They’re wondering if they could still safely follow the “4 percent rule.” This rule suggests Chris and Louise could withdraw about $52,000 from their portfolio this year. That’s because 4 percent of $1.3 million is $52,000. In the years that follow, they could increase those withdrawals to match the rising cost of living, and their money should last at least 30 years. 

But with US stocks down this year about 18 percent, to May 20^th, 2022, Chris wonders if his money could last the couple’s lifetime. Would the 4 percent rule work?

Back-tested rolling 30-year periods, beginning in 1926, suggest Chris and Louise’s money should last at least 30 years. For example, from 1929-1932, US stocks dropped about 87 percent. As terrifying as that would have been, someone could have retired in 1929 with a diversified portfolio of 60 percent stocks and 40 percent bonds, withdrawn 4 percent in their first year and made annual adjustments for inflation or deflation over the next 30 years.

After retiring at history’s worst possible time, they would have still had money left after three decades of withdrawals.

However, people are living longer than they did in the past. Many, like Chris and Louise, are also retiring at much younger ages. That means young retirees, especially, are likely to live longer than another 30 years.

And while that might increase the risk, it won’t always change the game. It’s entirely possible that Chris and Louise could withdraw $52,000 this year (4% of their $1.3 million) and then increase withdrawals for another 45 years, taking them to 99 years of age.

For example, assume one of the Rockefeller descendants retired in 1972 with $1 million: 60 percent US stocks and 40 percent intermediate government bonds.  She would have withdrawn $40,000 in her first retirement year. Each year after that, she would have made adjustments to cover inflation. Some of the earliest years of her retirement would have been downright hairy. 

During the 1973-1974 meltdown, US stocks crashed about 46 percent. Adding to the fear, Ms. Rockefeller would have also faced high inflation levels. As a result, she would have withdrawn a lot more every year. In 1973, she would have withdrawn $44,963. In 1976, she would have withdrawn $56,642. By 1979, she would have withdrawn $74,647 and in 1981, she would have needed to withdraw a whopping $91,484. Yes, inflation ran like a pack of thieves.

Let’s assume Ms. Rockefeller was thirty years old when she retired in 1972. She spent the following 51 years volunteering with a community of budding Scientologists. According to portfoliovisualizer.com, if she continued to withdraw an amount that aligned with inflation, her annual withdrawal would have increased from $40,000 in 1972 to $271,341 in 2021. 

You might wonder whether her portfolio could have sustained the market crashes of 1973-1974; run-away inflation in the 1970s and early 1980s; the stock market crashes of 2000-2002; the financial crisis of 2008-2009; and the recent decline in 2022. The answer would be, Yes.

This is mind-boggling stuff, so I’m going to lay it out:

Ms. Rockefeller would have retired with $1 million in 1972.

After 51 years of ever-increasing withdrawals, she would have pulled a combined $7,685,350 from her portfolio.  Yes, that’s $7.68 million.

And by May 2022, her portfolio would have still been worth about $5.1 million.

However, unlike Chris and Louise Phinney, Ms. Rockefeller wouldn’t have needed to brave a stock market crash during the first year of her retirement. If a crash had occurred in 1972 (when she made her first annual withdrawal), she would have a lot less than $5.1 million today.

For example, assume Ms. Rockefeller retired in 1973, not 1972. In 1973, US stocks fell 18.18 percent. The following year, they plunged a further 27.81 percent. By May 2022, she would have still had money left. But instead of $5.1 million, she would have had $1.7 million remaining.

Of course, that’s still a roaring success. But it goes to show how a market decline in a retiree’s first year can have a big, long-term impact.

However, neither a market drop nor inflation is the greatest risk to a retiree’s portfolio. For example, assume someone retired with $100,000 in 1973: 60 percent US stocks, 40 percent bonds. Stocks fell about 46 percent over the next two years. After the first two years of retirement, the portfolio would have slumped from $100,000 to just over $69,000. The cost of living was also ramping up. Between 1973 and 1981, inflation averaged 9.5 percent per year.

Would most retirees have had enough faith to stay the course? In most cases, I would say, No. They would have freaked out, seeing their portfolio fall so hard in just the first two years of retirement. They would have likely tinkered with their allocation. They might have sold everything at a low. Yet, if someone retired on the eve of the 1973 crash, then endured the 1974 crash, plus run-away inflation, the money (if they withdrew an inflation-adjusted 4 percent) would still have had lasted more than 40 years (you can see a year-by-year table in this column).

Life doesn’t offer a guarantee…nor does the 4 percent rule. Future stock returns might be lower than they ever were in the past. Inflation might be higher than it ever was before.  That’s why you should treat the 4 percent rule as more of a guideline than a rule. Retirees could withdraw a little less during market down years. And if, after several years, their portfolio values swell, they could sell a little more.

More important, however, is remembering that our reactions to fear are more damaging than anything the markets or inflation could ever hit us with. 

He worked as a photographer. She was a nurse. And they were homeless. For them, rising home prices were like bouncers who kept shoving them away from home ownership. But they had an out-of-the-box plan to afford a down payment. For the previous two years, they lived in their camper on Victoria’s city streets.  As a nurse, she showered every day at the hospital where she worked. He had a gym membership, so he showered at the gym. Sometimes, they splurged to pay $600 a month to stay in their camper at a trailer park. But most of the time, they stayed on dead-end streets or Wal-Mart parking lots.

Two years after I met them, I was back in Victoria, B.C. From the open patio door of our third-floor condo, I heard my wife chatting to a couple below. They had just bought their first home, a condo across the street from ours. After listening for a few seconds, it dawned on me. These were the people we had met on the Mexican beach. I raced downstairs to learn more of their story. Four and a half years. That was how long two professionals with decent incomes lived in a camper van to afford a down payment for a condo in one of Canada’s most expensive cities.

