A Beginner’s Guide to Investing

Below, you will find an unedited chapter from my upcoming book about wealth building, investing and personal finance, The Ten Year Turnaround. To get a free copy of the book when it comes out in July 2016, visit www.tenyearturnaround.com

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. –Paul Samuelson

Building wealth through investing will be both the easiest and hardest part of your ten-year turnaround. Developing and implementing a plan to build wealth and create a life-time income is surprisingly easy, but there are many traps that can derail your efforts along the way. It will take many years for you to hit your long-term savings goal that can provide for your dream lifestyle. You will be tempted to make decisions that are not in your best interest along the way. You might be tempted to pull your money out of the market during a recession, want to move your money into a hot sector, or get wooed away from your strategy by a commission-based sales person that promises a bigger better deal. The key to successful investing is developing a long-term plan, sticking to it and not letting market conditions cause you to make emotional trading decisions.

In this chapter, I’ll show you how to avoid the most common traps that cause investors to lose money. You will learn an investment strategy that has historically outperformed the S&P 500 with lower volatility. You’ll learn whether or not you should work with a financial advisor, how to minimize investment management fees that can kill your returns and how to use tax-deferred and tax-free accounts to keep the government off of your investment returns. Most importantly, you’ll learn how to build an investment portfolio that will generate income each month so that you can eventually live entirely off of your investment income.

What are we trying to accomplish?

The long-term goal for your investment portfolio should be to replace the income from your job with income that is generated by investments. When your investments throw off enough income to pay to cover your monthly expenses as defined by the dream spending plan you created in Chapter 1, you have achieved financial freedom. You will no longer need the income from your day job or your business to cover your expenses. If you want to live off of $5,000 per month and you have investments that generate $5,000 per month, you can pretty much do whatever you want. You will have the complete and total freedom to quit working all together, switch to a more enjoyable job or start the business you’ve always wanted to start. Any additional money that you earn after you’ve achieved financial freedom is pure gravy that you can use to give to charity, to travel or to fund additional upgrades in your lifestyle.

Investment Trap #1: Emotional Buying and Selling

Before we dive into developing an investment strategy, we must first review the many different mistakes that investors make that cause their investments to underperform the broader stock market. By far the biggest mistake that investors make is emotional buying and selling. People buy when they should sell and sell when they should buy. When the market takes a dip, people sell their investments because they are afraid of losing more of their money. When the market is doing well, investors put more money into the market (often paying a premium for their investments) because they see that the market has been doing well recently.

Selling low and buying high has a huge negative impact on the returns that mutual fund investors receive. According to a Dalbar study, the average equity mutual fund investor underperform the S&P 500 in 2014 by 8.19%. Mutual funds themselves posted an average return of 13.69%, but mutual fund investors only earned 5.50% on their money. The problem isn’t that mutual funds are over-stating their returns, but that mutual fund investors switch funds too often and buy when prices are high and sell when prices are low.

If you want to do well in the market over the long-term, you have to learn to emotionally get over the volatility of the stock market and stick to the strategy that you started with. When you develop your asset allocation and long term investment strategy, you need to plan to stick with that strategy for at least 5 years and hopefully even longer. Switching between strategies too often and buying and selling based on fear and greed are a recipe to dramatically underperform the market.

If you can’t handle the swings of the stock market, you should probably hire a fee-only financial advisor to look after your money for you. A good financial advisor will be able to talk you down from the ledge when you’re tempted to sell because of a bear market. Even though the financial advisor will take a 1% account management fee each year, that fee will pale into comparison compared to the money that you lose because of emotional buying and selling. I don’t believe that everyone needs a financial advisor, but if you can’t keep cool during a recession, you should hire a financial advisor to protect you from yourself.

