Ignore the Hype. Brian Perry
One of the main goals of much of the financial industry is to provide you with guidance about what security, sector, or asset class will serve you best in the coming months and years. This has always been the case and it makes sense. Undoubtedly, in the years to come, some sectors of the stock market will do better than others. Perhaps technology stocks will lead the way. Or maybe energy stocks will produce the strongest returns. Or it could be consumer discretionary companies or consumer nondiscretionary companies. Although we don't know which of the sectors will perform the best, we do know that some will do better than others.
It's the same with asset classes. Perhaps small-company stocks will do better than large-company stocks over the next decade. Maybe commodities will outperform real estate.
Figure 2.2 shows the performance of several asset classes and portfolio mixes over a 20-year timeframe (1999–2018). As you can see, some investments have done better than others. The cumulative affect has been that investors in say, real estate investment trusts (REITs) have grown their wealth significantly beyond that of investors who purchased bonds (at least during the 20-year time frame measured in Figure 2.2).
Figure 2.2 Asset Class and Portfolio Performance (1999–2018)
SOURCE: Analysis by Brian Perry. Data from JP Morgan Asset Management & Dalbar Inc.
Consider that a $50,000 investment in REITs during that 20-year time frame would have grown to $330,311 while the same $50,000 invested in bonds would have turned into $120,585.
That, in one simple example, is why investors place so much focus on asset allocation, economic research, market forecasts, and the like. Picking the correct asset class, or mix of asset classes, can hold the key to financial success.
No wonder Wall Street churns out a constant parade of asset class forecasts!
No wonder the media talks breathlessly about the best or worst performing sectors!
Make no mistake: Buying the right sectors or asset classes can make an enormous difference in your investment returns and ultimately determine whether you achieve financial freedom.
A Twist in the Plot
Everything I wrote earlier is absolutely true. Some asset classes or sectors greatly outperform others. And choosing the winners will produce better results. But here's the interesting thing. Let's look again at that chart with the returns of the different asset classes and portfolio mixes.
This time, though, I'm going to add one bar to the chart. That bar, which you can see in Figure 2.3, represents the performance of the average individual investor across the past 20 years.
It turns out that it almost didn't matter what you bought over the past 20 years! Almost anything would have produced better results than what most people actually achieved!
Sure, buying real estate investment trusts (REITs) was better than buying bonds, and the S&P 500 did better than international stocks. But at the end of the day, buying and holding any of those would have outperformed the average investor's portfolio.
Figure 2.3 The Performance of the Average Investor (1999–2018)
SOURCE: Analysis by Brian Perry. Data from JP Morgan Asset Management & Dalbar, Inc.
The same holds true for asset allocations. Yes, different investors might want to have different investment mixes. And the asset allocation mix is one of the most critical decisions you need to make. But ultimately, nearly any reasonable asset mix would have done better than the actual experience of the average individual over the past two decades.
So, first I talked about the importance of asset allocation and selecting the best sectors or asset classes. But now I'm telling you it didn't matter what you bought, because almost anything would have done better than the average investor. So, what gives?
Time in the Market versus Timing the Market
The difference between asset class performance and investor performance comes about as a result of timing issues – namely, many people are getting in and out of sectors and markets at the wrong time, and all too often buying high and selling low. Moving in and out of the market and spending too much time on the sidelines prevents an investor from leveraging the most powerful tool at their disposal.
But what exactly is compound interest? Well, let's say you invest $10,000. One year later you've earned 10% on your investment, or $1,000. Now assume that in year two you also earn 10% on your investment. Have you earned another $1,000? No. You have in fact earned $1,100, because you earned 10% not only on your original $10,000 investment, but also on the $1,000 worth of gains you'd achieved in the prior year. (Please note that 10% annual returns year after year would be exceptional. I've selected that number simply for ease of math.)
This pattern would continue indefinitely; if in year three you again earned 10%, your dollar gain would come out to $1,210. Over longer periods of time, this compounding factor can produce truly immense gains.
| In 10 years, $10,000 grows to $25,937 |
| In 15 years, $10,000 grows to $41,772 |
| In 20 years, $10,000 grows to $67,274 |
| In 30 years, $10,000 grows to $174,494 |
| In 50 years, $10,000 grows to $1,173,908 |
Figure 2.4 Growth of $10,000 with 10% Annual Returns
SOURCE: Analysis by Brian Perry.
For instance, using the initial $10,000 investment from the preceding example and assuming 10% annual returns, Figure 2.4 shows what your growth would look like.
As you can see, while the percentage returns remain consistent, wealth accumulates exponentially. That ability to convert small initial investments into vast sums reflects the power of compound interest.
That power in turn leads to a couple of important truths when it comes to organizing your finances.
First of all, time is your friend. The sooner you begin investing, the more likely you are to build wealth. In the earlier example, someone who had invested $10,000 shortly after graduating college would have accumulated more than $1,000,000 by their early 70s.
The second important takeaway is that compounding works in both directions. That same power that can build your wealth can also destroy it, if you allow yourself to become saddled with too much debt. The compounding effect of credit card, student loan, and other consumer debt can make it virtually impossible for some people to dig their way out.
The final takeaway is that, given that financial markets tend to go up more often than they decline, staying invested is vitally important. In other words, an investor needs to remain invested in order for compound interest to work its magic.
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