The Very Cheapest Stocks (Price/Book) Do Very Badly

Book to price is a bad value factor. It is a decent stock selection factor overall, but relative to the other ways of measuring value (earnings to price, cash flow to price, EBITDA/EV, etc) it is sub par. 

I've been interested lately in very concentrated value portfolios, and found it interesting that when running very small portfolios (as little as 1 stock selected per month, with an annual holding period) based on book/price, you wouldn't have done very well (and would have lost money in the one stock versions!)

Here are the absolute and excess returns for concentrated book/price portfolios since 1963. It is not until you get to 25 stocks that the return of the concentrated portfolio edges out the market's average rate of return (11.45% in this period). I also ran concentrated portfolios of the most expensive stocks by book/price and was very interested to find that for the 5 and 10 stock versions, the expensive portfolios outperformed the cheap ones (barely, but still)! Once you get to larger baskets of stocks, then things normalize and cheap beats expensive. 

Let's consider the 5-stock version as an example (which underperforms the equal-weighted market by nearly 5% per year). Below are the rolling 3-year excess returns for that portfolio: consistently bad with occasional periods of brilliance. 

 

These stocks tend to be very different from other value stocks. The 5 cheapest stocks at the end of 2014, for example, failed to crack even the cheapest 1/3 of all stocks as measured by a composite value score (e/p, fcf/ev, ebitda/ev, s/p, shareholder yield). Four of the five have negative earnings, so look very expensive by other measures. 

Unlike with other value factors, these results suggest that you do NOT want to own a very small basket of stocks that are only cheap based on this mediocre measure of value. Stick to other value factors instead. 

More on Profit Margins

Jesse Livermore has a characteristically great and thorough look at U.S. profit margins up on his website, which I highly recommend. 

I've written about margins a few times in the past and find them fascinating. Jesse's key point is how important financial and technology stocks are to current U.S. profit margins, so I thought I'd add some fuel to the fire. Below are the top 24 stocks by contribution to overall margin in the U.S.

This means that Apple, for example, is responsible for 3.45% of the markets overall net profit margin (the math is (Apple's margin (21.6%) * Apple's share of the overall markets sales (1.27%) / the markets overall margin (7.98%)) = 3.45%). These 24 companies alone determine about 1/3 of the U.S. markets total profit margin. 12 of these 24 are financial or tech stocks--a notably disproportionate total given that these are just 2 of the 10 GICS sectors.

These 12 financial/tech stocks make up 19.5% of the markets margin. 

The future of U.S. margins, then, rest squarely on their shoulders. Their average margin is 19.8%. That is damn high! Who knows if these are sustainable, but these are the companies that matter most. I'd love to hear what you think about their sustainability. 

Buffett wisdom that you may not have heard before

I work hard to not quote or invoke Warren Buffett too often. His wisdom is ubiquitous and he doesn’t need another preacher. But I came across some unique insights from Mr. Buffett through a third party that I feel compelled to share.

These notes came from Jason Ke Wang (@Wangkejason), a graduate student earning his MBA at Stanford. I met Jason at our offices as he was in the middle of an incredible tour visiting many of the biggest names in investing: Bogle, Lou Simpson, Joel Greenblatt, and of course Buffett. He was generous enough to share his notes with me and allow me to share them here.

Buffett answered 16 questions across two and a half hours, and I was struck by several pearls that I hadn’t heard before (although I am sure he has mentioned elsewhere). Lots of what he said was similar to other statements he has made in public appearances and letters, but these ideas (or at least the wording of them) stuck out. Emphasis is always mine.

 On sourcing investment ideas:

“Found Berkshire in Moody’s Manual for Industries. You may think that today competition has increased and information is easily available but I used the same approach to find Korean stocks a few years back. Read the Korean stock manual one Sunday afternoon and found 15-20 stocks that way”

I love that old methods can still work. People are still lazy.

One of my favorites was this thought on the importance of speaking, writing, and communicating well.

