know-Nothing Investor
Some of you may have heard of Warren Buffett. He is currently the world’s richest man according to Forbes Magazine, and he is arguably the greatest investor who has ever lived. Lucky for us, he shares his wisdom with us regularly, and it doesn’t cost us a cent. As CEO and chairman of Berkshire Hathaway, he writes the annual letters to Berkshire Hathaway shareholders. His letters are extremely educational about investing and business in general. His 1993 letter describes the central concept behind the “Know-Nothing Investor” strategy:
“Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
This means that you can invest without knowing anything about stocks and still beat the professionals! Better yet, it doesn’t take any research. While the professional investor is slaving away analyzing data in order to decide what stocks to buy or sell, you can earn a better rate of return than them while watching TV or taking a nap on the couch.
The S&P 500 Index
The Holy Grail for professional investors is beating the rate of return on the S&P 500 Index, often referred to as the S&P 500. The S&P 500 is a broad stock market index that consists of 500 large companies, many of which are household names, such as Amazon, Coca Cola, Google, GE, and many more. The S&P 500 companies make up about 75% of the value of the entire US stock market, which makes it a good proxy for the stock market as a whole. This is one reason why the S&P 500 Index serves as one of the most commonly used benchmarks in investing. Because the S&P 500 index makes up such a large proportion of the US stock market, the rate of return on this index is approximately equal to the average return on the entire stock market.
You might think that beating the S&P 500 would not be difficult since it basically just earns an average return. However, approximately half of investors will do worse than the average and half will do better in any given year. Research shows that beating the average consistently over many years is exceedingly rare. Most investors who outperform the S&P 500 for a few years will go on to underperform it in subsequent years. This is one reason that looking at the historical track record of mutual funds is of limited value, especially funds that focus on one sector or type of company. There is always going to be a sector that is outperforming the stock market at any point in time. The problem is that the outperformance is usually pretty short-lived and generally ends up reverting to underperformance. It is very difficult to separate out the investment professional’s contribution to the rate of return from the contribution from economic conditions.
If You Can’t Beat ’Em, Join ’Em!
If you can’t beat the S&P 500, then you should invest in it. Just find a low-cost mutual fund or ETF that tracks the S&P 500 (i.e. buys shares in S&P 500 companies for you), make regular contributions, and don’t touch it. To show you how powerful this strategy can be, I tested the “Know-Nothing Investor” strategy using actual historical returns from the S&P 500 from 1926 through 2009. I calculated how much money you would have if you invested $1,000 on January 1 of each year over various lengths of time from 5 years to 60 years. I deducted 0.15% from the actual annual returns to cover mutual fund or ETF expenses (this is a conservative estimate of expenses compared to low cost funds that are available in the marketplace). Here are the results.
| Investment | $60,000 | $55,000 | $50,000 | $45,000 |
| Years | 60-years | 55-years | 50-years | 45-years |
| Minimum | 3,191,786 | 1,598,362 | 952,193 | 630,830 |
| Maximum | 14,347,954 | 7,488,020 | 3,840,250 | 1,956,055 |
| Mean | 7,161,121 | 3,834,876 | 2,038,491 | 1,138,573 |
| Median | 6,378,127 | 3,548,172 | 1,795,333 | 1,096,294 |
| Investment | $40,000 | $35,000 | $30,000 | $25,000 |
| Years | 40-years | 35-years | 30-years | 25-years |
| Minimum | 420,783 | 270,622 | 131,553 | 65,880 |
| Maximum | 1,227,138 | 813,043 | 559,367 | 361,393 |
| Mean | 690,238 | 433,144 | 269,344 | 156,962 |
| Median | 665,580 | 413,425 | 273,560 | 151,021 |
| Investment | $20,000 | $15,000 | $10,000 | $5,000 |
| Years | 20-years | 15-years | 10-years | 5-years |
| Minimum | 30,855 | 16,494 | 8,122 | 2,687 |
| Maximum | 177,692 | 79,787 | 33,309 | 10,979 |
| Mean | 84,631 | 42,445 | 19,462 | 6,956 |
| Median | 76,522 | 39,025 | 18,681 | 6,805 |
For example, if you invested $1,000 on January 1 for 20 consecutive years sometime during the period from 1926 through 2009, the worst you would have ended up with is $30,855 (this was the period from 1955-1974). The best you would have ended up with is $177,692 (over the period from 1980-1999). Out of all of the 20-year periods from 1926 through 2009, on average you would have ended up with $84,631. And in half of the 20-year periods, you would have ended up with more than $76,522 (the median), and in half of the 20-year periods you would have ended up with less than $76,522. Keep in mind that you would have invested only a total of $20,000, and your investments would be spread out over 20 years.
