Why do most investors fail to beat the market returns of broad-based stock market indexes when there are thousands of books, magazines and websites explaining how to invest?
Is there a missing piece?
Is there some secret that is buried so deeply that only a select few have access?
Here's the point: Financial success will prove elusive and expensive if you seek money secrets and strategies on the Internet, look for 'wins' by playing the lottery, and spend lavishly on schemes and courses.
Learn the simplest of money principles, and wealth can be yours. Just not overnight.
The secret?
Legend has it that Albert Einstein called it the most powerful force in the universe and the mathematical discovery of all time.
And what is it?
Compound returns.
I teach investing at a university. My students don't believe that when you double a penny and its product on each successive day of a month that ends on day 31, that penny will be worth more than $10 million.
It's true. On day two, the penny is worth 2 cents.
On day three, the amount doubles to four.
On day 19, the penny is worth $2,621, a far cry from $10 million.
The largest amount of growth occurs at the end. On day 26, that penny doubling daily is worth $335,000.
And by day 28, your wealth has compounded to more than $1.3 million.
According to InvestingAnswers.com, 'Compounding is the process of the exponential increase in the value of an investment due to earning interest on both principal and accumulated interest.'
Obviously, a 100% daily return is impossible. Yet, stocks have returned close to 10% annualized during the last 80 years or so. And bonds returned in the neighborhood of 5% annualized.
Let's take a more realistic example:
In my book, How to Get Rich, Jill starts investing at 25 with $200 per month. Her employer matches with an extra $100 per month. For the next 40 years, Jill invests the same amount. Even though Jill's salary increases, she does not increase the amount she invests.
Assume Jill earns an annual 7 percent per year during the 40-year period. At 65, her nest egg is worth $792,037.
During those 40 years, Jill keeps her investments simple. She chooses a widely diversified bond index fund and a widely diversified international stock index fund. She doesn't watch CNBC and adjust according to the talking heads. She doesn't subscribe to Investor's Business Daily to uncover stocks with positive momentum. In fact, she just glances at her quarterly statements.
Some quarters, when the markets are in a cyclical downturn, her investments lose money. Other quarters, they increase. She does not panic, but she lives her life. She does not play the lottery because her investment plan has already created her own winning lottery.
If you didn't start investing at 25, are you out of luck? No, it's just going to be more difficult. If you don't start until you are in your 40s, you can still build a nest egg, but you will need to invest larger amounts. Assume Jack starts investing at 40 and earns the same annualized return as Jill. In order to reach $791,983 by age 65, Jack will need to invest $972 per month. That's more than twice what Jill invested.
Jill invested $144,000 (including her employer's contribution).
Jack invested $291,600 (hopefully Jack's employer will contribute to his retirement investing as well).
To earn the same amount of money, Jack had to invest more than twice as much as Jill, because he started later.
The Investing Answer: Investing success takes time. Not just weeks or months or years. If you're looking to become a day trader and make large sums of money quickly, I can't help you. Sure, some people are lucky and strike it rich. But, if you're not one of them, take the tried and true path of building wealth slowly.
After all, Vanguard Group founder John C. Bogle and authors Burton G. Malkiel and Charles D. Ellis advocate regular investing into a diversified portfolio of index funds... Are you that much smarter than they are?
Barbara Friedberg, MBA, MS, wrote How To Get Rich: Wealth Building Guide for the Financially Illiterate, which not only lays out the simplest investing strategies for wealth, but also tackles how to make lifestyle choices in housing and spending in order to end up wealthy. She's also a finance instructor at Santa Clara University, portfolio manager, and publisher of Barbara Friedberg Personal Finance.com.