At your age the best way you can improve yourself is to learn to communicate better. Your results in life will be magnified if you can communicate them better. The only diploma I hang in my office is the communications diploma I got from Dale Carnegie in 1952… “Without good communication skills you won’t be able to convince people to follow you even though you see over the mountain and they don’t”

On crisis management:

- If you have a city of 330,000 people (the number of people Berkshire employs) there are bound to be some people who are doing wrong. Try very hard to set the tone at the top. Send a two page letter to all employees every two years:

“We have all the money we need. We also have the best reputation one could possibly have. If you lose money, that’s something which is easy to earn back. But if you lose reputation, it is extremely difficult to earn that back. Act in a way such that if your actions were published in the local newspaper you would not be ashamed of your neighbors and friends reading that story. Play in the center of the field. I am old and cannot see the boundaries at the edge, don’t venture there”

- If a problem does occur there are four things you need to do

1. Get it right – get the facts right

2. Get it fast – move to action swiftly

3. Get it out – get it completely out of the system

4. Get on – move on

- Never let a problem sit unattended to

Misc others.

Long Term Capital (LTCM) – “they were right about everything except human emotion”

- Only way to stop a panic in today’s times is to have someone say with absolute authority, “I will do whatever it takes to make this right.”

- “The next panic will most likely come from a cyber/nuclear/biological or chemical attack on the US. The ability of psychotics, religious fanatics etc. to impact people has tremendously increased since 1945 (atomic bombing of Hiroshima and Nagasaki)”

- “The US will always bounce back. Our system really works, if you have cash during a time of panic, BUY”

- The auto industry has been the one of the most important industries during Buffett’s investing career. He has extensive knowledge of auto. Despite that he doesn’t feel comfortable buying auto stocks. Instead he chose to buy an auto dealer with 78,000 dealerships across the US. Simply because five years from now, he doesn’t know which model will sell but he does know that the auto dealer will sell it. This is the same story in tech, Buffett does not know who the leader will be.

“Every year I go the Microsoft Summit and face people with 180 IQs and tell them that if you asked me to choose between giving up a $10mn airplane and a $100 computer, I would choose the airplane. Why then, do you still charge me only $100 for the computer. You 180 IQs are not that smart.”

“It is very important to associate with people who are better than you, you will move in that direction. It’s just smart to do that. Not just people who are better in terms of IQ but also people who are better in terms of character”

As always, some great advice from Buffett. Thanks again to Jason for sharing. 

Technology Cash Machines

You'd be uncomfortable if you didn't have enough cash to pay your bills, right? Well its the same story for companies--its good to have cash to cover your short term liabilities. I was curious how balance sheets looked today by a measure called the cash ratio, which is a convenient measure of short-term liquidity. The results revealed an amazing trend in one corner of the market... 

The cash ratio is calculated as cash (and short term equivalents) divided by all current liabilities, where current liabilities are short term debt, accounts payable, income taxes payable, and misc other items. 

So how do stocks look? Do they have their liabilities well covered? Here is what the market's cash ratio looks like over the past few decades (higher is better)

Pretty damn good looking trend, eh? Well, the market has changed a lot. The majority of this trend is coming from one sector: cash rich technology stocks. Here is the same ratio broken out by sector:

These technology companies are like Scrooge McDuck, swimming in dough. All U.S. listed technology stocks are sitting on more than $800 Billion in cash and short term equivalents...almost double the next closest sector.  Oh, and these numbers don't include long-term investments (Apple alone has $130B categorized as long term investments, which many consider part of their cash hoard). 

as of 11/30, all U.S. listed stocks, Cash + Short Term Equivalents

Any thoughts on this trend? I am amazed by the ability of these technology firms to generate cash without significant liabilities. No wonder Silicon Valley is booming. 

5 Predictions for 2015

1.       Everyone will continue to make predictions despite overwhelming evidence that predictions are useless.

My father has been an incredible mentor, but you’d be surprised how few investing lessons he’s ever taught me. There were never lessons about ratios or sectors or discounted cash flows. Instead when I was growing up there was just one simple requirement: if you want something, produce a compelling argument and we will give you what you want. The emphasis was almost exclusively on how to think and how to build an argument with good evidence. I was rarely taught what to think.

