The Rational Investor, Part I

by wubbles 2 min read30th May 201329 comments

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First off, note that I am not in possession of any of the licenses that entitle me to call myself a financial advisor. However, the approach to investing I will present in this article is endorsed by many economists, Warren Buffet, and Vanguard. I personally follow it, and you can too.

What is the goal of investing? To turn money today into money tomorrow. There are several ways to do this, and people on Wall Street are constantly inventing new ones. What is more, you have professional competition in this activity: people who want to make money today into more money tomorrow then is otherwise possible. You are producing a commodity, and the better you understand this, the better investing decisions you will make.

What are the ways to make money today into money tomorrow? There are many ways. But we want to make money today into money tomorrow in the most efficient way that involves the least amount of worry.  After all, we have specialised in some other area of human activity, and are not good at this area. So we should pick an investment that requires no upkeep, no worry, and good returns. This rules out real estate entirely, and the last criterion rules out letting money sit there.

So how does money today turn into money tomorrow? First you pay taxes on the money today, then give the money today as a loan (called "buying a bond")  to someone who needs it to do something that will be profitable. Or you can purchase a bit of an enterprise that makes money (called "buying stock") and let it make money, and pay you in the form of dividends or appreciation of shares, as the company grows. Then you sell what you have or get payed back and get taxed again.

But what if they don't pay me back or the company fails? Then you are screwed.

So what if I put a little bit of money in each loan and each share? Then the failure of each one won't hurt you that much.

Okay, I'll do that! Got a few million lying around?

Nope. So I can't do that? Nope, you can't. Bonds come in units of $1000 face value, and stocks in lots of 100.

Wait, what if I got a bunch of my friends together, and we pooled our money? That's called a mutual fund, and you can buy them. But the person who manages the fund charges you money, and that comes right out of the money tomorrow, and sometimes out of the money you put in.

So I should try to minimize these charges? Exactly!

Someone promises me higher returns for his fees! He's lying: academic research has shown no evidence of after-fee returns beating the market in general. After all, wouldn't you keep this secret for yourself if it really worked? He gets paid the same even if you lose all your money.

So what is the fund with the lowest fees? Well, the Vanguard Admiral Shares S&P 500 has fees of 0.05% of your money. Check out the prospectuses before you invest: they list out all the things that can go wrong.

But I don't like the risk! Remember bonds? You are more likely to get paid back, but the price is lower returns.

But I want diversification! So buy a bond mutual fund as well. And as usual there are fees you want to avoid.

Do I need anything else? According to CAPM, no. (We can talk about international stocks, but the S&P 500 do business worldwide, and there are lots of details about the costs of diversification etc.)

But how much do I put in each? That's a research question. But there is plenty of advice on this one question, and it doesn't cost you anything.

What about taxes? That's between you and the IRS. But sign up for a 401(k), maximize it, put as much into an IRA as you can, consider carefully the Roth IRA, think about which bonds you want to hold, and don't trade!

Don't trade? Don't trade: remember, you have competition. Trading hurts retail investors: it is expensive and they aren't good at it.

But I have a really good idea! Then work on Wall Street and risk someone else's money. Best part: you get paid either way.

But I want to change which mutual fund I hold to one that got more returns! Don't do it: the high returns don't last. Reversion to the mean is a powerful force.

I want to move to bonds as I get older! Still don't do it: you get taxed on the realized gains. It's easier to buy new then to sell old.

So what should I do? Think of your portfolio as one thing, and think about how to minimize taxes and fees as you go from where you are now to where you want to be. Then do it. But think first! Buying doesn't destroy the basis the way selling does, and overbalancing in tax-deferred accounts cancels out imbalanced non tax-deferred accounts.

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Sources: http://www.vanguard.com/bogle_site/sp20051015.htm, 

http://online.wsj.com/article/SB10001424053111904583204576544681577401622.html

Buffet endorsing the index fund http://www.berkshirehathaway.com/letters/1996.html

http://johncbogle.com/wordpress/wp-content/uploads/2011/09/The-Professor-The-Student-and-the-Index-Fund-9-4-11.pdf

Similar sources exist everywhere. Ask your local economics professor what his investments are, and I will be willing to bet 10:1 odds that they are majority placed in an index fund.

 

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