Investment Trap #2: Investment Costs

Another common trap that cause investors to underperform the market is paying far more than they need to in fees, which significantly hamper the ability of compound interest to work in their favor. Let’s say that you invested into an S&P 500 index fund that has a management fee of 1% per year. While that doesn’t sound like much, it can compound dramatically over time. You max out your Roth IRA each year from age 25 to age 65 and put your $5,500 annual investment into that mutual fund. If the mutual fund earns an average of 9% per year, you’ll retire with about $1.6 million in the bank. If you were to invest in the same investments without the 1% annual fee from the mutual fund, you would have instead retired with $2.145 million. The 1% expense ratio charged by your mutual fund reduced your account returns by a whopping $545,000 over the course of your working life-time. Because investment fees can dramatically reduce your returns, it’s extremely important to know what fees you are paying and work to minimize those costs.

Here are the types of fees that can investors should watch out for.

Mutual Fund Operating Expenses – Mutual fund operators charge a variety of annual management fees to invest in their funds. These annual fees can include management fees, 12b-1 or distribution (and/or service) fees and other expenses. These fees are often reported as an expense ratio, or the percentage of your assets in the fund that you will have to pay each year in fees. Mutual funds can have annual management fees that are as little as 0.05% to as high as 2.0% per year. If you invest in mutual funds, take time to look up the expense ratio of each fund you own. Compare the expense ratio of each fund to similar funds offered by Vanguard, Fidelity and T. Rowe Price. If you are paying dramatically more in fees than comparable funds offered by those three providers, consider switching to the lower cost option.

Sales Loads – Some mutual funds charge a sales load, which serves as a commission for the financial professional selling the mutual fund to you. Sales loads can be charged at the time of purchase, known as a front-end load, or when you sell the mutual fund, known as a back-end load. I personally only purchase “no load” funds which do not charge a sales load, because typically there is a “no load” equivalent of any mutual fund that charges a sales load you may be evaluating.

Advisory Fees – If you use a financial advisor to manage your investment portfolio, your advisor may charge you an ongoing annual fee based on the value of your portfolio. These fees can range from 0.5% on the low end to 2.5% on the high end. If you use a financial advisor, ask them what their annual management fee is. If your financial advisor charges an annual management fee of more than 1%, you should move your money to a less expensive advisor or managing your money yourself.

401(k) Fees – Expenses for operating and administering a 401(k) plan are often passed along to its participants. These fees are charged in addition to the operating expenses of any mutual funds you hold inside of your 401(K) plan. These fees can vary significantly between different 401(k) providers. While it’s good to be aware of any 401(k) fees you may be paying, you probably can’t do much about the fees you are paying unless you can convince your employer to switch to a lower cost provider.

Variable Annuity Fees – Variable Annuities are very high-fee investment vehicles that are often promoted by commission-based sales people. If you were to invest in a variable annuity, you will likely be charged an annual management fee to cover the expenses of a variable annuity on top of the operating expenses that are held inside of any mutual funds that the variable annuity holds. If you want to get out of your variable annuity, you will likely be hit with a surrender charge that will vary based on how long you have owned the variable annuity. I do not recommend that anyone purchases a variable annuity under any circumstances because of the high-fees that are charged by this type of investment vehicle.

Commissions – You will pay a commission when you buy or sell a stock through a brokerage account or a financial professional. Most brokerage accounts charge less than $10.00 per trade. You can reduce those fees to as little as $2.00 if you are with the right low cost broker and have a sufficiently large account.

Before buying a mutual fund or any other investment product, calculate the total fees that you will have to pay to make the investment. While there’s no hard and fast rule about what is “too much” to pay in fees as a percentage of your investment, the lower that you can get your investment fees, the better. Personally, I pay an average of less than 0.25% per year to maintain all of my investments. By not using a financial advisor for the bulk of my investments and investing primarily in low-cost index funds and individual stocks through Vanguard, I have been able to pay dramatically less in both management fees and transaction fees than most investors.

Investment Trap #3: Investing in Tech Startups, Friends’ Businesses and Private Equity Deals

I can’t count how many times that I’ve been asked to invest in the businesses’ of friends and acquaintances, private equity investments, tech startups, private loans and other complicated investment strategies. People in my community know that I’m a successful entrepreneur and I get hit up for these types of things at least every other week. In many cases, someone believes they have the next big business idea and they just need a little bit of money to get started. Other times, a company is promoting a unique investment strategy, like investing in private mortgages, that promises better-than-market returns. These pitches tend to be alluring to investors because of the possibility of getting better returns and because it’s fun to be able to share with friends and family about a great investment that you made.