But there is one thing he taught me which still sticks with me (mostly because I had no idea what the hell he was talking about, I was 12 years old). He said, “People are deterministic thinkers in a probabilistic world.”

Over the years I figured out that he meant was that we are pattern junkies obsessed with identifying patterns and extrapolating them into the future, and we fail because the future isn’t pre-ordained and deterministic. His lesson was: you should never bet on specific outcomes, but rather bet on high probability outcomes. This is very good investing advice.

But sadly humans don’t think like that. We see two of something and automatically predict a third. My favorite example of our pattern addiction is a study referenced by Jason Zweig in his book Your Money & Your Brain, which pitted humans against pigeons. Both humans and pigeons were show two lights, one red and one green, which were flashed 20 times per round. The lights were rigged such that the green one flashed 16 of the 20 times (80%), but other than this rule the sequence was entirely random. Rewards were given to people and pigeons when they guessed the next light correctly. The pigeons quickly figured out that the best strategy was to just guess green all the time, and their average score was about 80% correct. But us stupid humans, obsessed with prediction and patterns, constantly tried to outsmart the odds by guessing red occasionally—the end result being a score of just 68%. Stupid humans.

The best way to look at the future is as Howard Marks suggested in his last memo, “the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.”

Bottom line: I predict that our predictions will suck.

2.       Some book will be a massive bestseller, and no one will read it. We should create an award for this perennial snoozer and call it “the Piketty.” Mark Twain had it right: a ‘classic’ is a book which people praise and don’t read.

3.       Some asset class, currently despised, will explode upward. Energy stocks, perhaps[i]?

4.       I will announce a huge and very fun new project at some point during 2015—one that will require your help. I know this one is coming true ;)

5.       I hate predictions so much I can’t even come up with 5.

Happy Holidays!

 

[i] THIS IS NOT A PREDCTION 

Value + Momentum: The Tortoise and the Hare

Buy cheap stocks, or follow the trend? Two conflicting (and often exact opposite) strategies that have both worked well through market history. Momentum, when it’s working well, can be unstoppable for years. When it’s not working, it can lead to horrendous results relative to the market. Value has been steadier, but it too undergoes periods of significant underperformance. So what about combining these two ideas by looking for cheap stocks that the market is just beginning to notice? Think of the combination as the best aspects of the tortoise and the hare.

First, consider the results for a pure value and a pure momentum strategy[i]. Here are the rolling 3-year excess returns of these two strategies (best decile) versus all stocks since the 1960’s.

Notice that momentum is much choppier, but it has three separate 3-year periods when it outperforms by more than 20% per year for three years! Value only reaches that level once.

So what if you combined these ideas? I ran a series of tests combining value and momentum into a single factor, giving weights from 0-100 for both value and momentum factors—so, for example, a 50/50 combination gives equal weight to a stock’s momentum rank in the universe and its value rank in the universe. The long-term and rolling results for the best decile portfolios are listed below.

Best decile portfolios, 1/1965-9/2014

The best combination, measured by risk vs. volatility, was 70% value, 30% momentum. This strategy focuses on cheap stocks, but avoids those that are still in relative free fall versus the market. Check out the best and worst case 3-year returns for pure momentum. At one point (late 90’s) it outperformed by more than 34% per year for three years (that is more than 140% cumulative outperformance). Of course momentum was terrible during the market recovery following the 2009 bottom, underperforming by more than 13% per year for three years, causing many to abandon the momentum strategy.

In the rolling returns above, you can see that combinations of the two factors are much steadier performers. Value was crushed in the late 90's, for example, but including some momentum in the mix would have mitigated the damage. 

With factor investing all the rage, it’s good to know that both of these strategies work, and that they work at different times. But the most powerful combination is a strategy that measures both value and momentum at the stock level. Both value and momentum have had 3-year periods where they underperformed the market by more than 10% annualized. But the worst case for a 50/50 combination of value and momentum? Just 5.5% annualized underperformance over three years.

