You don’t have to beat the market for wealth creation, just match it.

just match the market

 

There is an old stock market story that goes like this,

Two fund managers go camping one day and while they are walking through the forest they get news of a wild bear roaming the area attacking people.

Fund Manager #1: “I’m not worried, I’m a fast runner”

Fund Manager #2: “Don’t be foolish, you can’t outrun a wild bear. They have been known to sprint up to 40km/h when chasing down their prey.”

Fund Manager #1: “Of course I can’t outrun the bear, the only thing that’s important is that I can outrun you.”

There is a dogma that in order to be successful in the stock market you have to beat the market. The reality is, you only have to match the market to accumulate considerable wealth over the long-term and the only way to match the market is to hold stock in every position. This, for obvious reasons isn’t possible for the majority of investors however, through the introduction of low cost Index Funds and ETF’s (Exchange Traded Funds) this has become a reality. An Index Fund holds a basket of stocks that closely resembles the index it is intended to track. An example of an index fund would be the S&P 500 Index Fund, which holds each of the 500 top stocks, in proportion to market capitalisation.




This investment strategy sounds easy enough but, what is a simple task in principle is a difficult task in action. The reason for the difficulty comes down to our emotional behaviour. You see, the principle is to invest in a well-diversified basket of quality common stocks and hold them through thick and thin for the long run – in excess of 20 years. The result of this is an expected long-term return of 7-10%, before inflation. The problem is encountered when we respond to media reports and market commentary. All too often, investors alike will hear a negative outlook and the first thought is that they need to get out before significant loses are incurred. The first mistake in this action is that by selling lower than you bought you are automatically incurring a loss, the second mistake is that by getting out of the market you are excluded from the gain that will inevitably occur when the market recovers. And the stock market always recovers! Using the US Dow Jones Industrial Average as the example, there have been five major bear (low) market positions since 1900 and each time the market recovered in spectacular fashion. Additionally, by not returning to the market you are forfeiting the power of compounding – $1,000 invested at a conservative compound return of 7% pa, the average nominal return on stocks will accumulate $7,612 over 30 years. Stretch the initial investment out to 40 and 50 years and the return jumps to $14,974 and $29,457 respectively.

The following is considered a sound strategy for the investor that doesn’t want or have the time to actively research and monitor common stock. Although, it does become fun! All this can be performed by the average investor and the use of an online, no-frills brokerage company like E-Trade. I will provide easy to digest complimentary information in coming posts on how to determine quality common stocks and what to look for in an Index Fund.

Sample Investment Strategy – The simple approach

  1. Invest 70%, the majority of your portfolio in Index Funds. With the following break-down:
    • 50% in US based indexes (60% in large capital indexes such as S&P 500, 40% in low capital indexes such as Russell 2000)
    • 50% in international indexes (60% in large capital indexes such as S&P 500, 40% in low capital indexes such as Russell 2000)
  2. Invest 20%, in large capital stocks. With the following break-down:
    • a. 50% in US based stocks
    • b. 50% in international stocks
  3. Invest 10%, in small and mid-sized capital stocks. With the following break-down:
    • a. 50% in US based stocks
    • b. 50% in international stocks



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