July
25, 2003 7:00 a.m. Seven
Rules for Investing Young
It’s
never too early to start (but never too late either).
o invest is
to defer. It's an act of faith, the abnegation of desire. When you buy
a company's stock or a government agency's bonds, you decide not to consume
your cash today but to entrust it to an institution that, you hope, will
produce rewards for you in the future.
History
shows that, if you make your choices with modesty, discipline, and good
sense, the rewards arrive. And the longer your money is at work in an
investment, the more you'll make — by a huge margin. Albert Einstein,
who knew about such things, called compound interest the most powerful
force in the universe. When you make interest on interest, or dividends
on dividends, or capital gains on capital gains, the numbers mount fantastically
over time. For example, an investment of $100, compounded at 10 percent
a year, becomes $259, not $200, over 10 years. And there's a bonus: The
volatility of stocks — the extremes of their ups and downs —
declines over long periods.
What's the point? Start
early.
When? At birth would
be nice. Imagine you are born on Jan. 1, 1947 (as it happens, my birthday),
and on that date a rich uncle (that part I am making up) puts $5,000 on
your behalf into stocks representing the Standard & Poor's 500 index, a
good reflection of the market as a whole. At the end of last year, your
stock account, exclusive of taxes and expenses, would be worth $2,435,449.
Now, imagine you are
a parent. You buy your 8-year-old daughter $1,000 worth of stock. Over the
first 10 years, if her shares perform at the average rate for equities,
they will grow in value by $1,600. Over the next 10, by $4,100. Over the
next 10, by $10,700. Over the next 10, by $27,800. You get the picture.
Finally, imagine you
are the target audience for today's column: in your twenties or early thirties.
You regularly invest $200 a month in an all-stock tax-deferred account such
as an IRA or a 401(k) plan.
If your fund returns
an annual average of 10 percent — which is about what you should expect
over long periods in an index mutual fund that reflects the market —
you will have $48,300 at the end of 10 years. After 20 years, you'll have
$167,352; after 40 years, $1.3 million; after 50 years, $3.4 million.
In the past, I have
told the story of Anne Scheiber, who retired as a government lawyer in 1944
at age 50 and turned her life savings of $5,000 into a stock portfolio worth
$22 million by the time she died — at age 101. But starting when you
are 50 is risky, and it's harder to enjoy the fruits of your denial when
you reach triple digits. It's better to begin at 20 or 30.
So here are seven rules
for investing young — to absorb for yourself or to pass along to your
children or grandchildren or pals:
1. Time is money.
It's the single most important factor in investing — more important
than the stocks or the bonds you pick, or your cleverness in buying or selling
at just the right moment. The stock market will suffer bad stretches, but
if you start early you can ride them out. Research by Jeremy J. Siegel of
the Wharton School at the University of Pennsylvania found that since 1802,
a broad market-mimicking portfolio of U.S. stocks has never lost money —
even after inflation — in any period longer than 17 years.
2. Stick with stocks.
Forget bonds if you are a young investor with a long time horizon. Stocks
have vastly outperformed bonds, returning 10.3 percent a year, on average,
compared with 5.5 percent for Treasurys over the past three-quarters of
a century (after inflation, the differences are even more striking: about
7 percent for stocks, a little over 2 percent for bonds). In addition, stocks
have produced remarkably consistent returns over long periods; in Siegel's
judgment, they are no more risky than bonds after inflation. Looking at
research by Ibbotson Associates covering every 20-year period since 1926
(1926-45, 1927-46, etc.), I found that the worst such period for large-cap
stocks produced average annual real returns of 1.3 percent; the best, 13.9
percent. For long-term Treasury bonds, the worst period showed an average
annual loss of 3.2 percent; the best, a gain of 8.4 percent. In fact, long-term
T-bonds have suffered real losses in the majority of the 20-year periods
since 1926.
3. Diversify.
Don't try to guess which sectors, or which individual stocks, will do best.
Instead, make a single prediction: that the U.S. economy will continue to
grow at roughly the same rate it has grown during the past century or so.
The easiest way to put that prediction into practice is to buy a broadly
diversified mutual fund — either an index fund that tracks the S&P
500 or the broader Wilshire 5000, or a fund managed by an actual human being
that has a crack at beating the index. Or, if you have the time and inclination,
put your own portfolio together, with representative companies from at least
a dozen sectors (such as health care, energy, or retail). To get enough
diversification to dampen risk sufficiently, recent academic study shows
you need to own 30 to 50 stocks. If you're busy building a life, be happy
that mutual funds were invented.
4. Keep costs low.
The average stock mutual fund charges 1.4 percent per year in expenses (and
some charge a load, or upfront fee, in addition). As an article in the new
issue of AAII Journal, the publication of the American Association
of Individual Investors, puts it, "Extremely high expense ratios are a negative,
and very low expense ratios are a long-term positive." With mutual funds,
you don't necessarily get what you pay for.