While I have made a few small private equity investments, I generally say no to investments that promise better-than-market returns by default. While the initial pitch you receive might sound compelling, the actual mechanics of the deal are usually more trouble than they are worth. These types of investments are typically illiquid, have a lot more risk and often come with complicated terms and conditions that can come back to bite you later. You often won’t know what the real risks of these types of investments are until you get into them. If someone is coming to you for money, that probably means they have already tried and failed to get money from a bank or other investors. If the opportunity they were presenting to you as a small angel investor were really that great, a bank, an angel fund or a VC firm probably would have already written them a check. While some people make good money doing private equity deals and angel investments, it’s usually not the person that has $25,000 or $50,000 to put into a business. Unless you plan on becoming a professional investor that knows the minute details of every deal that you participate in, you should probably stick to stocks, bonds and real-estate.

Investment Trap #4: Investing in What You Don’t Understand

A good rule of thumb is that you shouldn’t invest in anything that you don’t fully understand. If you don’t know exactly how an investment instrument works, what you’re investing in, why the investment will make money, what the expected returns are, what the investment costs are and what the potential risks are, you shouldn’t invest your money. This is true for both investments that you might make in a business and for investments that a financial advisor or sales person might try to pitch you. If a financial salesperson is pitching you something that doesn’t make sense to you, don’t invest your money. If you’re not 100% sure what you’re signing up for, you risk getting stuck in an expensive investment vehicle that may be difficult to get out of down the line. If a salesperson is aggressively pushing you toward a financial product that you don’t understand, it’s probably because they are probably going to earn a big commission check for selling it to you. If the financial advisor doesn’t do a great job of explaining what they’re selling to you, you should find another advisor that can do a better job of educating you on investing.

Good investing should not be complicated. In fact, good investing is pretty boring. Effective investing usually just involves picking the right asset allocation of stocks and bonds, selecting low-cost mutual funds, regularly investing money every month and being smart enough to leave the money alone until you’re financially free and want to start living off the income generated by your investments. If you can do those things and avoid the traps of emotional buying and selling, regularly changing your strategy, paying too much in fees and buying things that you don’t understand, your investments will significantly outperform most other investors.

Should I Use a Financial Advisor to Manage My Investments?

If personal finance and investing are a hobby for you and you want to spend time learning about asset allocation, researching mutual funds and keeping an eye on your accounts, you probably don’t need a financial advisor. Since you are currently reading a personal finance and personal development book, there’s a pretty good chance that you fall into this category. If you’re willing to do a little bit of research and legwork up front, you can setup your own investment account with a brokerage, like Vanguard, TD Ameritrade or Fidelity and develop an asset allocation that would be very similar to what a financial advisor would set you up at significantly lower costs.

If your eyes glaze over whenever you try to read anything about investing, you will want to hire a financial advisor to manage your investments for you. A financial advisor can help you select what type of retirement or other investment account is best for you, what kind of investment asset allocation is best for your situation and keep you from making trades that are against your best interest when the market is down. Financial advisors generally won’t be able to “beat the market,” but they can make sure that you don’t dramatically underperform the market by making sure you’re doing all of the right things.

A financial advisor will charge an annual management fee of 0.5%-1% of your portfolio value each year. If your advisor charges more than 1% each year, you should switch to a lower cost advisor. If you are okay working with an advisor over the phone an email, you can hire a personal financial advisor from Vanguard for a 0.3% annual management fee. If you don’t mind not talking to a human at all, you can use a robo-advisor like WealthFront or Betterment to manage your investments for you for as little as 0.25% of your account per year. While you won’t get the personal touch of a financial advisor that you meet in person with a robo-advisor or an over-the-phone advisor, you can significantly reduce the cost of having someone manage your investments for you.