Rising home prices are a global problem.

Back in 1988, it was relatively easy to buy a home in the US for $85,000. That was, after all, the national median home price. If we index $85,000 to inflation, an $85,000 home in 1988 would be worth about $200,000 in 2022. But try finding a home in the US for $200,000 today. According to Trading Economics, the median single-family home in the United States is worth more than $375,000. And that price looks quaint in most American cities.

Sure, mortgage interest rates are still near historical lows. But that doesn’t make it easier for young people to scrape together money for a down payment on a mortgage. The chart below compares the Case-Shiller Home Price Index with median household income…proving it’s tougher than ever for people to afford a home. Median home prices, compared to median incomes, are even higher than they were in 2007 at the peak of the housing bubble.

Source: Longtermtrends

First-time homebuyers can’t control home prices. The only option is to creatively stretch their money in ways that their parents and grandparents never had to.  Some might draw inspiration from people like the couple I met who lived in a camper for four years. Others might rent a room in a home with other singles or couples to reduce rent. In some cases, two young families could even rent the same house.  Others might choose to buy a Tiny Home.

This might sound crazy. But people are adaptable, resilient and fully capable of sacrificing when they need to. I’m not saying this is easy. It isn’t. But there is a silver lining. People typically feel great when they achieve something tough.  That’s why people run marathons and suffer through cross fit workouts. It’s the feeling we get after pushing ourselves through initial discomfort. And at some point, as with the tough workout, we begin to enjoy the process as much as the reward. 

The broader market indexes look better.  But they’re just the best-looking corpses in the morgue.

January 1 – May 11, 2022

Investors are globally getting soaked. Stocks, bonds and crypto could also fall a lot further. If you’re wondering where to seek refuge for your assets, consider this story of an Indian village.

Every year, the monsoons come. They soak the streets. They flood the crops.  They sometimes damage homes. Now imagine someone saying, “I won’t put up with this!” He leaves his village to seek drier ground. Most of the time, he can’t find it.  But if he finds a cave in the mountains, he might stay dry.

There’s only one problem. He can’t predict when the rains will stop and the sun shines again. Meanwhile, most of his former neighbors don’t even try. They collect rainwater for the future. When the climate turns hot and dry (as it always eventually does) they will have water to drink and water for their crops. And because they didn’t run for mountain caves, they’re close to their fields. When the soil is ready, their newly planted crops flourish.

It’s different for the man in the cave. Several times, he thinks the rains have stopped and he begins the journey back to the village. But the weather mocks this man. Whenever he starts to leave, the rains pore down.

When the monsoon ends, the man dithers. He’s too afraid to be mocked by the weather again. After several sunny weeks, he makes the journey back. But because he was gone from the village, he didn’t collect enough water for the summer ahead. Nor did he have enough time to plant new crops. 

That’s because he ran from the rain instead of embracing it.

Plenty of investors do much the same thing. When stocks fall, they run. They sell or cease to buy. They stuff money into bonds, gold, savings accounts or mattresses. Meanwhile, smart investors embrace these drops. Like villagers collecting rainwater, they keep buying every month. And when stocks recover, their planted seeds grow.

It’s easy to think we can sell before a drop and buy again before a rise. But like the man in the cave, the markets mock us.

When the Indian monsoon begins, most people don’t run. They dance. They celebrate.

Investors who are more than five years from retirement should do much the same thing.  Young investors, especially, should be thrilled to see stocks crash.  The longer stocks stay low, the more seeds they will sow.

For retirees, it’s different. After all, instead of buying stock market assets, they are selling because (in many cases) they don’t have an income, besides Social Security.

But retirees should also fight the temptation to run for those mountain caves. If they stick to an intelligent withdrawal plan, they should be able to retire on the eve of a market crash and not run out of money. Their biggest threat won’t ever be the markets. Instead, it will be the urge to speculate. It will be the urge to protect current portfolio values. Unfortunately, that pull to protect usually reduces future wealth.  

The stock market, even more than the weather, has a knack for eventually hurting those who believe they can see the future.

https://www.popular.com/en/popularone/articles/investments/responses-to-10-common-arguments-against-investing/

Or perhaps you were flying along with the breeze in your hair and the tire exploded under a pile of broken glass. Either way, riding with a flat takes a heck of a lot of effort.

When I was a young bike racer, my fellow competitors and I bought tires that could handle maximum pressure. Bicycles with really low tire pressure, as most people know, are really tough to pedal. Pump them up hard and the bike rolls well. That was why we Tour de France dreamers grunted over our pumps. Before every race, we forced 120 psi (pounds per square inch) into those skinny tires.

At the time, it didn’t make sense to stop at 80 psi. That would slow us down. At least, that’s what we believed. However, tires with higher air pressure burst more easily. Sometimes, they even blew right off the rim. This happened to me more often than I can count. I still remember leading a pack of hungry riders close to the finish line. I then hit a sharp stone, a thorn or a chunk of glass. And when my tire blew, my competitors streamed by. I was the fastest on that day, but that didn’t mean a thing. If I had less pressure in those tires, I likely would have won.

How fast a tire rolls, and how well a bike racer performs can be two separate things. The racer with the highest-pressure tires takes more risk. Sure, their wheels might roll a bit faster. But if they don’t make it to the finish, or they lose precious time changing a flat, they’ll likely lose no matter how tough their thighs.

This is similar to investing. For example, a portfolio allocated 100 percent to stocks is like a high-pressure tire, running 120 psi. Sure, over time it’s supposed to roll further than a balanced portfolio of, say 80 percent stocks and 20 percent bonds, or a traditional 60/40 portfolio. But how the allocation performs and how the investor performs are often two different things.