Bottom line, the tortoise and the hare both have their merits: cheap valuations rule AND the trend is your friend. Look for stocks that have both.

P.S. while these two factors are powerful, other factors matter too. Value and Momentum are two of the five factors that I explore in Chapter 6 of Millennial Moneyso check out the holiday offers for the book over here.

[i] Momentum is defined as trailing 6-month total return, value is defined as a combination of price-to-sales, price-to-earnings, EBITDA/EV, and Free Cash Flow/EV.  The best decile portfolios are rebalanced on a rolling annual basis. 

Value and Glamour Investing, Re-Envisioned

Did you know that the best performing glamour stocks outperform the best performing value stocks? Sounds exciting, right? Well it may be, but expensive stocks still stink. In this piece I visualize the performance of value and glamour stocks (inspired by and originally designed by the director of research at OSAM, Chris Meredith) in a new way to make the point once more that value trumps everything. 


Why in the world do people buy expensive stocks? Every shred of academic evidence shows that they underperform over the long term, and yet we keep buying.

We do this because we are so focused on the spectacular possible outcomes when we should instead be focused on the more sobering probable outcomes. I’ve referred to expensive stocks as lottery tickets in the past, because while investing in a group of expensive stocks (or lottery tickets) is usually a bad idea, sometimes you’ll get a winning ticket.

In the case of glamour stocks, these winning tickets have yielded incredible returns. Last October, Tesla and Cheniere Energy were the two most expensive large stocks trading in the U.S. Tesla was priced at 15 times its sales, Cheniere at 35 times sales. And yet over the next year, Tesla was up +51% and Cheniere +88%. People see results like this and think “valuations be damned.”

I define glamour stocks as the most expensive 10% of the market (rebalanced annually) by measures like p/sales and p/earnings. Glamour stocks as a group do poorly, but digging a little deeper we see that some are huge winners. Within the glamour stock universe, I sort stocks based on their forward 12 month return into ten equal groups.  The average results are illuminating:

You notice that the best performing glamour stocks beat all stocks by an average of 115% over the coming year. Talk about winning the lottery. But here is the problem: the median glamour stocks lost to the market by -11%, on average and the worst glamour stocks lost by 75%. Over and over again, we are seduced by the possibility of earning huge excess returns and blinded to the probability that we will underperform the market. Probabilities are boring, possibilities are exciting. But probabilities are all that matter in an uncertain world.

The first lesson, as always: some expensive stocks kill it, but the category stinks.

There is a flip-side which is much more enticing. Howard Mark’s (and many others successful investors) always highlight the importance of asymmetry in the investing process. The best way to succeed is to follow a strategy which is skewed in your favor on the upside.

In a recent memo, Marks said, “The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls.  But that doesn’t mean the avoidance of all losses is a reasonable objective.  Take another look at the goal of asymmetry set out above: it talks about achieving a preponderance of gain over loss, not avoiding all chance of loss.” (his emphasis)

With that in mind, check out the same results for the value portfolio:

This shows that value investing offers the right kind of asymmetry that investor should seek: on average there is more to gain than to lose, because while some value stocks get killed, the average ones significantly outperform the market on an annual basis.

Glamour/lottery stocks, by contrast, have the wrong kind of asymmetry: some do exceptionally well, but the average ones significantly underperform the market.

It is fascinating that if you could see the future, you’d do the best if you bought the best of the glamour stocks: the best performing glamour stocks outperform the best performing cheap stocks. But you can’t predict the future, so don’t try. Forget the splendiferous possibilities of glamour stocks and focus your portfolio in value stocks that offer the highest probability of success. 

Favorite Interviews

Interviews are my favorite. Lighter than presentations and easier than long pieces of text, interviews can provide fun and digestible insight into a topic--just look at the rise of the podcast!