Financial advisors can do a number of other things besides managing your retirement investments. They can help you setup 529 college savings plans, charitable trusts and other unique investment account types. They can serve as a financial planner and make sure that you are on track to hit your long-term investment goals. They can also help you with your estate planning and help you put together wills, trusts and powers of attorney. Some financial advisors also work as independent insurance agents and can find the best deal on a variety of different types of insurance policies.

I don’t personally use a financial advisor to manage the vast majority of my investments, but I do use a financial advisor for my “backdoor” Roth IRA, for a variety of insurance policies and for estate planning purposes. I have my advisor manage my Roth IRA because of the complexity of setting up an IRA when you are above the income limit. My advisor also has a much better beat on the insurance market than I do and does a great job of keeping an eye on my health insurance, life insurance and long-term disability insurance policies. I have also worked with an advisor to setup an estate plan for my family.

If you want to hire a financial advisor, you can find a local financial advisor through the National Association of Personal Financial Advisors (www.napfa.org) or the Garret Planning Network (www.garrettplanningnetwork.com). Make sure that the financial advisor you select is required to work as your fiduciary, meaning that they are required to make investment decisions that are in your best interest. Make sure that there’s a good personality fit between you and your advisor. Also verify that your advisor has a CFP, CFA or equivalent certifications. The Wall Street Journal has put together an extensive guide on how to hire a financial advisor located at https://guides.wsj.com/personal-finance/managing-your-money/how-to-choose-a-financial-planner/.

A Note for Christians about Investing

In the Bible, there are about 500 verses on prayer, fewer than 500 verses on faith and more than 2,000 verses on money and possessions. Like many other financial topics, the Bible offers several principles that Christians and Jews should be mindful of when investing their money:

God Provides the Ability to Produce Wealth – “You may say to yourself, “My power and the strength of my hands have produced this wealth for me.” But remember the Lord your God, for it is he who gives you the ability to produce wealth, and so confirms his covenant, which he swore to your ancestors, as it is today” (Luke 12:33-34)

Christians Should Invest in God’s Kingdom – “Sell your possessions and give to the poor. Provide purses for yourselves that will not wear out, a treasure in heaven that will never fail, where no thief comes near and no moth destroys. For where your treasure is, there your heart will be also.”

Carefully Watch Your Investments – “Be sure you know the condition of your flocks, give careful attention to your herds; for riches do not endure forever, and a crown is not secure for all generations” (Proverbs 27:23-24).

Diversify Your Investments – “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land” (Ecclesiastes 11:2).

Avoid Get Rich Quick Schemes – “Wealth gained hastily will dwindle, but whoever gathers little by little will increase it” (Proverbs 13:11).

The most notable instruction in the bible on investing is Jesus’s parable of the talents, which is told in Matthew 25:14-30. In the story, a master entrusts his wealth with three of his servants. Each of the servant receives a sum of money in accordance with their abilities. The first servant received five bags of gold, the second servant received two bags of gold and the third servant received a single bag of gold. The master goes on a long journey and returns years later to see what the servants did with his investments. The first two servants invested their money and were able to provide good returns for their master. The third servant was afraid of losing the money and buried it in the ground. The master scolds the servant for not even bothering to put the money on deposit with local bankers to receive interest. The master takes away his bag of gold and gives it to the first servant who was faithful with what he was given.

While the parable of the talents might seem like a straight forward lesson on using money wisely and investing it for the future, the actual meaning is much deeper. Like in Jesus’s other parables, the parable of the talents is plausible real-life story that helps readers better understand the relationship between God and man. In the parable of the talents, the master represents Christ and the servants represent his followers. The master’s journey and return references Christ’s ascension to heaven and his eventual return. The entrustment of wealth to his servants represents the various gifts and abilities that we have been given to do good with while on Earth. The master’s return and evaluation of the servants’ work points to Christ’s return and judgement of believers for what they did while on earth. The rewards for the faithful servants and the punishment for the unfaithful servant point toward future spiritual rewards that faithful believers will receive in heaven.

