The first question often asked, when discussing money management, is why the stock market? Frequently safety is attributed to long-term financial success, while this may ring true to an extent. I don’t think one should be betting the house on a snapchat stock short in their retirement fund, it’s proven that stock market returns historically outpace all other investment vehicles in terms of growth. Especially in the current climate of low interest rates, the national average interest rate on savings accounts is currently 0.09%, one’s strong appetite for safety and access to immediate liquidity can actually decrease the value of savings due to interest rates underperforming the annual rate of inflation, which is currently 1.9%.
In previous decades, it was quite easy to find savings accounts offering rates around 3%, but by 2009, the national average interest rate had fell to 0.22%. This is due to the Federal Reserve lowering rates and holding them steady from 2008 to 2015. Now with the recent rate hikes in 2018 and in the upcoming year, savings account interest rates, also known as annual percentage yield (APY), should climb in the future but don’t expect them to rapidly rise anytime soon.
To emphasize why one should invest in the stock market I’ve provided an informative chart from Investing for Dummies by Eric Tyson, which visually shows the historical returns of stocks, long-term bonds and short-term bonds in the U.S. since 1802.
Eric Tyson states that “Going back all the way to 1802, the U.S. Stock Market has produced an average annual return of 8.3%. While inflation has grown at 1.4% per year. Thus, after subtracting for inflation, stocks have appreciated about 6.9% faster annually than the rate of inflation. The U.S. stock market returns consistently and substantially beaten the rate of inflation over the years.” As one can see bond returns, average 4% to 5% per year, significantly below the stock markets average of 8.3%.
Now, the one issue that remains true today and for the future, is what stock to choose. If your intent on picking your own stock, I applaud your personal determination, but the stock market is vast and difficult to understand. The best place to start is most likely a mutual fund. Mutual fund’s offer three attributes that particularly make them attractive: built-in diversification, professional management and easy buying and selling. When you purchase a share of a mutual fund, your personal money is pooled with the money from other investors. This allows you to purchase a pool of investments rather individual ones, which makes it vastly easier for the investor to diversify.
Diversification, also happens to be one of the most important aspects of financial safety. Investopedia defines diversification as “a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. For more on the topic and pros of diversification check out the pdf link below by Pamela Drake.
One of the best mutual fund parent company to start with is Vanguard. Founded by the recently deceased John C. Bogle in 1975, Vanguard is one of the largest investment management companies with around $4.5 trillion under management. The main advantage is the company offers of a diverse range of low-cost and no-load funds. This means you can hire a full-time money manager to invest your money, while only charging you a small fee (expense ratio). Hence, I’ve included a screenshot from Vanguard’s website which visually shows their U.S. stock funds and International stock funds past performance.
Among the two asset classes, the lowest 10-year average total return is the International Value Fund (VTRIX) at 9.28%. The highest 10-year average total return is the Small-Cap Index Admiral Shares Fund at 18.14%. Also, every expense ratio is below the 0.5% to 1.0% average expense ratio for actively managed mutual funds. The low expense ratio combined with great returns is why so many investors have chosen Vanguard to manage their money for them.
Now to visually highlight the difference in capital appreciation (starting with $10,000) in the past decade among the lowest performing Vanguard fund shown (VTRIX) and the highest performing Vanguard fund shown (VSMAX), I’ve made another chart. Keep in mind the 10-year annual rate of return for VTRIX is 9.28% and the VSMAX is 18.14%. As a third barometer, I calculated the 10-year average total return for all 8 funds in the image above, which came out to 14.685%. In the chart below, this value is referred to as the Vanguard Average.
The red bars chart the respective total return for the past 10 years on an original $10,000 investment. Also inflation, in the past decade was 19.5268%. This means $10,000 (your original investment) 10 years ago has the same purchasing power as $8,235.14 today. Please note that one cannot directly invest into the Vanguard Average because it is a representation of the average return rate among all eight Vanguard funds. Also, the chart is only applicable in the situation where the investor reinvests all dividends and holds for the full 10 years without selling.
- A $10,000 original investment into the VTRIX fund 10-years ago would yield a nominal rate of return of 142.88% or $24,288.84. When including the inflation rate from the past decade, the real rate of return would be 119.38%.
- A $10,000 original investment into the VSMAX fund 10-years ago would yield a nominal rate of return of 429.62% or $52,962.69. When including the inflation rate from the past decade, the real rate of return would be 359.27%.
- A $10,000 original investment into the Vanguard Average fund 10-years ago would yield a nominal rate of return of 293.61% or $39,361.01. When including the inflation rate from the past decade, the real rate of return would be 245.48%.
Hence, the information above indicates that Vanguard mutual funds and other fund companies such as Schwab and Fidelity offer the beginning investor financial safety through diversification, significant growth and professional management at a low cost. These are great investment vehicles for growth and rapidly outpace both inflation and savings account interest rates. Rather than stressing through piles of information trying to choose the right stock, an investor can both mentally and financially gain from choosing a company like Vanguard to manage their money.
Calculations included for Vanguard the Beginning Investor’s First Friend
*To get the Vanguard Average I first added up all the percentages as decimals (.1481+.1665+.1751+.1802+.1814+.0928+.1004+.1303)= 1.1748 Then since there were 8 funds in the image, I divided (1.1748/8)= .14685 or 14.685%.
*To get each individual (Return after 10 years) I used a compound interest calculator: https://www.investor.gov/additional-resources/free-financial-planning-tools/compound-interest-calculator I then set each intial investment to $10,000 and the period of time to 10 years. Then I plugged in the respective rates for 10-year average total return. Hence, the (nominal return after 10 years) for each symbol is
- VTRIX (Return after 10 years)= $24,288.84
- VSMAX (Return after 10 years)= $52,962.64
- Vanguard Average (Return after 10 years)= $39,361.01
*To calculate an individual stocks Average Annual Total Return use the formula:
[(Ending Value/Beginning Value)^1/n]-1
For example, if you purchased 100 shares of Coca-Cola at $10 a share, your initial investment would be (100x$10)= $1000. 5 years later the share price had risen to $20 a share an you decided to sell. This means your ending value would be (100x$20)= $2000.
[($2000/$1000)^⅕]-1= 2^⅕ -1= 0.1487 or 14.87%
Hence, your Average Annual Total Return for your investment is 14.87%.
*Inflation over the past 10 years is listed as 19.5268%. This means $10,000 (your initial investment) 10 years ago has the same purchasing power as $8,047.32 today.
*To calculate the nominal rate of return use the formula:
([Current Market Value – Original Investment] / Original Investment)x100
For example VTRIX would set up as
([$24,288.84 – $10,000] / $10,000)x100 = 142.8884 or 142.88%
*To calculate the real rate of return use the formula:
([1+nominal rate] / [1+inflation rate]) -1
For example VTRIX would set up as (recall inflation is 19.5268% or .195268)
([1+142.8884] / [1+.195268]) -1 = 119.38 or 119.38%