Saving and Investing - Two Very Different Animals
Most things in life are better if we work at them. Working at eating better could mean giving up that semi-regular Big Mac (that I love so much) in return for having a longer and healthier life. The same philosophy can be applied to saving. Working at saving might require giving up the immediate gratification of driving an impressive sports car off the lot in order to reach financial independence sooner. But can the same philosophy be applied to investing? Does working harder really mean our portfolios will grow faster? The answer to both is a resounding "no!"
A little background
I teach both personal financial planning and investments at Colorado College. Much of the financial planning course is on budgeting. And nothing better illustrates the consequences of spending more than you're making than the documentary, Maxed Out, where the misery of those hopelessly in credit card debt can be painfully felt.
Successful Saving
Saving successfully isn't rocket science. It simply requires spending less than you are earning. So I teach my students how to live within their means. Step one is developing a budget and monitoring how much they are spending compared to their budget. This feedback loop gives us the information to either adjust our budget or our behavior.
Much of the class covers areas that can be cut back on from forgoing the Starbucks coffee to gaining millions by driving a modest car. Of course, working harder and making more money is also part of the equation.
Successful savings still comes down to giving up things today for a better future tomorrow. Working harder in their careers is important, as it leaves less time for the acquisition and enjoyment of material things. Though putting off purchases today can be challenging, because what we're actually deferring is the gratification we're sure buying it will bring. Just like dieting, the formula is simple but the execution is quite difficult.
Successful Investing
When I teach investing, however, I realize just how different it is from saving. Working hard in your investing actually results in lower returns. In fact, as Brad Barber and Terrance Odean noted, trading is hazardous to your wealth. The more securities analysis we do to try to identify the losers to dump and the winners to buy, the worse our portfolio tends to perform.
As part of the investing curriculum, I teach the efficient frontier and all of the math that surrounds it. But I also teach that the logical conclusion to building an efficient portfolio is just to own the entire market. It eliminates all diversifiable risks and builds the most efficient stock portfolio.
So what works well in investing happens to be laziness. Paul Farrell, of Dow Jones MarketWatch, has been writing about eight lazy portfolios for years. My son, with a little help from me, developed one of these eight portfolios called The Second Grader Portfolio. Because investing is a zero sum game where we can only think we are all above average, the more we work or pay others to work to beat the market, the worse we'll do. Owning the entire market through broad index funds means we don't have to give up time to do the research, or pay others hefty sums that only result in lower returns. Being lazy is the ticket!
Achieving Proper Behavior
I'm not suggesting that my students lead lazy lives, quite the contrary. The focus and discipline required to work hard and live within their means is something that is actually hard to achieve. It takes commitment and a lot of work. What I am suggesting, is that they be lazy investors.
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