For example, during a 30 or 40 percent global stock market decline, a portfolio allocated 100 percent to a global stock index will fall 30-40 percent. Not only does the investor suffer a puncture, but such declines could also break their spirit. Such an investor might vow to “dollar-cost average no matter how stocks perform,” but emotions can derail the best-intentioned plan. The investor might hesitate to get back on their bike until markets return “to normal.”

This is common, and it can cost investors money as they sit on the sidelines, waiting for prices to rise again. Or, even worse, they are lured to speculate. They might be tempted to buy gold or Bitcoin in an often-fruitless effort to reduce short-term losses.

Most investors overestimate their tolerance for market volatility. They believe they can ride out anything until a blow brings them down.

In contrast, a portfolio that includes a bond market index is like a rider running tire pressure of 70-80 psi. Such lower-pressure portfolios (and riders) have lower odds of getting flats. For example, if the stock market crashed 30-40 percent, their portfolios wouldn’t fall as far. Psychologically, this can help investors stay on the road.

If you believe I’m a wimp who’s simply making this up, that’s good. Skepticism is important. Morningstar’s research, however, says there could be something to this. First, let’s look below at how three portfolios performed over the 25 years ending December 31, 2021.

How Did The Allocations Stack Up?

25 Years Ending December 31, 2021

Source: portfoliovisualizer.com

The fund rating company, Morningstar, takes great interest in assessing how funds perform, compared to how investors perform in those funds. Like bicycle racers with different tire pressures, they often aren’t the same thing. For example, the ten years ending December 31, 2020 should have been easy on investors’ nerves. Over that decade, US stocks experienced just one calendar year decline: a drop of just 5.26 percent in 2018. 

It’s rare to have a decade with only one calendar year decline. Psychologically, that was one of history’s easiest decades to be invested 100 percent in stocks.

Yet, Morningstar found that investors in 100 percent equity funds and ETFs underperformed the performance of their funds by quite a bit. If we average investors’ underperformance in US stock market equity funds, international equity funds, and sector funds, investors underperformed their funds by an average of 2.17 percent per year over the ten years ending December 31, 2020.

Morningstar also found that over the same 10 years, investors in balanced (multi-asset class) funds underperformed the posted returns of their funds by just 0.69 percent per year. In other words, diversification helped these investors stay the course.

If Morningstar’s research extended over 25 years (from 1996-2021, as per the table above) the behavioral difference between how equity fund investors performed, compared to their funds themselves, would likely have been worse.  After all, this 25-year period included two painful bear markets: 2000-2002 and 2008-2009. In other words, it’s entirely possible that the average investor with a balanced allocation beat the average investor with 100 percent stocks.

Even though an allocation of 100 percent US stocks beat an allocation of 60 percent stocks, 40 percent bonds by 1.64 percent per year (from 1996-2021) if the balanced allocation gave the more conservative investors a behavioral advantage of more than 1.64 percent per year, they would have beaten the average investor with high pressure tires.

Broad diversification, after all, helps calm investors’ nerves. And that’s what’s most important: staying on the road; continuing to pedal; adding regular sums to portfolios through thick and thin. Or, if such an investor were retired, maintaining their nerve and withdrawing something close to an inflation-adjusted 4 percent per year.

Investing is simple. But our emotional makeup means it’s rarely easy. So, consider the risks of investing 100 percent in stocks. History says these portfolios roll well, long term. But the most important question is, “How well do you roll?”

A woman named Amy responded: “What areas of (not) spending have you feeling miserable?”

Jamie replied, “Mainly my hair and food. If I grow out my hair, I’ll save $600 a year. But I love short hair. I spent $200 on food last month…”

Natalie added, “Have you considered cutting your own hair?”

Natalie learned how to do it herself on YouTube. 

Many of the questions and suggestions on this Facebook group are sensible. But several others are bat-poop crazy. I’m not judging someone who spends $200 a month on food or decides to cut her own hair…if that’s what they enjoy. But voluntary, extreme frugality has to be somewhat fun. If it isn’t, such FIRE devotees play tennis with toothpicks.

If we’re fortunate enough to earn more money than we need, we should allocate our income to maximize our lives. That doesn’t mean prioritizing some distant future date. Life can be short. We should live for today with an eye on tomorrow. Living in a miserable state to stockpile money makes little sense.

If we asked Jamie why she wants to live like a pauper, she would likely say, “I want early financial independence.” If we dig further to ask, “Why do you want early financial independence?” she would likely say, “I believe it will make me happy.” It might sound like I’m putting words in her mouth. But as a curious guy, I’m always asking people, “Why?”

Whether someone is raising their children a certain way, giving to charity, running a marathon, or running to the bathroom, when we ask someone why they are making such decisions, and we continue to dig with, “Why?” the answers begin to sound the same. People want to feel safe, secure, comfortable, purposeful, or helpful. These are components of life satisfaction.

Life satisfaction. That’s what Jamie wants.

While doing research for my book, Balance, I identified four quadrants for a happy life:

1. Strong relationships with other people
2. Physical and mental health
3. A sense of purpose
4. Enough money

To my knowledge, no research suggests that early retirees are happier people. We only think they must be. But what we think will make us happy, and what actually makes us happy, are often two different things. Daniel Kahneman, a Nobel Prize winner in Behavioral Economics, says we don’t really know what will make us happy. We might believe a new car, a fancy purse or a ten million dollar investment portfolio will do the trick. That’s why we often buy stuff we don’t need. But based on hedonic adaptability (the fact that we quickly get used to what we own) such things almost never boost our life satisfaction.  We only think they will.

Early retirement could be much the same. Of course, plenty of people who retire early are happier than they were when they were working. But on aggregate, that might not be true. Early retirement can deny us a sense of daily purpose. It can limit our physical activity and our social interactions. And because these elements are linked to longevity, research suggests early retirement could shorten our lives.

