Thanksgiving is a time for gratefulness. For most of the year, people often become too focused on the things they don’t have. But when this season rolls around, we are encouraged to pause, reflect, and appreciate all that we do.
Our financial literacy team is extra thankful this year for all of the tremendous strides in financial education. A solid financial education affords us the ability to plan for and achieve our financial goals.
To keep in the spirit of the season, we talked to Professor of Finance Robert Johnson at Heider College of Business. We asked about the aspect of financial literacy he’s most thankful for: investing.
What are you thankful for when it comes to having a financial education?
“This may seem counterintuitive, but individuals need to be taught to invest for retirement and not to save for retirement. The surest way to build true long-term wealth for retirement is to invest in the stock market.”
Back when Johnson was a student at Creighton University, his professor Dr. Jerome Sherman emphasized the distinction between simply saving for retirement and investing that money for retirement.
“It made a huge difference in my life,” Johnson said.
Now, 35 years later, he is financially independent and stresses that others learn about the importance of investing, too.
Why is investing important for retirement?
Many people know that investing is important, but inexperience or concern about risk stop them before they start.
“Mistakes begin early in life and the biggest financial mistake people make is taking too little risk, not too much risk,” said Johnson.
This fear has resurfaced recently.
“A recent UBS study showed that millennials and the World War II generation have similar asset allocations—low allocations to equities and inordinately high allocations to cash,” Johnson said. “Both generations were shaped by cataclysmic financial events in their formative years—the WWII generation with the Great Depression and millennials with the financial crisis.”
What can millennials do in order to learn from the mistakes of previous generations? One solution is to begin compounding as early as possible, said Johnson. Then, let compounding work for you over the next few decades.
How can compounding interest work to your benefit?
“Albert Einstein is rumored to have said the power of compound interest is the most powerful force in the universe,” said Johnson. “Whether he said it or not is irrelevant, but people should act as if it is so.”
“According to data compiled by Ibbotson Associates, large capitalization stocks (think S&P 500) returned 10.2 percent compounded annually from 1926 to 2017. Over that same time period long-term government bonds returned 5.5 percent annually and T-bills returned 3.4 percent annually.”
The choice between stocks (stakes of ownership in a company) versus bonds (debts) and other investments boils down to time. The nature of the stock market typically means that stocks are riskier in the short term. Long term, however, stocks historically prove more valuable with less variance over multiple years.
What does this mean for you?
The best way to guarantee wealth building over the long-term is to invest in a diversified portfolio of common stocks, explained Johnson.
“Someone with a long time horizon should not have exposure to money market instruments, yet many investors do because they fear the volatility of the stock market,” he said.
The consequence is that “[i]nvestors who get in and out of the stock market invariably end up buying high and selling low. Even missing a few positive days can negatively impact your return over a long period of time.”
Johnson gives the following example drawing on the old Wall Street adage that ‘time in the market is more important than timing the market.’
“From 1996 through 2016, the S&P 500 returned 8.19 percent annually,” he said. “If an investor attempted to time the market and missed the five best days, her return would fall to 5.99 percent. Miss the 10 best days and the return falls by over half to 4.00 percent.”
“While it is true that long periods of time can witness anemic returns in the stock market—the lost decade of the 2000s witnessed an average annual return of -0.9 percent on the S&P 500—since 1970s the lowest 20-year holding period for large cap stocks provided a return of 7.20 percent annually. The best way for the novice investor to accumulate wealth is to invest in the stock market and hold for a long period of time. Remarkably, $1 invested in a large capitalization stock market index at year-end 1925 would have grown to $7,352.68 by year-end 2017.”
Compound interest is significant for those with longer investment time horizons, but even those thinking short-term should consider taking advantage of its power.
Why is investing for retirement difficult for many people?
According to Johnson, saving and ultimately investing for retirement is difficult because it is a choice between current consumption and future consumption. It is hard for people to give up a new car, vacation, or everyday impulse purchase in lieu of saving money for the distant future.
“My overriding message is that people saving for retirement over-complicate matters and feel overwhelmed and simply delay thinking about saving for retirement — essentially, out of sight out of mind,” he said.
In order to overcome human nature, people should automate as many financial decisions as possible. Saving money is a habit, but habits need time to develop. Taking the work of saving money out of your hands is one way to ease the process.
“A particularly sound way to do this is to agree to have a specific amount (or better yet, percentage) deducted from your paycheck every month and put into a retirement account,” he said. “If we are automatically enrolled in a retirement plan, inertia and the inherent laziness of people tend to work in our favor. That is, once enrolled in a retirement plan, people tend to stay enrolled.
“Last year, University of Chicago Professor Richard Thaler received the Nobel Prize in economics for his work in behavioral finance. The premise of behavioral finance is that human beings aren’t rational profit-maximizing machines, but often succumb to behavioral biases. One of the biggest behavioral biases that humans succumb to is the bias toward immediate gratification over delayed gratification.”
“Making retirement and savings contributions the automatic, default option, so that we must actively opt out of saving is a wise approach,” Johnson said, adding that “people need to predetermine savings for retirement instead of needing each month (or paycheck) whether to invest in retirement or not.”
What tips do you have for investors?
Johnson said that the majority of investors, novice and advanced alike, would be well-served to adopt the mantra KISS–Keep It Simple, Stupid.
“The best thing for most investors is to invest in a low fee, broadly diversified, stock market index fund. Buying an individual stock is subject to tremendous risk. A mutual fund or ETF diversifies and the volatility of that investment will be much less than that of the average single stock. A low fee fund is essential, as that means that more of the investor’s hard-earned cash is being put to work. Just as stock market returns compound over time, the deleterious effects of high fees also compound over time.”
Robert R. Johnson, PhD, CFA, CAIA, is a professor of finance in the Heider College of Business at Creighton University. He was previously the president and CEO of The American College of Financial Services and was deputy CEO of CFA Institute. Bob is the co-author of Strategic Value Investing, Invest With The Fed, Investment Banking for Dummies, and The Tools and Techniques of investment Planning.