While the parable of the talents is really an exhortation for believers to use their gifts and abilities in the service of God, we can also glean an important principle about investing from this story. Capital that remains un-invested and “buried in the ground” doesn’t do any good for anyone. If you have a large jar of change sitting in your home or money hidden in your mattress, you should probably do something more productive with that money. The parable also tells us that money that is diligently invested will grow over time. If we want to see our money multiply, we should follow the example of the two faithful servants and invest our money.

Using 401(K)s, Roth IRAs and Tax Deferred Plans

One of the best ways to increase your after-tax investment returns is to invest through tax-advantaged accounts that were setup by the government, including 401(k) and 403(b) plans, Roth IRAs, health savings accounts (HSAs) and 529 college savings plans. If you are self-employed, you have a variety of additional choices that will allow you to set aside more money each year, such as the Simplified Employee Pension (SEP), the individual 401(k) plan and the Simple IRA.

The two most common types of retirement plans that people use are the 401(k) plan and the individual retirement arrangement (IRA). The Roth IRA is the single best retirement vehicle that investors have available to them in the U.S. As of 2016, you and your spouse (if married) can each deposit up to $5,500 per year or $6,500 per year if you are over the age of 50. You can setup a Roth IRA through any online brokerage and can invest the money in any combination of mutual funds that you want. While you don’t get an immediate tax deduction for investing in a Roth IRA, 100% of the growth and earnings generated by the investments in your Roth IRA are tax free in retirement. You can withdraw your Roth IRA contributions tax free at any time (although you shouldn’t) and can withdraw the earnings from your Roth IRA penalty-free beginning at age 59 ?.

Technically, the income limits to invest into an IRA are $131,000 for an individual or $183,000 for families as of 2016. However, there’s a loophole referred to as a “backdoor” Roth IRA that can allow anyone to invest into a Roth IRA by opening a non-deductible IRA and immediately converting it to a Roth IRA. While I do most of my own investing, I have a financial advisor manage my “backdoor” Roth IRA because the steps in setting it up and moving the money around each year are a bit involved.

You may have also heard of the term traditional IRA. A traditional IRA functions very similar to a Roth IRA, but you receive an up-front tax-deduction on your contributions and have to pay taxes on the money at retirement. In almost all cases, it’s better to invest in a Roth IRA because you are investing your money after it has been taxed and before you reap the benefit of decades of compound interest. You also don’t know what tax rates are going to be during retirement, so it’s better to “lock in” a tax rate on your retirement dollars by investing in a Roth IRA now than taking a chance on paying significantly higher taxes in retirement.

401(k) plans are pre-tax retirement accounts that are setup through your employer. As of 2016, 401(k) plans allow employees of a company to invest $18,000 in pre-tax dollars. In many non-profits, a 403(b) plan is offered in lieu of a 401(k) plan. Functionality, 403(b) plans work very similar to 401(k) plans and have the same contribution limits. You may receive a bonus from your employer, known as a match, when you invest in your 401(k) plan. You can begin to withdraw money from a 401(k) plan at either age 55 or 59 ? depending on if you leave your job before age 59 ? (https://moneyover55.about.com/od/preretirementplanning/a/401k-Retirement-Age-55-59-1-2-Or-70-1-2-Different-Rules-Apply.htm). Some 401(k) plans also now offer a Roth option, which allow you to invest after-tax dollars and receive tax-free life-time growth. If offered, I recommend the Roth option for the same reasons that I recommend a Roth IRA over a traditional IRA—decades of tax-free compounding growth.

If you are self-employed, you have a variety of different retirement account options that other people cannot access. If you have no employees, you can setup an individual 401(k) plan that will allow you to invest up to $53,000 of pre-tax dollars each year. There is some paperwork to set an individual 401(k) plan up, but many big brokerages have streamlined the setup process. You can also setup a simplified employee pension plan (SEP), which allows you to set aside up to 25% of your self-employment earnings each year up to $53,000.00 on a pre-tax basis. While individual 401(k) plans and SEP plans are the two most popular types of retirement plans for self-employed individuals, there are also SIMPLE IRAs, money purchase plans (MPP) and traditional pension plans to consider as well.