To be fair, plenty of people who become financially independent at a young age do continue to work. I am among them. We seek projects that fulfill our passions. We often try to help others. But because life can be short, people shouldn’t suffer to stretch a buck for the promise at the end of a rainbow.

That’s why people like Jamie should embrace life satisfaction research. Sure, they should save for retirement. But they should also enjoy their money now.  That doesn’t mean splashing out on a new car every five years. Behavioral science says that won’t make their lives any better. Instead, we should spend money on experiences, especially if we can share them with people we love.

Also, give to charities.

Happiness researcher Elizabeth Dunn says this works best when it’s pro-social giving. In other words, you’ll get more happiness for your buck if you connect with the people you are helping (see professor Dunn’s TED Talk here). As I referenced in Balance, generosity can also boost your strength, your health, and your longevity. 

It’s fine for people to cut their own hair, let their hair grow long, or spend just $200 a month on food (as long as that food is healthy). But if frugality isn’t fun, don’t waste your time. After all, time is the only non-renewable resource we have. 

Why waste it?

In sharp contrast, Warren Buffett’s Berkshire Hathaway shares are defying gravity. As of April 8^th, they were up 17.38 percent year-to-date. Over the past 12 months, they were up a whopping 33.59 percent. You might be asking, “Why are shares in Berkshire Hathaway rising and shares in Netflix falling? The answer is simpler than you might think. Stock prices are driven by supply and demand. Simply, the dollar value of the sales transactions for Facebook, Netflix, and Amazon shares are higher than the purchase transactions.  That’s why those shares have fallen. In contrast, more money is flowing into Berkshire Hathaway shares.

Berkshire Hathaway was an ailing textile manufacturer when Warren Buffett first bought shares in 1965. He began paying about $7.50 per share. Today, those same shares are worth about $529,000. No longer in the textile business, Berkshire Hathaway is predominantly an insurance company. When Buffett receives insurance premiums he puts a conservative amount aside to pay out future insurance claims and invests the remainder of that money in private companies and publically traded stocks.

That means anyone buying shares of Berkshire Hathaway indirectly ends up owning more than 100 businesses. Buffett doesn’t typically buy businesses that he thinks will one day earn a profit. The private and publicly traded companies he buys earn profits now. He likes companies that efficiently earn large sums of cash with relatively low capital investments.

His investment philosophy is documented best in his annual letters to shareholders. Lawrence Cunningham’s book, The Essays of Warren Buffett, thematically compiles The Oracle’s wisdom in a highly readable form. Authors such as Robert Hagstrom, Timothy Vick, Mary Buffett, and David Clarke have also written solid books describing Buffett’s methods. His philosophy, in fact, is remarkably consistent. He buys great businesses at reasonable prices.

Until recently, most investors ignored that “reasonable price” component. Much as we did in the 1960s and the late 1990s, we’ve been willing to pay sky-high prices for stocks with relatively low business profits. In other words, we’ve been more attracted to future promises than current earnings. But the tide might be turning. Berkshire’s resurgence might mean more investors are, once again, insisting on paying reasonable prices.

My thesis, however, isn’t pegged to Berkshire alone. Stocks are often categorized as growth stocks or value stocks. A growth stock is one with fast-growing corporate earnings. Netflix is an example. But Netflix’s stock price increased far faster than the company’s corporate profits. In contrast, a company with solid corporate earnings but a relatively low stock price is called a value stock. And much like Berkshire Hathaway, value stocks are once again gaining popularity.

For example, despite a drop in the overall stock market, Vanguard’s Value Stock Index (VIVAX) gained about 2.5 percent from January 1 to April 8, 2022. In contrast, Vanguard’s Growth Stock Index (VIGRX) plunged 13.03 percent over the same time period.

It might look strange to see value stocks winning. After all, these are typically boring stocks. But over long time periods, boring stocks usually beat popular growth stocks. Below, you can see the results of value stocks versus growth stocks from January 1972 until March 31, 2022. The blue line represents a three-way split between US large-cap value stocks, US mid-cap value stocks, and US small-cap value stocks. According to portfoliovisualizer.com, over this 51+ year time period, a $10,000 investment in value stocks would have grown to $4,324,830.

If the money were split between US large-cap growth stocks, mid-cap US growth stocks, and small-cap US growth stocks, that same $10,000 would have grown to $1,598,664.

Long Term, Value Stocks Beat Growth Stocks

January 1972 – March 31, 2022

Source: portfoliovisualizer.com

I’m not saying you should pile everything you own into Berkshire Hathaway or a value stock index. But, if like many others, you’ve shunned diversification to invest only in high-flying growth, it might be time to switch things up.

This isn’t a suggestion to time the market or play musical chairs into a new investment style. After all, I advocate sticking to a single plan through thick and thin. That plan includes exposure to the world’s entire market, not just high-flying growth. If you embrace that strategy, long-term, you’ll be happy that you did.

Since then, his portfolio has only done better. The aggregate return of his three largest holdings (Alphabet, Google, and Apple) gained a further 250 percent from January 2018 to March 29^th, 2022. They’re represented by the blue line below and compared to the US stock index, in red.

Source: portfoliovisualizer.com

A compound annual return exceeding 30 percent a year from 2009 to 2022 is spectacular. You might know someone who did something similar. But however tempting it might be to follow a strategy of buying hot, popular stocks, it’s good to remember the investment paradox:

Investment results sometimes have little correlation with the intelligence of the plan.

In 2017, 31-year-old Alex Honnold climbed the 3,200 vertical feet of Yosemite’s El Capitan without ropes. His preparation and achievement was documented in the film, Free Solo. A writer for The New York Times said, “Alex Honnold’s free solo climb of El Capitan should be celebrated as one of the greatest athletic feats ever.” In many circles, Honnold became a hero.