Here are my favorite interviews so far:

Talking all things investing (whether you are a millennial or not) with the great Morgan Housel of the Motley Fool and Wall Street Journal

Talking millennials and money on Squawk Box

A wide ranging discussion with Carol Massar on Bloomberg Radio

Have a great weekend!

 

How Much Capital is Needed To Produce Sales?

How much capital is required to produce sales? I think this is an interesting question across U.S. economic sectors. Some sectors require boatloads of capital, others very little. Below are two looks at capital intensity (using capex-to-sales and assets-to-sales). For both, higher numbers indicate more capital intensive businesses. 

Utilities and Telecoms are traditionally the most capital intensive sectors, requiring tons of assets and capex to produce sales. Conversely, Consumer stocks have traditionally required far fewer assets to produce sales. Of note is the major rise in Capex/Sales for the energy sector, as more expensive means of extracting fossil fuels (tar sands, shale, etc) have become more important. 

 In a future post I'll analyze whether or not these have been useful factors for stock selection, both within and across sectors. 

How do you think capital intensity should factor into the investing process? I'd love to hear your thoughts below on the utility of these factors. 

How Concentrated Should You Make Your Value Portfolio?

To take advantage of value investing, you need a smaller portfolio than you may think. I was curious to see what different levels of portfolio concentration would have produced in a value-only portfolio over the past 50 years, and report the results here.  

I set up portfolios which bought the absolute cheapest stocks trading in the U.S. (including ADRs). Portfolios ranged from 1 stock to 100 stocks, and stocks needed to have a minimum market cap of $200MM (inflation adjusted). Cheapness is defined as an equal weighted combination of a stock’s price/earnings, price/sales, EBITDA/EV, Free Cash Flow/EV and total (shareholder) yield. Each portfolio was rebalanced on a rolling annual basis (meaning 1/12 of the portfolio is rebalanced every month.  Think of it like maintaining 12 separate, annually rebalanced portfolios). This means that the “one stock portfolio” will have more than one stock, because different stocks rise to the top through the months. This process removes any seasonal biases and makes the test more robust.

Here are the results, including return and Sharpe ratio. The best returns came from a 5 stock (!) portfolio. The best Sharpe ratio came from the 15 stock version. Both return and Sharpe degrade after 15 stocks.

The same is true of glamour portfolios. The concentrated glamour portfolios have bad returns and are incredibly volatile.  The 1-stock version had an annual standard deviation of 50% and the 5 stock version had a standard deviation of 40% (hint, I wouldn’t short these!).

I’ve written before about overdiversification. I’m also a huge believe in high active share, and that to beat the market you must dare to be great (that is, different). These results are further evidence support these beliefs. 

The Contrarian (Sociopathic?) Mindset

Expensive stocks suck. Cheap stocks are great. If you had followed these basic concepts through history, your results would have been incredible. Look below at the disastrous returns you’d missed by avoiding expensive stocks! And the huge returns you would have earned buying cheap stocks! On paper these results are enticing. But achieving results like this in the future would require a resilient and contrary mindset. Do you have what it takes?

These results are for the cheapest and most expensive large, non-financial stocks in the U.S. based on their EBITDA/EV ratios (rebalanced on a rolling annual basis). But “expensive” and “cheap” are not really the right words to be using to describe these two types of stocks. More accurate would be “exciting” and “terrifying.”  Stocks at these market extremes are those for which the market has the greatest consensus—both positive and negative.

In the case of exciting stocks, the consensus opinion is that the future is bright. It helps to replace the word “valuation” with “expectation.” High expectations—for companies like Tesla—lead to “exciting” prices. In the case of terrifying stocks, the consensus opinion is that the future is bleak or non-existent. Again using “expectation” instead of “valuation,” low consensus expectations lead to “terrifying” prices.

