Moneybox

If You Want To Get Rich, Avoid These Stupid Mistakes

How To Get Rich

First things first. I have been advised that if I don’t promise to tell you how to get rich in the markets, you won’t read The Wall Street Self-Defense Manual. So let me get that out of the way.

How To Get Rich: Invest $100,000 in a low-cost equity index fund for 50 years. This should make you about $11 million.

Yes, it’s not a get-rich-quick scheme, and there is fine print: This performance is not guaranteed. You must reinvest all dividends. You must make the investment in a tax-free account. Inflation will maul you. But no investment strategy is more likely to make you rich than this combination of low costs, equity returns, and time.

I have also been advised to tell you how Wall Street will take you to the cleaners. So let me get that out of the way, too.

How To Get Taken to the Cleaners: Invest $100,000 in an average-cost equity mutual fund for 50 years. This should make you about $6 million … and cost you about $5 million.

That’s right. Thanks to the magic of compounding, $100,000 invested in a low-cost fund for half a century should grow to $11 million. Thanks to the black magic of advisory fees, meanwhile, $100,000 in an average-cost fund should grow to only $6 million. That average-cost fund, in other words, will probably cost you $5 million over 50 years.

Wait—where will that $5 million go, again? Will you get swindled? No—assuming you choose your own fund, you will just be making a poor choice. The average fund subtracts more value than it adds. Every dollar you pay in fund fees is a dollar that will no longer compound in your account, and over the long run this will cost you far more than the fees (in this example, $4 million vs. $1 million). In other words, you will take yourself to the cleaners—with Wall Street’s help.

Here are two more ways to get taken to the cleaners: 1) trade too much; 2) shove your money under a mattress. Frequent trading will likely cost you several percentage points of return per year. After 50 years of average inflation, meanwhile, every dollar you have now will be worth less than a quarter.

Again, the key to investing intelligently is avoiding mistakes and letting the markets do the work. The mistake you make by buying an average-cost mutual fund is that “average-cost” is actually mind-bogglingly expensive. The mistake you make by shoving your money under a mattress is that currency is usually a terrible investment. The mistake you make if you trade frequently is that, in most cases, you would do better if you just bought and held. This last mistake, by the way, doesn’t hurt only day traders. It hurts almost all of us. The first step toward avoiding it is to draw a distinction between investing and entertainment. 

So how rich can you get?

Let’s assume you have the fortitude and time horizon necessary to stick all of your money in stocks. Let’s assume that you start with a meaningful nest egg of $100,000. Let’s further assume that you 1) invest well enough to capture the market return (easier said than done and far better than most investors do); and 2) never add or take money out. Here, after various time periods, is how rich you would get: 

Initial Investment:  $100,000
Annual Return:        10 percent

10 Years: $259,000
20 Years: $673,000
30 Years: $1,745,000
40 Years: $4,526,000
50 Years: $11,739,000

Nearly $12 million after 50 years? Amazing! Investment advisers fall all over themselves to show you numbers like these—and no wonder. Unfortunately, the numbers are misleading.

Before we discuss why, note that the vast majority of the wealth creation comes in years 20 through 50. After 20 years—20 years!—you would have only $673,000. The most important determinants of your future nest egg, in other words, are the amount you save and the length of time it compounds. This reveals the real secret to getting rich in the markets: Start investing immediately and save as much as you can.

So, why are the numbers misleading? Because they aren’t adjusted for inflation. Because they don’t deduct the vast sums you will pay stockbrokers, fund managers, traders, and the tax man. Because they assume you won’t make a single mistake, such as panicking in a crash and selling at the bottom. Because they assume you won’t fire your advisers and prematurely generate taxes, or try to beat the market and end up lagging it. Because they assume you won’t make the wise but return-reducing move of putting some of your portfolio into bonds, cash, or other volatility-reducing asset classes. Because they assume a straight-line return instead of the inevitable booms and busts. Etcetera.

Will these factors affect your returns? You bet. Inflation will likely cut your purchasing power by about 3 percent per year. A modest cash and bond position will reduce your long-term return by 1 percent to 2 percent a year. Brokers, fund managers, and traders will, if you let them, help themselves to about 2 percent of your money each year. And Uncle Sam might swipe an additional two points of return per year.

After bonds, inflation, costs, and taxes, in other words, your long-term return might drop from 10 percent per year to about 2 percent. How rich would that make you? Not very. 

Initial Investment:  $100,000
Annual Real Return After Costs and Taxes: 2 percent

10 Years: $122,000
20 Years: $149,000
30 Years: $181,000
40 Years: $221,000
50 Years: $269,000

This is why it’s tough to get rich in the markets. This, in part, is why even people who know better often swing for the speculative fences (which isn’t the answer, either). This is why it is crucial to save as much as possible and capture as much of the market return as possible. This is why you should ignore what you can’t control (market performance) and focus on what you can control (diversification and costs). The good news is, if you do the latter, you can improve your long-term return by at least three points per year. This will make a major difference in how rich you get.

To strike a more optimistic note, in fact, let’s see what happens if you invest intelligently and reduce costs and taxes enough to generate a 5 percent real, after-tax return (a return many investors will snicker at in disgust, before they generate a lower one). Remember, these numbers are adjusted for inflation and therefore represent real increases in purchasing power. 

Initial Investment:  $100,000
Annual Real Return After Costs and Taxes: 5 percent

10 Years: $163,000
20 Years: $265,000
30 Years: $432,000
40 Years: $704,000
50 Years: $1,147,000

Now that’s more like it.

What if you don’t have $100,000? What if you plan to save and invest over time? As long as you start immediately, you should do almost as well. If you continue saving after you have socked away $100,000, moreover, you should eventually do even better. Here, for example, is what would happen if you saved and invested $10,000 per year for the next 15 years at a 5 percent real, after-tax return (i.e., the same scenario as the one above, except with a total investment of $150,000):

Initial Investment:  $10,000
Annual Investments Each Year for 14 More Years: $10,000
Annual Real Return After Costs and Taxes: 5 percent

10 Years: $142,000
20 Years: $289,000
30 Years: $471,000
40 Years: $767,000
50 Years: $1,250,000

And, finally, here’s what might happen if you followed a typical savings pattern, making small contributions when you were young and salary-challenged, and bigger ones as you got older and richer:

Initial Investment:  $1,000
Annual Contributions for Years 1-9:       $1,000
Annual Contributions for Years 10-19:   $5,000
Annual Contributions for Years 20-29:   $10,000
Annual Contributions for Years 30-39:   $20,000
Annual Real Return After Costs and Taxes: 5 percent

10 Years: $18,000
20 Years: $98,000
30 Years: $295,000
40 Years: $712,000
50 Years: $1,159,000

That’s the ticket.