After you max out your retirement plans each year, you have a couple of other tax-advantaged investing options. If you have children and want to save for their college education, you can put money away into a 529 college savings plan. The growth and income from investments inside of a 529 plan can be spend on qualifying education expenses tax free. If you want to open a 529 plan, read Clark Howard’s 529 Plan Guide (https://www.clarkhoward.com/clarks-529-plan-guide), which offers specific recommendations on which state’s 529 plan you should enroll in.

If you have a qualifying health insurance plan, you can also invest up to $6,750 per year (as of 2016) into a Health Savings Account (HSA). You can invest in mutual funds inside of your HSA and use the money to pay for your long-term medical expenses. When you put money into an HSA, you receive an immediate tax deduction on your contributions, but also get to spend the money tax-free on qualifying medical expenses. That means you can put away $6,750 per year of pre-tax money, invest it and spend it on medical expenses without ever having to pay tax on that money.

After you have maxed out your 401(k)/403(b) plan, your Roth IRA, your 529 plan (if applicable) and your HSA (if applicable), you should then just start investing in your taxable accounts. You might get pitched an annuity or a whole life insurance policy that has some tax advantages, but they are usually more trouble than they are worth because of the high-fees and restrictions associated with them. You also do want some money that you can live off of now in an individual account in the event that you want to stop working before you are eligible to withdraw money from your 401(k) and Roth IRAs. While it might seem farfetched today that you might max out all of your retirement accounts, it’s entirely possible that this will become a real issue toward the end of your ten-year turnaround. If you work to increase your income and also become a super saver, you will easily max out your retirement savings options.

How to Get Market Returns

Earlier in the chapter, we learned that most mutual fund investors significantly underperform the mutual funds themselves due to switching strategies and buying and selling at inopportune times. While many investors set a laudable goal of beating the market, many investors would do much better than they are now just by getting actual market returns. If you want to match the performance of the S&P 500, buy a low-cost S&P 500 index fund and hold on to it. It’s not any more complicated than that. If you have $10,000 to invest, you can buy Vanguard’s Vanguard 500 Index Fund Admiral Shares (VFIAX) and pay an expense ratio of just 0.05% for the privilege of investing in the S&P 500. If you invest money into that fund or another low cost S&P 500 fund and don’t try to time the market, you will get returns that are basically equivalent to the S&P 500.

Between 1965 and 2015, the S&P 500 earned a compounded annual growth rate of 9.75% per year with dividends reinvested (https://www.moneychimp.com/features/market_cagr.htm). Since many investors don’t average anywhere close to 10% on their money each year, you may be well served to simply invest into a low-cost S&P 500 index fund and know that you’ll get about 10% per year back on your money. While you’ll receive solid returns over time, the market has a lot of volatility on a month-to-month and year-to-year basis. You may have years like 2008 where the S&P 500 is down by 37% and years like 2013 where the S&P 500 is up 32.4% (https://ycharts.com/indicators/sandp_500_total_return_annual). Because of short-term volatility, you should only invest in the market if you plan to leave the money alone for at least five years.

While investing in the S&P 500 is a good baseline for any investor, you may want to invest in other things like bonds, international stocks, commodities and real-estate to diversify your money across borders and asset classes. A lot of intelligent people that are much smarter than I am when it comes to investing disagree about what the optimum asset allocation is for any given investor. The broad strokes usually tend to be that investors should hold a mix of U.S. stocks, U.S. bonds and international stocks. The percentage of your portfolio that you should have in each category will depend on your age and your risk tolerance.

Rather than suggest a specific allocation for your long-term investments, I believe it would be better to point Ten-Year Turnaround readers to a variety of tools and questionnaires that you can complete to develop an asset allocation that’s best for your specific situation:

Vanguard Mutual Fund Recommendations 

WealthFront Asset Allocation Questionnaire

AAII Asset Allocation Models

Betterment Asset Allocation

CNN Money Asset Allocation Wizard

BankRate Asset Allocation Calculator

Should I Invest in Real-Estate?

