behavior came to the fore shortly after I was named CEO at Vanguard in 1996. The market went on an extraordinary surge (up 166% from December 1995 to September 2000) in a continuation of a bull market that started in the early 1990s. With such a prolonged period of gains, investors become infatuated with the stock market and investing. The ardor dissipated quickly when the market came back to earth with the bursting of the so-called tech bubble. Stocks fell 49% and didn't turn around for another two years. It was a painful, but instructive, period.
Despite periodic setbacks, the historical trend suggests that you'll be rewarded if you invest in the stock market. But there is no guarantee, of course. You shouldn't put your money in stocks if you don't share the belief that the economies around the world will continue to grow over the coming decades. Without growth in productivity and innovation in the products and services in our collective economies, there will not be good returns on stocks, and corporate bonds will prove risky. Instead, put your money in the bank and collect a guaranteed return, or buy U.S. Treasury bills, the safest debt instrument in the world. Recognize that you'll have to be content with very modest returns that may not keep ahead of inflation. Remember the trade-off: Lower-risk investments (i.e., ones that possess price stability) cannot be expected to reward you as well as riskier ones (i.e., ones that possess price volatility).
Portfolio Pitfall: Keeping Your Emotions in Check
When you follow the market's ups and downs on a regular basis, you allow the market to dictate your mood, so to speak. If you hear on the car radio or read on your daily newsfeed that the Dow Jones Industrial Average plunged 1,200 points, you are naturally inclined to calculate that you've lost money. If the market falls three days in a row and posts considerable losses, you may feel despondent. It might even compel you to check your balance. Don't!
This penchant for “mental math” can also play out over years. Suppose you had a $100,000 balance in your investment account at the end of 1994, as shown in Figure 2.2. Five years later, you are feeling pretty good with a balance of more than $350,000 in 1999. The market suddenly reverses and, at the end of 2002, your balance now stands at $219,000, and you figure that you've lost more than a third of your portfolio!
Only you haven't. These are paper losses. By 2006, your portfolio has recovered. To demonstrate how the market can quickly give and quickly take away in the short term, refer to Figure 2.2. As you can see, the value of your investment account is subject to euphoria-inducing gains and gut-wrenching losses over the short term. But over the long term, you are well rewarded for participating. (This example is for illustrative purposes and is based on $100,000 invested in the S&P 500 Index with dividends reinvested. Your portfolio is likely to include bonds and cash reserves that will offset the short-term losses incurred by stocks.)
Figure 2.2 Growth of $100,000 Invested in the U.S. Stock Market (1995–2019)
Sources: Vanguard, S&P
Trust in Time
If you believe that the economy will grow over the long term, time will be your greatest ally in accumulating wealth. That's because of the power of compounding. Compounding is what happens when you invest a sum of money and then reinvest the earnings instead of withdrawing them. Your nest egg grows much faster because those prudently reinvested interest payments, dividends, or capital gains in turn generate further earnings. My friend at a competitor firm, Mellody Hobson, aptly observes, “We talk about long-term patient investing, and that idea that slow and steady does win the race, that time can be your best friend when it comes to investing. That's why we have a turtle as a logo at Ariel.”
So, think tortoise, not hare. The longer you invest, the effects of compounding are all the more astonishing. Consider the simple example shown in Figure 2.3. Suppose you invest $5,000 in a tax-advantaged account at the start of each year for 10 years and then contribute nothing more. Next, suppose that the account earns 8% a year, after expenses, and that you have all of your earnings reinvested in the account. After 25 years, you would have more than $248,000, of which only $50,000 came from your pocket. And after 40 years, that sum would have grown to more than $787,000. The power of compounding is absolutely amazing.
Figure 2.3 The Power of Compounding
Source: Vanguard
Here's a point that requires special emphasis. If you're going to make the most of the power of compounding, you must reinvest all the income and dividends that you earn on your investments instead of taking them in cash. You must also keep your hands off the money in your accounts. If you repeatedly dip into your long-term accounts to pay for living expenses or big splurges, your wealth won't grow as efficiently as it could otherwise. Like a chef who keeps sampling the food while it's cooking, you're apt to end up with a lot less in the pot than you planned.
Trust Your Financial Partner
For your safety and peace of mind, you need to establish a relationship with a financial services provider or two that you can trust. Or, a relationship with a financial advisor whom you can trust. (I will focus largely on firms in this section, although some of the lessons apply to financial advisors, which I cover in more detail in Chapter 12.) A trustworthy firm will serve you with integrity and help you accomplish your financial goals. And it won't push products and services that meet the company's quarterly sales goals but that do little for you, or seek to lure you with bait-and-switch tactics. Fortunately, there are plenty of good investment companies that offer sound products and quality services.
Picking a trustworthy partner is important to your success in more ways than one. If you do business with a firm that you trust, you will be better able to endure the misgivings that come when your portfolio has an off year. Believe me, sooner or later, that will happen. It's one of the facts of investing. If you trust your investment partner, you'll realize that a mutual fund or exchange-traded fund with a strong long-term track record is still a good investment even after it's had a bad year.
How can you be sure you are dealing with a firm that deserves to be trusted? There are several factors to examine, but it's not a bad idea to start by collecting referrals from friends, co-workers, or family members. Word-of-mouth is fine, if you trust the person giving you the recommendation and know that he or she has experience and good judgment. Though I warned earlier about believing stock tips from family members and friends, referrals are a different matter. If your sister, to whom you're willing to entrust your children if you die, says, “I trust this organization,” that should carry considerable weight. Even this endorsement deserves scrutiny, however. It is a good idea to trust, but also to verify. I've known several colleagues fall prey to too-good-to-be-true propositions or put their trust in questionable firms or individuals.
The firm's history is an additional consideration. An institution that has been in the business for many years will have a track record and experience serving clients effectively through up and down markets. For example, I've always believed an investment firm's greatest competitive advantage is its demonstrated trustworthiness through good times and bad. And the market agrees—the three largest fund families have roots in the business that go back for 75 years or more. There are plenty of newer firms with talent