In the same issue,
the association identified the five large-cap stock mutual funds with the
best returns for the five years ending in 2002 and found that all of them
had significantly below-average expenses. Only three of the five are open
now to new investors: Clipper Fund (CFIMX), which returned an annual average
of 10.8 percent, beating the typical fund in its category by nearly 12 percentage
points a year; Mairs and Power Growth (MPGFX), with a return of 7.8 percent;
and Fidelity Export and Multinational (FEXPX), also 7.8 percent. Clipper
carries an expense ratio of 1.1 percent; Mairs and Power and the Fidelity
fund are both 0.8 percent. In addition, Clipper and Mairs and Power have
each been run by the same manager for at least 20 years, and each has been
significantly less risky than the market as a whole.
Vanguard, which specializes
in index funds, charges expenses of only 0.2 percent for its Index 500 (VFINX),
which tracks the S&P, and Total Stock Market Index (VTSMX), which tracks
the Wilshire. Dozens of other firms offer similar index funds, most with
fees that are a little higher. Another good choice is Schwab 1000 (SNXFX),
which owns the same stocks as the S&P plus 500 smaller ones and charges
expenses of 0.5 percent. If you choose to manage your own portfolio, be
careful of commissions but don't obsess over a few bucks. If you buy stocks
with the intention of owning them for a long time — as you should —
then, amortized over the life of your shareholding, the difference between
a broker that charges $10 a trade and one that charges $50 is inconsequential.
Taxes, of course, are
another cost. If you buy and hold stocks in a taxable account, you'll only
pay the tax (now reduced to 15 percent) on dividend income. Index funds
change only about 5 percent of their holdings annually, but the turnover
is far greater (about 100 percent, on average) for managed funds, which
can rack up sizable capital gains. That tax liability gets passed straight
to you each year.
5. Marginalize your
gambling. Many young investors think they're such terrific stock pickers
or market timers that they can whip the averages. That is a dubious proposition,
but I would never deny anyone the pleasure of trying it out. If you want
to wheel and deal in stocks, trading shares daily or weekly or monthly,
then isolate your gambling (that's what it is) by setting up a separate
Fun & Games Account. It should be small, representing no more than 10 percent
of the total money you devote to stocks, and it should be walled off from
your main investment account. It serves three purposes: to satisfy unquenchable
urges, to provide some exciting entertainment and to offer a way to learn.
Over time, it's unlikely that your F&GA will beat your diversified buy-and-hold
account. If I'm wrong, you're either lucky or talented. But don't jump to
conclusions for about 10 years.
6. Keep paying off
your college loans. If your college loans carry an exceptionally high
interest rate, pay them off as quickly as you can. If you can't, then the
best strategy is to retire the debt slowly and start an investment account,
even if it is a tiny one, at the same time. It's important to get into the
habit of saving and investing. Also, if the future is like the past, stocks
should return around 10 percent annually for the next decade, or about 7
percent after taxes. As long as your loan rate is less, you're better off
in stocks. Still, get out from under your debt. And, certainly, taking on
more debt to buy stocks — called buying on "margin" — is a foolishly
risky practice.
7. Start now.
Say that your goal is to accumulate $1 million by the time you are 55. If
you start at 24 and invest $5,000 a year at an expected — though never
guaranteed — return of 10 percent annually, you will reach your goal.
But if wait until you are 34 to begin, you'll accumulate just $300,000 by
age 55.
Here is an even more
dramatic example of the importance of starting early. One investor decides
to begin investing at age 25. She puts $2,000 a year into a portfolio of
stocks that returns 10 percent a year. At age 35, after investing a total
of $20,000, she stops and never adds another penny to her account. But the
value of her fund keeps growing, and by the time she is 65, she has $546,197.
A second investor waits until he's 35 to begin. He, too, invests $2,000
a year at the same rate. But he invests for a full 30 years — a total
of $60,000. How much does he have at age 65? Just $328,988.
There's no excuse for
not opening an account. If you can't make up your mind where to invest,
then simply call a mutual-fund house and put your money into an index fund.
Then ask your bank to make regular transfers to the account, monthly or
quarterly. Or call a broker and purchase "Spiders," or Standard & Poor's
Depositary Receipts (SPDRs, with the symbol SPY), which are individual shares,
again with low expenses, that make up the entire S&P 500 index, roughly
the 500 largest listed U.S. companies. A similar choice is "Diamonds" (DIA),
which track the 30 large-cap stocks of the Dow Jones industrial average.
You can buy as little as a single share (SPY and DIA each trade around $100
these days) if you want; by contrast, the minimum investment for Vanguard
500 Index is $3,000. Clipper, unfortunately, requires $25,000 for starters;
Mairs and Power Growth, a more typical $2,500.
Exploit your advantage.
You young people have something us old guys will never have again: youth.
It's the best investment strategy of all.
—
James K. Glassman is a fellow at the American Enterprise Institute
and host of TechCentralStation.com.
Of the securities mentioned in this article, Glassman owns Spiders. This
column originally appeared in the Washington Post.
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o invest is
to defer. It's an act of faith, the abnegation of desire. When you buy
a company's stock or a government agency's bonds, you decide not to consume
your cash today but to entrust it to an institution that, you hope, will
produce rewards for you in the future.
