6 Factors That Increase Wealth Over Time
I was 15 years old when I bought my first investment. It was a Fidelity Pioneer mutual fund. I followed my dad when he’d check out the latest prices in the newspaper. And watching him, I wanted to learn how to invest. He let me buy a few shares and we’d track them together. When I was 18, I bought my first stock. My dad got a “stock tip” on Qualcomm. This was about 1992. While my dad made over 800%, I still made 200% but had to sell early because I needed the money. Had to pay my fraternity dues in college. What can you do?
I’ve always been fascinated with investing. I’ve read many books on the topic with topics ranging from asset allocation (David Swensen) to prioritizing cash flow over capital appreciation (Robert Kiyosaki). I’ve handled my own personal investing ever since I opened up a Roth IRA in 1998. In that near 20 year lesson, I’ve learned a few things. I’ve found that even though I’ve spent a lot of time trying active investing, for 99% of the population, using passive index investments will improve your return over time. Most of my future investing is being done with passive index investing.
When investing, I’ve found that there are 6 factors, that drastically increase wealth over time.
1. Keeping Expenses Low
There’s only 1 thing we can truly control as investors and that’s how much we’re willing to pay in management expenses. Fees really add up over time. There are many fees inside active mutual funds and even hidden fees inside 401k plans. All these fees act as drag on your return, especially compounded over a long period of time. It’s important to pick low-fee investment options such as index ETFs. Over time, they are going to beat their high-fee counterparts.
2. Diversify — Asset Allocation Over 10 Asset Classes
I think it was Jim Cramer who said diversification is investing’s “only free lunch”. And, I think he’s right. Diversification is a critical component to Modern Portfolio Theory (MPT). Simplified, MPT states that there’s only 3 ways to produce a return — Market Timing, Security Selection and Asset Allocation. Diversification speaks directly to asset allocation. By investing in several different asset classes, the investor is reducing volatility and risk. Diversification based on your risk profile provides an equation for what asset mix will produce optimal results related to your investment goals over time.
3. Re-balance Portfolio
Re-balancing is merely the mechanism to keep your proper asset allocation. It’s the mechanism that systematically allows an investor to “buy low, sell high”. In a very simple example, let’s say your asset allocation is 50% stocks and 50% bonds. What is the stock market increases 15% and now you have 57% stocks and 43% bonds. If your target asset allocation is 50/50, then you would sell 7% stocks and buy 7% bonds to get back to 50/50 . This allows you to see some stocks (or whatever asset class has appreciated) and buy some bonds (or whatever asset class depreciated) at a discount.
4. Contribute Monthly, Automatically
One of the most important behaviors in investing is to make contribution automatic. This allows you to build a system to ensure you’re generating results towards your goal over time. Monthly contribution also allows you to dollar cost average into investments. If markets go down one month, then you’re able to buy more shares with your monthly contribution. Over time, this will help improve your cost basis. But really, it’s about have a process, a system, that’s incorporated into your financial plan of contributing to your financial goals consistently over time.
5. Tax-loss Harvesting
Tax-loss harvesting is an important process in a taxable, brokerage account. It won’t help you in a qualified account, like an IRA or 401k. But, if you have an investment account in a regular brokerage account, it can help you save a lot of money. Tax-loss harvesting is a technique used to lower your taxes while maintaining the expected risk and return profile. It harvests previously unrecognized investment losses to offset taxes due on other gains (or income). This process can generate lower tax bills and better returns over time.
6. Reinvest Dividends, Systematically
Systematic dividend reinvestment allows you to turbo-charge the compounded return. You’ve heard that anecdote about investing $100 per month for 10 year then letting it grow for 20 years vs. investing $100 per month for 20 years but letting it grow only 20 years. The results are staggering. Well, dividend reinvestment allows you to get your dividends paid to you, from the company, in company stock instead of cash. If you get $50 in dividends, then you’d get $50 worth of company stock when the dividend gets paid out. Over time, stock paid with dividends starts to pay dividends and you create a very virtuous cycle. Since half of the S&P500's total return over the last 50 years has come in the form of dividends, this approach to reinvestment can really increase your returns over time.
Passive Index Investing with Asset Allocation — The Solution
There are new services out there that can help an investor will all six. They are called “robo-advisors”. Companies like Wealthfront, Personal Capital and Betterment do these all for you. It’s time to automate your investing life so you can drastically improve your results over time. It’s because of consistency.
Stop spending time trying to pick the right investments. People waste a lot of time and money trying to select the exact right stock or fund. Most do well for a while, then they don’t. Stop trying to time the market. People rarely produce a significant and consistent return over time by trying to time the market. MPT shows us that it’s the least important of all the factors over a long period of time. I recommend you strongly consider one of these tools, like Wealthfront or Betterment, to help systematize your investing life. It will improve your total returns, especially over long periods of time.