I know many people that have done very well in their lives by purchasing rental real-estate. Investing in real-estate can offer great diversification from the stock market and also offers excellent tax benefits. A good rental property can easily match or even exceed the investment returns you can get in the stock market. While rental real-estate can be a great investment, it’s not for everyone. Rental real-estate can require much more work than owning other types of investments. In order to get started, you have to save up a down payment, find a suitable property, get financing, purchase it and rent it out. You also have to collect rent each month, maintain your property, deal with emergencies and re-rent the property when a tenant moves out. If you don’t mind the extra work and can afford to purchase a property, rental real-estate can be a great investment. I personally don’t do much with rental real-estate because I don’t want to deal with the hassle and managing rental properties wouldn’t be a cost-effective use of my time. However, that doesn’t mean that you shouldn’t do it. Many people have built their fortunes through real-estate and you can too if that’s the route that you want to go down.

Specific strategies related to real-estate investment are beyond the scope of this book, primarily because I don’t want to try to teach something that I have not done personally. However, there are a lot of great books and courses about rental real-estate if that’s a path that you want to go down. If I wanted to start investing in rental real-estate, I would find an established landlord that owns multiple properties and has been in the business for at least ten years. I would ask to buy an hour of their time and ask them as many questions as I could about the industry. I would also read several books about rental real-estate and complete a reputable course or seminar about investing in rental real-estate.

Dividend Growth: The Investment Strategy That Beats the S&P 500

At the beginning of this chapter, I promised that I would show you an investment strategy that has historically outperformed the S&P 500 with less volatility. If you know anything about the investment world, that’s an awfully big claim. Because most money managers can’t consistently outperform their benchmarks, it would be surprising to anyone to find a strategy that has outperformed the market over a long period of time. While there’s no way to be sure that the investment strategy that I use will continue to outperform the market in the future, it has done far better than the S&P 500 since at least the early 90’s.

No, I haven’t stumbled cross a little-known investment strategy that the market missed. This strategy isn’t complicated or exotic and is a lot more boring than you might think. I invest in a series of individual stocks that pay strong dividends and have a history of raising their dividends over time. While I had previously been a staunch proponent of investing in index funds, but I became a believer after seeing how well dividend-paying stocks perform through many different types of markets. The S&P 500 publishes a list of companies that have raised their dividends ever year for at least 25 years in a row. The Indexology blog recently published a chart comparing the performance of the S&P Dividend Aristocrats Index compared to the S&P 500. While investing In the S&P 500 resulted in cumulative returns of about 1,100% during this time-frame, the S&P 500 Dividend Aristocrats Index had cumulative returns of more than 1,900% (https://www.indexologyblog.com/2014/12/12/inside-the-sp-500-the-dividend-aristocrats/#comments).

Why does investing in dividend stocks work so well? The magic isn’t in the dividends themselves, but in the companies that consistently pay strong dividends. If a company is going to pay out a good chunk of their earnings in the form of a dividend, they are going to have to have the cash flow to support that dividend. Because they have to pay out a dividend each quarter and the market will expect them to raise their dividend by 5%-10% each year, they are going to need to have consistently strong earnings and steadily grow their earnings overtime. If a company raises their dividend for 25 consecutive years, there is a pretty strong chance that they have solid earnings, cash flow and growth potential, which makes them great companies to invest in regardless of whether or not they paid a dividend.

The companies that in the S&P 500 Dividend Aristocrats index tend to be well-established blue chip companies, like McDonalds, Target, Procter & Gamble, Chevron, Coca-Cola, Verizon and Johnson & Johnson. These are large established players and they tend to be less volatile than the broader market. The S&P 500 Dividend Aristocrats index has a beta that averages around 0.9, which means that those companies are, on average, 10% less volatile than the broader market. My personal portfolio which consists almost entirely of established dividend payers has a beta of just 0.66, meaning that I can avoid as much as a third of the wild price swings of the market.