One of the experts interviewed in Free Solo says, “Everybody who has made free soloing a big part of their lives is dead now.” Some of them, arguably, were better climbers than Honnold. In Honnold’s case, his decision to climb El Capitan without ropes was celebrated as brilliant…because he succeeded. But if he fell, people would have called him foolish. 

When we take risks with a concentrated portfolio of stocks, we aren’t going to die if things go south. But the same premise applies. As with people who climb without ropes, most of the people who do it eventually fall back to Earth.

History is filled with people who beat the market until they didn’t. They include legendary investor Bill Miller, whose Legg Mason Value Trust fund beat the S&P 500 for 15 years in a row. They include the hedge fund maestro, Ray Dalio, who trounced the market for years, until the market trounced him. They include Cathie Wood, the outspoken visionary and fund manager of ARK Investments whose market-beating record looks more tenuous every day. Her flagship fund, ARK Innovation, lost a whopping 23.38 percent in 2021. And over the first three months of 2022, it fell a further 27.39 percent.

Trying to beat the market can be hazardous to our wealth, especially if we shun diversification. But more importantly, we shouldn’t judge the soundness of a plan based on the outcome, whether we’re climbing mountains or investing money. This applies to index funds, too.

For example, a few years after I wrote Millionaire Teacher, plenty of readers emailed to say, “Thank you! I’ve made a lot of money with index funds, so your strategy works.” Unfortunately, they judged the intelligence of the strategy based on the result, and not the premise itself. They didn’t understand that whether they made money or not, a diversified portfolio of index funds will beat about 80 percent of professionally managed money invested on an equal-risk adjusted basis. That’s an irrefutable, academic reality, whether the markets rise, flat-line or sink. It’s that premise that makes it a sound strategy, regardless of how it performs over a year or a decade.

Without understanding this, someone could have started investing in the year 2000, added money every month, watched their portfolio lose value for almost three years, and said, “It’s a bad strategy because it didn’t make money.” Without understanding why index funds win, they wouldn’t have realized that, despite not making money, they still thumped most professional investors on an equal risk-adjusted basis.

My friend who made a killing with a handful of technology stocks believes his strategy was smart. He confirms the intelligence of what he did based on the outcome. But he took an outsized risk. Like Hannold, the odds that he would fail were greater than the odds he would succeed.

I’m thrilled that he did well. But going forward, if you want to build a portfolio based on a smart investment strategy, there are two things you should do:

1. 1. Understand the downside of a concentrated portfolio compared to a diversified one.
2. 2. When choosing your allocation of stocks and bonds, understand how different allocations have performed in the past. Look at the “worst-case” historical scenario to see what could go wrong. This can help you make an educated decision.

If your portfolio doesn’t perform well over a designated period, that doesn’t make your strategy bad. Nor does a soaring portfolio or a soaring stock market make your investment strategy good. That’s the investment paradox.

For my part, I prefer a low-cost portfolio of stock and bond market index funds. I won’t beat the market. And when stocks fall, my portfolio will too. But I’ll summit my own El Capitan, beating about 80 percent of the pros in the process.  And best of all, I’ll be climbing with ropes. 

I had assigned my tenth-grade students something our high school English department called, the Outlier Project. Most (if not all) of my students were from wealthy families. They attended a private international school in Singapore where I taught for 12 years. About 70 percent of them were American passport holders. The remaining 30 percent comprised 54 different nationalities. The Outlier Project was a research assignment that answered the question, “How did I get here?” In this case, “here” was an expensive private school and a materially privileged life.

Malcolm Gladwell’s book, Outliers: The Story of Success, inspired that project. Gladwell argues that successful people work hard. But they also experienced at least one lucky break. For example, Bill Gates was given free, unlimited time in his university’s computer lab to play and learn. That was lucky. Someone gave The Beatles unlimited playing time at a club in Germany, where they honed their skills. That was lucky, too.

When my students dug into their families’ pasts, they also found moments where luck or fate played a pivotal role in their family’s success. The girl with the grandfather who gave up his possessions focused her Outlier Project on her other grandfather. But it was the grandfather-turned-monk who fascinated me. Selfishly, I asked her to find out more.

I learned that the family shunned him for what he did. I asked my student, “What memories do you have of him?” She said, “I remember him sitting cross-legged in a loincloth, meditating on a rock. He was kind and he helped everyone. But he was crazy for giving everything away.”

Unlike his family, I don’t think he was completely nuts. Some might say the man was “enlightened.” Eckhart Tolle, author of the runaway bestsellers A New Earth: Awakening Your Life’s Purpose and The Power of Now: A Guide To Spiritual Enlightenment might suggest that he had stripped himself of his ego. His sense of self was no longer tied to his reputation as a businessman. He cast aside his material acquisitions to embrace his true, inner self.

Such ideologies are centuries old. But it might have been Chogyam Trungpa who first popularized such ideas for westerners. In 1973, he described this in his book, Cutting Through Spiritual Materialism. This is hard-core stuff. Trungpa asserted that even when we make efforts to become better people the act of self-improvement is often a way to develop and refine the ego. This, he said, isn’t a good thing because our egos should be empty.

Perhaps that man who gave everything away did successfully empty his ego. But I believe wisdom lies in balance. We can’t strip ourselves of ego. It’s part of our DNA. Contrary to what Trungpa taught, perhaps we should partially collar it for self-improvement. We can harness our egos in an attempt not to judge other people. We can harness it to keep calm, and not react when our egos are bruised. We can harness it to research and understand why someone would vote for a political party that we don’t support. We can harness it to keep FOMO (Fear of Missing Out) in check when the world goes bonkers over speculative investment products.

