Primer

(first posted 06-06-06)

I've lately become interested in investing in the stock market. I started several years ago investing in index funds. I wasn't interested at the time in getting exceptional returns - just getting returns and not having to think about it. Well, I put my money into an index fund at the top of the bubble, watched my index fund lose 1/3 of its value, and actually found a way to make this seem positive. (I was able to take advantage of dollar-cost averaging! What a coup!) Well, now I want to actually do something with my savings. So I've started to do a little reading.

My initial reading, years ago, was a book called Get a Financial Life. Next was Suze Orman's The Nine Steps to Financial Freedom, which was basically the same basic message as the first book. The investing that I had been doing was right in line with what was suggested by these books. I'm not sure what changed, exactly, but more recently, I became interested in reading about stock investing. I happened to hear about a book called The Little Book That Beats the Market. It came with a Magic Formula for ~30% returns (known as MFI, for Magic Formula Investing), and backtesting showed that the formula worked.

I read quite a while back about the magic of compounding. But yesteday and today, I played around with some numbers and was surprised to see how amazing it really can be. It seems pretty common to assume a $10K starting investment, so I've done that here. "Average returns" is the (more or less) 11% historical return of the market. "Modest savings" is $4K per year, the amount to max out a Roth IRA. The maximum investment in a Roth is bound to go up, but I left it at $4K for the entire time of the series. "Aggressive savings" assumes that the amount saved will go up every few years - to $6K in 3 years, to $8K in 6 years, and so on. "Amazing returns" is the 30% suggested by MFI.

For the first few years, saving helps a lot. But within ten years, MFI beats the more moderate returns. Here's a zoom on the first twelve years. (I added in a data set for amazing returns with moderate saving, because that is realistic - and in this case, average returns, even with aggressive savings, never wins.)

Another way to look at this is: how long until this hypothetical $10K has been turned into $1M? The difference in time scale is surprising. This was the data that made something very clear to me: The classic Suze Orman example of how to save an extra few bucks for retirement is to not drink coffee every day. That $4 at Starbucks really adds up! Well, I don't even drink coffee. As far as I'm concerned, I've saved a huge amount given that I've only ever been a graduate student and a post-doc. And if I listened to Suze, I'd never save enough to have even $1M at this rate - and my expenses are only going to rise.

There was a bit of a bait and switch there - when I complaind that my expenses will only rise. My salary will as well. But this small analysis tells me that the question is not how to save more - even a lot more, like after my salary makes a major jump when I get a real job. The question is how to get exceptional returns. That is what this blog will be about.