Time Heals All Wounds
You would have made money in about 88% of the 5-year time periods from 1926 through 2009 (i.e. you would have ended up with more than $5,000 in 70 out the 80 5-year time periods). As your time horizon gets longer, your odds improve. There were only two 10-year periods where you would have ended up with less money than you invested – from 1965 through 1974 (you would have ended up with $8,739) and from 1999 through 2008. This means that you would have made money in about 97% of the 10-year periods (i.e. you would have ended up with more than $10,000 in 73 out of the 75 10-year periods). However, this doesn’t tell the whole story. This means that if you don’t need to touch your money for at least 10 years, then your money should be pretty safe if history is any guide. If you don’t need it for only 5 years, then your money would be reasonably safe, but you might want to choose a safer investment option if it is very important that you don’t lose any money 5 years from now.
As you can see from the chart above, the longer you continue this strategy, the more powerful it becomes. If you found a way to invest just $1,000 (about $84 per month) for 60 consecutive years without touching it, you would very likely have more than $3.2 million, which is a staggering sum of money considering you would have invested only $60,000. In case you are curious, the best 60-year period was from 1940 through 1999, when you would have ended up with about $14.3 million from a $60,000 investment. In fact, all of the maximum values for periods 15-years or longer came from periods ending in 1999. However, this is because the stock market returns from the 80s and 90s were an anomaly. Returns like these are not likely to be repeated any time soon. Never fear though. Returns should do just fine.
Okay, so what’s the catch?
I started out by saying that this strategy is simple, but not easy, and that is the truth. The catch is that you have to fight your emotions and resist any occasional desires to abandon the strategy. The stock market fluctuates – sometimes quite dramatically – and you have to have the ability to ignore it. You have to have enough faith that you will be fine if you are patient and “let it ride.” For some people, this is extremely difficult. Look at the recent returns for the S&P 500:
| Year | Return |
| 2000 | -9.11% |
| 2001 | -11.88% |
| 2002 | -22.10% |
| 2003 | 28.69% |
| 2004 | 10.88% |
| 2005 | 4.91% |
| 2006 | 15.79% |
| 2007 | 5.49% |
| 2008 | -37.00% |
| 2009 | 26.46% |
Would you have been able to see your portfolio lose about 38% in the three years from Jan. 1, 2000 through Dec. 31, 2002 without abandoning ship? [In case you are wondering, you wouldn’t have lost 43% in 2000-2002 because each year you would be losing money on a smaller portfolio, so you end up only losing about 38%] If you abandoned ship, you would have missed out on the rebound, which would have reduced your loss to about 9% by December 31, 2009 (you would still have a loss because 2008 had the second largest annual loss from 1926 through 2009).
The Rules of the Game for the “Know-Nothing Investor” Strategy
If you want to effectively use this strategy, here are the rules:
1) Invest on consistent dates. This means invest at a pre-determined date every single year, quarter, or month. Investing monthly works best for most people because it works with their budgets. Don’t try to time your investments for when the stock market drops. This defeats the purpose of this strategy. Decide on a regular date to invest, and stick with it.