A free-running ego can be destructive. It can push us to follow other people’s consumption habits. It can seduce us to invest in something if our friends and neighbors look to be making a fortune with it. Our ego causes us to sell sensible investments at a low because we fear short-term losses. Our ego tempts us to try to beat the market through hot stocks or high-flying actively managed funds. Our egos cheerlead us to try to time the market.

But if we want the best odds of long-term investment success, we need to control our ego. We shouldn’t expect a lucky break that might not come. Instead, we should build a diversified portfolio of low-cost index funds. By doing so, we would have exposure to thousands of stocks from around the world. We should ignore market news and market forecasts. We should maintain a consistent allocation and invest as soon as we have the money. This is tough, requiring almost Zen-like power. It requires putting our ego on a really strong leash.

Few people could fully let their egos go. Our egos, after all, are part of who we are.  But if we can embrace humility, accept people of different beliefs, forgive ourselves for our mistakes, keep calm when our buttons are pushed, follow a consistent investment plan and ignore the seemingly easy-made fortunes of those around us, we can use our resources to help ourselves and assist those who need our help. Fortunately, we could do this without living like ascetics. But if you happen to know someone who embraced asceticism, gave everything away, and chose a life committed to service, respect that decision as something cool and rare.

The Pulitzer Prize-winning journalist, Anne Applebaum’s assessment of Europe in her 2021 book, Twilight of Democracy, The Seductive Lure of Authoritarianism, claims totalitarian figures are gaining ground in global politics…including Europe. That, combined with what this might mean for your investments, is more than enough to make plenty of people sweat.

This could have you wondering, “What should I do right now?” 

You can’t control how stocks will perform or whether Putin (or anyone else) will spray more fuel on a global fire. So, control what you can control and accept what you can’t. This might sound like I’m suggesting a head-in-the-sand solution. But let me explain why I’m not.

First, don’t shift your money around to protect against forecasted losses. Most forecasts are wrong. Plenty of people forecasted stocks would fall in 1980 when the USSR invaded Afghanistan. During the first three months that year, US stocks fell 6 percent. Anyone taking a cue from the war and falling markets to alter their portfolio allocation to limit their losses would have been disappointed. By the end of the year, the S&P 500 had a calendar year gain of 32.5 percent.

That doesn’t mean stocks will earn positive returns in 2022. They might. They might not. But if you guess they’ll drop further, act on that guess, and end up being right, you’ll be tempted to guess again. And if you do, you’ll almost certainly be wrong. Speculation is typically the enemy of a sound investment policy. So, stick to your goal allocation and don’t fool around.

Worrying about an escalated war is as fruitless and unhealthy as fretting about your money. However, there is something you can do. First, draw strength from realizing that the world isn’t getting worse. Sure, we’re in a bad patch now, but progress isn’t linear. And overall, when measuring progress with a longer stick, the world is getting safer…and better.

That’s why we shouldn’t believe we can’t make a difference. Decade by decade, we are making progress, and that should give us strength to know that our efforts aren’t in vain. As for the crisis in Europe, several of my friends have “rented” AirBnBs in Ukraine. Of course, they aren’t flying there, but they have connected with the owners and received some heartfelt messages about how the owners are using the money to help other people.

It’s easy to be cynical, but from my experience, most people in the world are good, and willing to help when they can. My friends aren’t saints, but one of them raised money to buy a bulletproof vest for a humanitarian aid worker they personally know. Another friend of mine (a Ukrainian living in the US) helped raise money to buy a needed ambulance. NPR listed several more conventional ways that you could help, here.

So, when it comes to your portfolio, stay the course and maintain your asset allocation. If you have the money, continue to add it. Ignore all forecasts. Statistically speaking, accepting what you can’t control will likely be better for your long-term wealth.

As for trying to help others, that’s the only thing you should do. It could change or save someone’s life, making it the best thing we do all year.

I began investing in 1989 when I was nineteen. Three years later, Joe Dominguez and Vicki Robin published Your Money or Your Life. It was one of the most popular personal finance books of the era. It prioritized embracing a minimalist lifestyle: a focus on time and life, instead of material things. It also recommended people put 100 percent of their investments in bonds. 

That wasn’t good advice. But we can see why the authors believed it. When that book was published in 1992, bond interest yields were high. According to portfoliovisualizer.com, a $10,000 investment in long-term US Treasury bonds in 1981 would have grown to $47,242 eleven years later. A $10,000 investment in a US stock market index would have earned less money, with more volatility.

Long-term US Treasury Bonds vs. U.S. Stocks

1981-1992

Source: portfoliovisualizer.com

But few people recommend 100 percent bonds today. After all, they pay barrel-scraping interest. And anyone caught with a 10-year bond will almost certainly lose to inflation. In January 2022 U.S. inflation (measurement in the rise of living costs) was 7.2 percent higher than it was, compared to January 2021. As interest rates rise, bond prices drop. That one-two punch is why one of my readers asked me whether she should diversify with stock index funds and cash in a savings account, instead of stocks and a bond market index. Several other readers asked me if they should switch from a diversified portfolio of stocks and bond market indexes to 100 percent stocks.

Here are four reasons I said no on both accounts.

1.  Savings accounts always lose to inflation
2.  The behavioral benefits of bond index funds are real
3.  A bond index’s internal turnover has added benefits
4.  Bond price drops (much like stock price drops) can benefit investors maintaining a consistent allocation.

Savings Accounts Always Lose To Inflation

Savings accounts lose every month to inflation, and CDs are designed to match inflation. But neither will ever earn a real (after inflation) return, as I explain here.