Impressive returns and lower volatility aren’t the only benefits of investing in established dividend-paying stocks. Dividend investing has the added benefit of being a form of income investing. Whenever you are ready to start living off of your investments, you can simply stop automatically reinvesting your dividends and start living off the dividend payments that you receive each month. You’ll receive a steady stream of cash flow without having to sell a single share of the companies that you own. You know that the payments you’re receiving a relatively secure and will likely go up by 5%-10% each year if you invest in solid dividend paying companies.

If you want to put together a portfolio of dividend growth stocks, you should look for companies that have raised their dividend every year for at least ten years. When a company has a track record of raising their dividend over a long period of time, you know that the company is committed to its dividend and will likely continue to raise its dividend in the future. Because this strategy is focused on generating long-term income that you can live off, you should also focus on stocks that have a dividend yield of at least 3.5%. It’s a lot easier to create a retirement account when your average portfolio yield is in the 4-5% range than it is with 1-3% dividends that are more common in the S&P 500.

When selecting dividend growth stocks to invest in, you also want to make sure that the company will have the cash flow to continue to support its dividend. You can verify a company’s ability to keep paying its dividend by looking at its dividend payout ratio, which is simply the percentage of earnings the company pays out as a dividend. Ideally, a company should be paying out no more than 75% of its earnings in dividends. REITs are the exception to this rule, as they are required to pay out 90% of their earnings as distributions to their shareholders. If a company is committed to paying out more in dividends than it earns each quarter, you know that company has a major risk of cutting its dividend. If you invest in companies that have a payout ratios around 50%, your dividend is safe and that the company has plenty of room to raise their dividend over time.

If you would like to explore dividend growth investing, I highly recommend that you readThe Ultimate Dividend Playbook by Josh Peters, who is the director of equity income strategy for Morningstar. Also read Get Rich with Dividends by Marc Lichtenfeld. These two books layout how to create a portfolio of dividend growth stocks in great detail. Peters also publishes a monthly newsletter called Morningstar Dividend Investor (https://mdi.morningstar.com) that offers an excellent dividend growth model portfolio that any investor can easily replicate.

It would be nice to be able to recommend a mutual fund or an ETF that selects dividend growth stocks that meet the criteria mentioned above, but one doesn’t exist. While there are a number of dividend growth mutual funds and ETFs, most of them have a lower average yield than we are looking for. They also generally don’t factor in a company’s payout ratio and include stocks that have dividend yields in the 1-3% range. If you want to build a portfolio of dividend growth stocks, the best way to do it is to build an investment portfolio of 10 to 25 companies that meet the criteria specified above. While this might sound like a daunting task, model portfolios such as the one published by Morningstar Dividend Investor can serve as a great starting point to identify companies you might want to put in your portfolio.

For my personal investment strategy, I currently own a collection of 27 different dividend stocks in my taxable account. The portfolio has an average dividend yield of 4.4%, an average payout of 79%, and an average annual dividend growth rate of 7.9% over the last three years. I’ve chosen not to include a list of stocks in my portfolio in this book, because they can and do change over time. If you really want to know what stocks I personally own, you can find a list an up-to-date list of my holdings in the terms of service page on MarketBeat.com under the “investment ownership disclaimer” section. I currently only use the dividend growth strategy in my taxable account. In my Roth IRA and my Individual 401(k) accounts, I use a more traditional mix of index funds because the dividend growth strategy is hard to replicate without owning individual stocks.

Wrap-Up

We have covered a lot of important ground in this chapter. We covered common investing mistakes, whether or not to use a financial advisor, various types of retirement accounts, asset allocation and dividend growth investing. While there’s a lot of technical know-how that goes into investing, it’s important to keep the big picture in mind. Remember that we are trying to build a stream of investment income that will eventually eliminate the need to earn a salary from a job. By investing a good chunk of your income into broadly diversified investments each month, you will build a sizable investment portfolio over time that will generate an income stream that you can live off when you reach financial freedom.

Action Steps:

• Learn the four major investment traps so that you can avoid them.
• Decide if you want to hire a financial advisor to manage your money.
• Setup your retirement savings accounts if you haven’t already.
• Determine what asset allocation you want to use for your investment.
• Setup an automatic savings plan so that you are automatically investing money each month.