To buy into a terrifying portfolio, you need to have a contrary mindset. This mindset is almost sociopathic, because it requires not just ignoring the crowd, but actively trading against it. This flow chart below illustrates the counter-flow required to be a successful contrarian investor:

Case in point: today, 12 of the cheapest (most terrifying) 25 large stocks are large energy stocks. Would you buy a portfolio that was 50% energy right now? Oil has been in free fall. Because the energy sector has gotten more and more capital intensive over time, it requires higher energy prices to be very profitable. These companies may not be able to pay dividends in the future. If energy prices continue to fall, who knows what will happen to these stocks. It is easy to build a bleak narrative for energy stocks.

Let’s say you can stomach lots of energy stocks today. Would you then be able face similarly scary portfolios every year for the rest of your investing career? Remember, this isn’t a one-and-done trade. It is a constant cycling into the most hated stocks out there. This is not easy stuff.

One of the best books I’ve ever read is The Tiger by John Vaillant, which chronicles the search for a man-eating tiger in the Russian wilderness. This passage from the book (with my emphasis added) highlights aspects of the mental fortitude it takes to be a truly contrarian investor.

“The most terrifying and important test for a human being is to be in absolute isolation...A human being is a very social creature, and ninety percent of what he does is done only because other people are watching. Alone, with no witnesses, he starts to learn about himself—who is he really? Sometimes, this brings staggering discoveries. Because nobody’s watching, you can easily become an animal: it is not necessary to shave, or to wash, or to keep your winter quarters clean—you can live in shit and no one will see. You can shoot tigers, or choose not to shoot. You can run in fear and nobody will know. You have to have something—some force, which allows and helps you to survive without witnesses…Once you have passed the solitude test you have absolute confidence in yourself, and there is nothing that can break you afterward.”

Contrarian investing will require that you be “alone” almost all the time. The rewards can be great, but the journey is arduous. As Joesph Campbell said, "the cave you fear to enter holds the treasure you seek."

The Value Convergence

The valuation difference between the market's cheapest stocks and its most expensive has always fascinated me. Here are the EBITDA yields (EBITDA/EV, higher=cheaper) at different break points since the early 1960s.

At the market extremes (99th and 1st percentiles), things have converged a great deal. The cheapest percentile (25 or so stocks) are much more expensive (lower yields) than they were in 2009. The most expensive percentile is less expensive (although still has a negative EBITDA, just less so relative to its enterprise value). 

No matter which breakpoints you choose, spreads have come in and sit near all-time lows. Are narrower spreads a sign of market complacency? Spreads have peaked at times of peak uncertainty (2009, aftermath of tech-wreck, early 80's). 

The years teach much which the days never know

Here are the monthly returns for the S&P 500 since 1871. Chaotic. Sometimes terrifying. Sometimes very exciting. This is the market in which we live. These are the sometimes great and sometimes awful returns that make us greedy, euphoric, panicked, and fearful. These returns do not matter. 

Source: Raw returns from Global Financial Data. 

Here is what happens when you take these same monthly returns and compound them over 20-, 30-, and 40- years. These returns are hard to feel but they are the only ones that matter. If you are young, and you are a real investor, remind yourself that these long-term numbers are all that matter. This reminder is especially important on days like today, when the market is down 2.5%. 

Source: Raw returns from Global Financial Data. 

Frame things right, and you'll navigate the tough times just fine. Emerson said it best: "The years teach much which the days never know."

The Millennial Way Forward

If nothing changed about your current retirement plan, would you be able to easily support yourself and your loved ones come age 65? For many of my fellow millennials this is a sobering question. On the one hand, it is hard to think and plan four decades ahead. We are still young — scraping our way to better careers and salaries — so our focus is not on our twilight years, but on the here and now. On the other hand, we are cautious and worried about money because we have come of age during a rotten economy, and have watched the housing and stock markets crash, bringing financial ruin to those we love.

We are a generation obsessed with self-improvement. Most wake up in the morning and think, how can I improve my lot in life? Very few are just satisfied. Self-improvement is hard work, but luckily improving one’s personal financial situation is straightforward. It is one of the easiest ways to get better right away. The cruel irony is that we work tirelessly in our 20’s and 30’s to improve our careers and ourselves, but then spend so little time thinking about how to put our money and success to good use.