The Behavioral Benefits of Bond Index Funds Are Real

Most people don’t know how they would respond if they were hit by a car and forced into a wheelchair. Research suggests we’re poor predictors of how we will feel when adversity hits. Many of us, for example, believe we could handle a portfolio invested 100 percent in stocks. But when faced with the volatility of such a portfolio, many of us sabotage our rides. We begin to speculate. We might hold back on deposits after stocks fall. We might sell low. We might stop investing, waiting for “a better time.” But diversified portfolios that include stock and bond market index funds can help. Such portfolios don’t fall as hard when stocks crash. That often helps investors stay the course. It’s important to remember that how a portfolio allocation performs isn’t as important as how a person performs with a specific allocation.

A Bond Index’s Internal Turnover Has Added Benefits

Bond market indexes often comprise thousands of bonds with different maturity dates. For example, Vanguard’s Total Bond Market fund includes more than 10,000 bonds. When a one-year bond within that index matures, the fund company uses the proceeds to purchase another one-year bond.  When a three-year bond expires, it purchases another three-year bond. One of the reasons bond interest rates were high when Joe Dominguez and Vicki Robin published Your Money or Your Life is because inflation was high. Few people, for example, would buy a 5-year bond yielding 1 percent per year if inflation were 7 percent. As inflation rises, bond prices drop, pushing interest yields up. To compete, when new bonds are issued, their interest rates reflect that new competitive rate.

This doesn’t mean your bond market index will make money every year. It can drop in value, perhaps for a couple of years in a row as bond prices dip. But bond index funds don’t fall as far as stocks when markets crash. Sometimes, they even rise when stocks fall.

Bond Price Drops Can Benefit Investors That Maintain A Consistent Allocation

It’s well known (although behaviorally tough to embrace) that when stock indexes drop, we’re able to buy more units with the same amount of money. It’s like a supermarket sale. But we often don’t consider the same reality with a bond market index. Yet we should, because short-term or broad bond market indexes aren’t the same as an individual bond. They have an internal turnover that replaces maturing bonds with new bonds. And when inflation rises, the drop in bond prices pushes their interest yields up.

The process of maintaining a consistent allocation between stock and bond market index funds requires investors to  rebalance their portfolios (you could do this once a year) by selling portions of their winning index to put those proceeds into their losing index. In some cases, the “winning index” might simply be the one that loses less. If the account is relatively small, investors could “rebalance” just by adding fresh money every month to the underperforming index.

It’s important, however, never to speculate. Don’t abandon a diversified portfolio of stock and bond market indexes because of forecasts, current interest yields, or a price drop. Don’t abandon bonds for cash. You don’t know what bond prices or yields will be next year or five years from now. Nobody does. And with bond market indexes, you won’t be stuck with current prices or current yields.

Unfortunately, every week of every year, a headline, forecast, or what’s “currently happening in the markets” will try to move you off course.  In this long-term game, patience and consistency will be your best friend. Acting on speculation will almost always hurt you most.

This isn’t news to most investors. But most people don’t know why indexes win.  They just know the following:

1. Index funds beat most actively managed funds when stocks fall.

2. Index funds beat most actively managed funds when stocks rise.

3. Actively managed mutual funds that are fortunate enough to beat index funds over one measured time period typically “revert to the mean.” This means they soon underperform.

You might believe index funds beat most actively managed funds because index funds incur lower costs. That’s true, but it doesn’t answer the question, “Why do these lower costs increase the odds that indexes win?”

If this “law” had a name, it might be the “Sharpe Law,” named after the Nobel Prize-winning economist, William F. Sharpe. In his research paper, The Arithmetic of Active Management, he asserted that the stock market’s return in any given year is equal to the return of all professionally managed money invested in that given market. For example, if the US stock market gained 5 percent this year, the aggregate return of all professionally managed money in US stocks would be 5 percent, before fees. As a group, they would earn the market’s return on their stocks because they represent the money that’s invested in the market.

In other words, if we identified the “owner” of every share in the market, these owners would represent the investors in all actively managed funds, day-traders, individual stock owners, institutional traders, pension funds, hedge funds, and…index fund investors. If the market gained 5 percent, the pre-fee return of indexes and the sum of active management in that market would be 5 percent. That’s as irrefutable as a law of physics.

After trading fees and expense ratio costs, actively managed funds must fall behind because they charge higher fees than index funds.

However, there’s a nuance worth pointing out. Most active fund managers keep a component of cash in their accounts. So, while the aggregate return of all active management would earn the market’s return on their funds’ stock market component, their funds might post a slightly higher return than the stocks they own when stocks fall. For example, assume all actively managed mutual funds had 20 percent of their fund’s value in cash in 2008. When stocks fell 37 percent, their aggregate return on US stocks would have been minus 37 percent, before fees. But if they had 20 percent in cash, that portion of their fund wouldn’t have lost value.

This might sound like an argument for active management during down markets.  And it would be if it weren’t for three things:

1.  Nobody knows when stocks will fall, so fund managers don’t know when to stockpile cash. Those who guess right once typically guess wrong the next time.
2.  Because such consistent predictions are almost impossible, the vast majority of actively managed funds still underperform their benchmark indexes when stocks drop. For example, according to SPIVA, 64.23 percent of US actively managed stock market funds lost to the US index when stocks crashed in 2008.
3. When active funds keep money in cash, their funds don’t rise as strongly when stocks rise…because their cash slows them down.

Over full market cycles, an ever-increasing percentage of actively managed funds lose to their benchmark indexes. For example, over the past 20 years, we had several market cycles. Stocks fell in 2001 and 2002.  Stocks gained ground from 2003to 2007. They fell hard in 2008 and rose strongly almost every year from 2009to 2020. As shown in the table below, over the 20 years ending December 31, 2020, (see the far right column) the vast majority of actively managed funds underperformed their benchmark indexes. For example, 94 percent of actively managed large-cap funds underperformed the S&P 500.

This will always be the case, much like a physical law of gravity or friction. That’s because the aggregate return of all professionally managed money in the stock market will always be the same return as the stock market itself…before fees.  After fees, active management must lose to the market.