2) Invest consistent amounts. Try to keep your regular investment amounts pretty flat. If you think that your cash flow available for investing has changed, then you can of course change the regular amount you invest, but try to keep it relatively flat. The point of the “Know-Nothing Investor” strategy is to take thinking out of the equation and to avoid the destructive impact your emotions have on your investment decisions. Especially avoid the tendency to invest more when the stock market is rising. Many investors, including professionals, get too excited when the stock market is rising. They don’t want to get left behind while everyone seems to be making money, so they abandon their plan and find more money to invest (usually at the wrong time).
3) Use laziness to your advantage. Don’t reallocate to other classes of assets. Many investors feel that they should try to time the market. They try to get out of the market and into cash or out of cash into the market based on what they think the market will do in the short-term. They can’t sit still. They feel like they should be active. Avoid this at all costs. As Warren Buffett once wrote, “Lethargy bordering on sloth remains the cornerstone of our investment style.” Sit on your butt, and stay invested in the S&P 500. You will be glad you did in the long run.
4) Invest windfalls right away. If you suddenly find yourself with some extra cash that you know that you don’t need and would like to invest, don’t delay. Examples include things like tax refunds, inheritances, etc. Invest it at the first opportunity. Many people try to either time the investment of a windfall or feel that they should invest it by making a series of payments. You improve your chances by consistently investing any windfalls immediately. There is no guarantee that this will be optimal, but because the market tends to go up over time, you will improve your odds if you consistently invest earlier rather than later.
5) Keep your costs low. Avoid mutual funds or ETF’s with high expenses, and avoid high custodial fees. Even annual expenses of 1% will reduce your returns by 10% each year over the long run (assuming long run returns of 10%). Don’t invest in mutual funds with loads (sales commissions), because this reduces the amount of money that actually gets invested, and if you buy ETF’s, use a discount brokerage to keep commissions low. These costs will have a major negative impact on the value of your portfolio over time. They are a silent killer because they are hidden and seem so small.
6) Don’t worry about diversification. If you are investing in the S&P 500 Index and follow the “Know-Nothing Investor” strategy, you don’t need to worry about additional diversification. The S&P 500 Index is made up of 500 companies from different sectors of the economy, and most of the companies are global companies doing business around the world. Furthermore, the S&P 500 already makes up 75% of the market value of the US stock market anyway. Many people have been programmed so heavily with the “diversification mantra” that they will encourage you to further diversify, but it really isn’t necessary and will probably hurt you since it will likely encourage you to try to time moves into and out of various sectors, once again short-circuiting the “Know-Nothing Investor” strategy. At the very least, make the S&P 500 index the dominant component of your portfolio.
7) Maximize contributions to retirement accounts whenever possible. Retirement accounts allow you to defer taxes (or avoid them forever if you invest in Roth IRA’s or Roth 401(k)’s). Check with your tax advisor to find out if you can contribute to a retirement account.
As you can see from the rules, you really can be a “Know-Nothing Investor.” You don’t have to know anything about stocks or what the market is doing, and in fact you will probably be better off if you don’t pay attention to the market. Put your investing on automatic pilot, and use the “Rip Van Winkle” approach to investing. Go to sleep for 40 years and wake up to a huge portfolio!
If you apply these rules consistently, you are virtually guaranteed to outperform the vast majority of investors, including professionals, over the long run. The key is to be patient, be consistent, manage your emotions, and have faith that the market will do just fine in the long run, just as it has in the past. Don’t let the volatility of the stock market shake your confidence.
Getting Started
To get started on your investment program, find a reputable low cost S&P 500 Index fund or ETF. An ETF is a fund that trades like a stock and can be purchased from a brokerage account. You can generally either invest in a mutual fund by investing directly with the mutual fund company or by investing in the mutual fund from a brokerage account (if you already have one).
In my opinion, the Vanguard funds are a great low-cost choice. The Vanguard 500 Index Fund only had a 0.18% expense ratio as of 06/30/09. Your can start a mutual fund account directly with Vanguard [Disclosure: I’m not associated with Vanguard in any way].
For more information on Vanguard’s S&P 500 Index Fund, go to their website:
Vanguard 500 Index Fund Investor Shares (VFINX)
Have fun beating the professionals by knowing nothing and being lazy!
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