This is a guest contribution by Nick McCullum of Sure Dividend.
When investors can identify trends that either increase returns or reduce risk, it is wise to implement them into their investment strategies.
With that said, implementing positive market anomalies is usually not hard. Rather, the difficulty lies in finding them.
Two of the most straightforward improvements that investors can make to their investment strategies are:
- minimize investment fees
- invest for the long-term
This article will describe how each of these techniques can improve investment performance and provide actionable tips on how to implement them into your personal investment strategy.
Long-Term Investing as a Competitive Advantage
On the surface, it might not be clear why investing for the long-term provides investors with a competitive advantage.
It becomes more obvious when you consider how large, institutional investment managers are measured on their performance. Most money managers report results each quarter, which prevents them from investing in compelling opportunities than might take more than a quarter or two to play out.
Individual investors do not have this constraint. By investing with an eye on the very long term, we can purchase compelling mispriced assets without worrying how long it will take for the markets to recognize their actual intrinsic value.
Jeff Bezos – the CEO of Amazon – is well-known for touting this competitive advantage to his shareholders and his employees.
“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.” – Jeff Bezos
Aside from providing an advantage over professional money managers, there are many other advantages to investing with a long-term orientation.
First and foremost, investing for the long term means that investors do not need to pay attention to erratic, day-to-day fluctuations in stock prices.
Despite what academic theory might suggest, the financial markets can be highly irrational in the short-term. Long-term investing means that we don’t need to pay attention to this market noise.
Long-term investing also allows investors to take advantage of deferred capital gains taxes.
When an investor sells a security for more than it was purchased, a ‘capital gain’ occurs and a taxable event is recorded. Importantly, capital gains tax does not need to be paid if securities are not sold. Investing for the long-term allows this capital (that would otherwise be spent on capital gains tax) to be re-invested to further compound wealth.
Investing for the long-term is most powerful when investors hold stock in very high quality businesses. That begs the question – how do investors find high-quality businesses?
The Dividend Aristocrats (covered extensively on the Dividend Diplomats website) are a great place to look. To be a Dividend Aristocrat, a stock must have 25+ years of consecutive dividend increases. This is indicative of a very durable competitive advantage, and a willingness to place shareholders’ interests first.
To invest in high quality businesses, you have to find them first. Using a database such as the Dividend Aristocrats to find high quality stocks and then holding them for the long-term is a fantastic way to build wealth.
How to Minimize Investment Fees
Investment fees are a meaningful detractor from portfolio returns.
On the surface, this seems obvious. So why do so many investors pay the hefty management fees of mutual funds and other financial products?
I believe it is largely because investors do not understand how a 1% management fee can effect their portfolio in the long run. 1% per year can seem misleading after seeing how it can destroy tens of thousands of dollars over the course of an investing career.
For instance, consider two mutual funds that return 20% per year before fees, on average. Mutual fund 1 charges a 1% management fee (for 9% net returns) and mutual fund 2 charges a 2% management fee (for 8% net returns).
Next, imagine that an investor who doesn’t pay attention to fees invests $10,000 into each fund. After 30 years invested, here is his two hypothetical account balances:
- Mutual fund 1: $122,676,78
- Mutual fund 2: $90,626.57
Despite only a 1% difference in fees, mutual fund 1 has, incredibly, a $32,000 – or 35% – higher balance than its higher-fee alternative.
Clearly, fees can be an enormous headwind to building long-term value. Interestingly, this phenomenon has been seen in asset classes other than stocks.
The following diagram shows that, during the ten years preceding 2013, low-cost mutual funds outperformed high cost mutual funds over a variety of asset classes.
So how can investors minimize the fees that they pay while investing?
One obvious – and popular – solution is to invest in passive products like index ETFs. Index funds are professionally managed investment funds (similar to mutual funds) but they do not make tactical investment decisions.
Instead, these investment vehicles generally track an index, often the S&P 500. By tracking an index, many of the fees (including the substantial research budgets) of active mutual funds are eliminated, and these savings are passed on to investors.
Jack Bogle of the Vanguard Group popularized these low fee investment vehicles, and saved American investors billions of dollars in the process.
“If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.” – Warren Buffett
Although passive index funds still generate lower investment fees than their actively-managed counterparts, they still charge fees as a percent of assets under management. This means that absolute-dollar fees will increase as a portfolio grows.
This phenomenon – that investment funds charge fees as a percentage of assets under management – is one of the main reasons why investing in individual stocks is more cost-effective.
Purchasing individual stocks generally means paying transaction fees which are usually fixed – say, at $6.99 per trade. These fees do not change whether you’re buying 10, 100, or 10,000 shares of stock.
Because investors that buy individual stocks pay fixed transaction fees, the management fee of investing in individual stocks is zero.
That’s one reason why Sure Dividend advocates for investment in individual stocks (although there are many others). Buying individual stocks is likely the best choice for investors looking to minimize their investment fees.
The two investment techniques discussed in this article – minimizing fees and investing for the long-term – were not chosen in isolation. These two strategies are highly complimentary.
Investing for the long-term reduces trading volumes and minimizes transaction fees that are paid to your stock broker. Further, investing for the long-term helps investors to realize (and avoid) the true impact that mutual fund fees can have on their portfolio’s final value.
Accordingly, the techniques described in this article are most useful when they are implemented together.