So far, a nice chunk of the millennial population has done something about long term financial planning: 43% of millennials have a 401(k) and 23% have an IRA. That is a good start, but it’s not enough. So how can millennials get started? The key is an education on the basics of money, personal finance, and investing.

Reaching millennials is tough because fully one quarter of them “trust no one” on money matters. Still, a large percentage — about one third — say that they trust their parents for advice on money. By laying some basic groundwork — either on their own or with encouragement from their parents — millennials can get off on the right foot and set themselves up for success.

The easiest way to understand the power of starting young is to focus on is the potential of every single one of your dollars.

The Potential of Each Dollar

What can every invested dollar grow to by the time you retire? The answer varies greatly depending on where and when you invest.

Those millennials that have saved and invested are very conservative with their money — opting for cash over stocks. The aforementioned stock market and housing crashes have been imprinted on our brains, and made us wary of “risky” investments like stocks. Because of our biological wiring, we are about twice as sensitive to losses as we are to gains. Once burned, twice shy as the saying goes — and we've been burned several times.

This biological imperative to be extra-sensitive to danger works great in a primitive, survival setting, but it wreaks havoc on our investments. Human nature compels us to sell after market crashes and buy at market peaks, even though we are supposed to be doing the opposite. These emotional reactions are very short-term in nature: our emotions make us avoid immediate dangers and pursue immediate opportunities.

The remedy is to redefine risk as a long-term rather than short-term concept. Here are four key lessons about the potency of your dollars.

The potential of every dollar fades quickly with time. If you start investing younger, you will harness the most important variable in the investing equation: time in the market. $1 invested in the stock market at age 25 has typically grown to $15 by retirement. The same dollar invested at age 40 has typically grown to $5 by retirement. Read that again. Dollars have typically had three times the potential when invested at age 25 versus age 40. Warren Buffett wasn’t a billionaire until he was sixty years old. He started investing when he was eleven. Step one, start young.

The potential of every dollar is maximized by spending long periods in the global stock market rather than in cash or bonds. If your time horizon is long enough — which it is if you are a millennial — then stocks have always trumped the alternatives. Millennials have built cash-heavy portfolios thus far, so consider the same potential of each dollar kept in cash (savings accounts, CDs). The average result for $1 invested at age 25 is growth to $1.20—a paltry return compared to the $15 from stocksWe think of bonds as the next safest option after cash, but the average $1 invested in bonds at age 25 has grown to $2.7. The long-term historical record is clear: stocks win out. Step two, if you are young, focus your portfolio in the stock market. Stocks are dangerous in the short term, but we are young so the short term is irrelevant.

The potential of every dollar fades the more often you check your portfolio. You are supposed to buy low and sell high. Most do the opposite. Human nature is great for many things, but investing is not one of them. The less you look at your results, the fewer chances you’ll have to screw yourself up. Step three, ignore short-term fluctuations in markets.

The potential of every dollar will be maximized if you make your investing automatic. Default options are powerful because we are lazy. If you automatically deposit a percentage of your income into your investment accounts (401(k), IRA, brokerage account), then you’ll build wealth without effort. Step four, automate contributions to your investing accounts.

The Way Forward

If you just invest a little bit of time and planning early in your life, you can effect significant change in your long term financial health. You can set yourself up so that your answer to the question “if you changed nothing about your current financial plan, will you retire comfortably?” is a resounding yes. Nothing is as powerful in the world of investing as starting young.

Here is something you can do today: check out companies like WealthfrontLiftoff, and Acorns. These companies sit at the intersection of investing and technology. Sign up today. Focus on stocks. Once you are set up, get out of your own way.

You’ll notice that a lot of this plan is simply protecting your dollars’ potential and letting them grow. But your dollars won’t work for you unless you get things started. Like millennials themselves, these young dollars are full of potential. They just need to be put to work.

 

For more on how to get started, check out my new book Millennial Money: How Young Investors Can Build a Fortune, which is on shelves today.