That’s the law.

The first modern mutual fund was launched in the United States in 1924. It provided a way for regular people to invest in the stock market while taking less risk. Before that time, anyone investing in stocks had to buy individual shares from the New York Stock Exchange. This could be risky, and my mother-in-law reminds me of this all the time. “Uncle Harry invested in stocks and he lost everything in 1929.” 

Unfortunately for Uncle Harry, he probably didn’t know that he could buy a mutual fund: a collection of several stocks handpicked by a professional fund manager. Instead, Harry likely bought a handful of stocks that he (or his broker) believed would soar. But during the crash of 1929-1932, Harry lost his shirt. I don’t know the details, but the companies he invested in probably went bankrupt.

Mutual funds don’t protect investors from falling markets. But the fund manager at the helm must ensure a minimum level of diversification. In other words, he or she can’t stockpile everything into just four of five stocks. That’s why, if you buy a mutual fund, you indirectly own shares in dozens or even hundreds of stocks. That would have given Uncle Harry decent odds of recovering his initial investment, and then earning a profit…if he were patient.

The fund manager also trades shares within the fund, trying to buy what’s hot while avoiding or selling what’s not. In other words, owning an actively managed mutual fund is a way to have a professional money manager picking stocks for you.

Such mutual funds are categorized into different asset classes and sectors. For example, assume a bank or investment firm launches a new fund. They might tell Tony, the handsome chap who’s hired to run the fund, “Tony, your job is to only buy stocks of large American companies. We’re going to call it, the Super U.S. Large-Cap fund.” 

Assume the mutual fund company also hired a woman named Tina. The firm tells her, “Tina, you’re only going to buy stocks from emerging market countries, like India, Brazil, Russia, China, Thailand etc. We’ll call this the Spectacular Emerging Market fund.

These are just two common fund categories, among plenty. Others include funds that focus on developed market international shares, small company international shares and small company US shares. Plenty of funds are also categorized by whether the fund manager’s mission is to buy growth stocks or value stocks. Growth stocks are companies that are expected to grow fast corporate profits. Value stocks are those that are currently priced at low levels, relative to the corporate earnings of the companies themselves.

Other mutual funds focus on bonds, or a mix of stocks and bonds. If they are actively managed, a trader (like Tony or Tina) trades such stocks or bonds, hoping to make money on behalf of the investor.

Indexed mutual funds, however, are different. As mentioned in this article, they don’t have fund managers that actively trade in and out of stocks and/or bonds in an attempt to squeeze out higher profits. And because indexed mutual funds don’t require an active manager, they cost less. On average, they also perform much better than actively managed mutual funds.

To provide the highest statistical odds of investment success, it’s better to invest in indexed mutual funds, compared to actively managed mutual funds.

“An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500).”

If that looks Greek, you aren’t alone.

The stock market comprises thousands of individual stocks. They include businesses like Coca Cola, Apple, Netflix, General Electric, Wells Fargo and a whole sea of others. If we want to invest, we can choose to buy a handful of individual stocks through a brokerage account. But that can be risky. After all, if we choose to buy shares in a business that goes bust, we could lose money that we never see again.

If we buy an index fund, however, that allows us to diversify. It allows us to buy hundreds (sometimes thousands) of stocks with a single purchase. For example, when people want to measure how the stock market is performing, they often look to the S&P 500. The S&P 500 is known as an index. It represents 500 large US company stocks from a variety of different sectors. It includes retail sector companies like Wal-Mart; drug companies like Pfizer; restaurant companies like McDonald’s; technology companies like Apple and 496 other businesses from a variety of different sectors.

When we buy a S&P 500 index fund, we become a part-owner in 500 different stocks. Some of these stocks will perform well. Others won’t. Sometimes, almost all of them rise together. Other times, such as during a market crash, they almost all drop. But over time, if you’re patient, a S&P 500 index fund can reap strong rewards. For example, anyone who invested $10,000 in Vanguard’s S&P 500 index when it was first launched in 1976 would have seen it grow to about $1.4 million by February 10, 2022.

When someone talks about, “Beating the market,” they typically refer to beating the return of the S&P 500. But over an investment lifetime, this is an extremely difficult thing to do.

You’ve likely heard of some other indexes, too. The Dow Jones Industrials is an index. It represents 30 of America’s largest stocks.  You could buy an index fund (or a product called an ETF) that includes just these thirty stocks. However, all of the stocks that are part of the Dow are also part of the S&P 500.

The most diversified US stock market index is the Wilshire 5000. Despite its name, it includes about 3,700 American stocks (and not 5000). Every Dow Jones Industrials stock and every S&P 500 stock are also inside this index. You could own a sliver of all these stocks if you bought, for example, Vanguard’s Total Stock Market Index, or Fidelity’s Total Market Index Fund.

But before you ask, “Which index is best?” you should know that over long periods of time (20 years +) the S&P 500, the Dow Jones Industrials and the Wilshire 5000 earn similar returns. If you must choose one of them, select the one that offers the greatest diversification.

Diversification allows us to put our eggs in multiple baskets. So why stop with US stocks? After all, there were four ten-year periods when US stocks didn’t make money: 1929-1939; 1930-1940; 1999-2009 and 2000-2010. If we diversify our money to include international stock market indexes and bond market indexes, we increase our odds of making money over any ten-year period..

One of the easiest ways to invest in a total US stock index, total international developed world stock index and a total emerging market stock index (as well as a bond market index for added stability) is with a single fund that includes all of these indexes.

Such a fund allows you to attain global market exposure at the lowest possible cost. In this article, I offer several examples. If you buy one, you will beat the performance of almost everyone you know. You won’t beat them every year. But over a lifetime, that’s a near-certainty.