"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it."
--Attributed to Albert Einstein
That's 30-plus years of evidence that stocks are a fantastic long-term investment. Think about it this way: If a 30-year-old in 1979 -- let's call her Sally -- had invested $1,000 in the companies that make up the Dow Jones Industrial Average, or the 500 companies that made up the S&P 500 in 1979, and let it ride for 35 years, her $1,000 would be almost $20,000 today.
There's a lot of evidence to support the value of long-term stock investing, from a number of studies. The thing is, those same studies also uncover a couple of other things:
- Most individual investors underperform the market.
- Most paid professionals (hedge fund and mutual fund managers) also underperform after fees.
So stocks are the best way to grow wealth, but there's a disconnect between the market's performance and the performance of investors. If the majority of us -- even the pros -- underperform, why bother? Simply put, it's not hopeless. It just doesn't happen without a little effort on your part.
Let's take a look at three things you can do to improve your returns.
No. 1: Stop trading so much
Our tendency to trade way too much -- the median holding period is around six months -- costs us time and money. There are two reasons why too much trading is ineffective and wasteful:
- We lose capital to brokerage fees and taxes.
- We are really, really bad at making short-term predictions on things like which way a stock price will go.
That $7 trading fee may not feel like much money today, but over 30 years, it's about $80 in value that you give away every time you buy or sell. Every 10 times you trade, you're taking $800 out of your pocket 30 years from now. In short, it's the time value of money.
No. 2: Max out retirement accounts first
Short-term trading gains get taxed as regular income. This further eats into your ability to beat the market, eating away at your account balance or reducing how much cash you have to add to your account. Either way, it's real money, and the impact can be significant.
The median household income is $51,000, so you're probably eligible for either a traditional or Roth IRA. Both protect gains (capital and dividends) within the account from taxes, so it's really a matter of whether you want to lower your income taxes now (with a traditional IRA) or in retirement (with a Roth). If you're investing in a taxable account before maxing out an IRA ($5,500 in 2014, $6,500 if you're over 50), then you're starting off wrong. Make sure your money grows tax-free for as long as you can.
And if you're not maxing out your employer's match in your 401(k) first, you're nuts. Sure, the mutual funds available will probably underperform the market, but your employer's match will more than make up for that underperformance. Two words: free money. Don't leave it on the table.
No. 3: Only invest in stocks if you can commit to the work
Face it: Nobody's born a stock picker. It takes work to develop, just like any other skill. Peter Lynch described it well in One Up on Wall Street, when he wrote that people "spend more time shopping for a good microwave oven" than researching stocks. But beyond skill, it takes discipline.
The best investors often owe their success to a handful of stocks they've held for years. Think of Warren Buffett's 20-plus year holdings of Coca-Cola and American Express -- $2.6 billion in investments now worth $31 billion today. If you're not prepared to ride out the ups and downs of the market, you'll never do better than the market. Case in point:
If Sally had instead split her $1,000 between Coke and American Express back in 1979, she'd have $45,000 today -- more than double the return of the market. And if she reinvested the dividends? She'd have a whopping $85,450.
But without the discipline to hold -- Coke fell more than 20% in 1979 and stayed depressed for three years -- Sally might have ended up losing money on one of the greatest investment opportunities of her lifetime. If she had cashed in on American Express in 1981 -- it was up 81% in less than three years -- she'd have sold early on an even better long-term investment than Coke. It's only by understanding the business that we can remain disciplined when our gut tells us to do something rash.
Sally would not have had a good vehicle to invest in the entire S&P 500 or Dow in 1979, but the modern low-cost ETF has changed that. Two of the most popular index funds are the SPDR S&P 500 (NYSEMKT: SPY ) ETF and the SPDR Dow Jones Industrial Average (NYSEMKT: DIA ) ETF. Investing in either of these two ETFs is like owning a piece of either the S&P 500 or the Dow:
If Sally had been able to invest in the indexes, starting at $1,000 in 1979 and increasing 5% every year, she'd have invested just over $101,000 of her own money over the past 35 years. Want to guess what her portfolio would be worth today? How does $250,601 sound? Not bad for mindlessly investing a set amount every year without fail. The point? Index funds like these two -- even if they're not the only way you invest -- probably have some place in your long-term portfolio.
Would you be better off following this plan?
The Motley Fool is built on the idea that stocks are the best way to financial freedom for most of us. Our paid newsletters like Rule Breakers and Stock Advisor are some of the best available, if you're looking for deeper insight. But the end result will largely be a product of your ability to remain disciplined. Start with the three things above, and when you're ready to retire, you'll be better off for it.
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