More Straight Talk on Investing - John J. Brennan

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points, you are naturally inclined to calculate that you've lost money. If the market falls three days in a row and posts considerable losses, you may feel despondent. It might even compel you to check your balance. Don't!

      This penchant for “mental math” can also play out over years. Suppose you had a $100,000 balance in your investment account at the end of 1994, as shown in Figure 2.2. Five years later, you are feeling pretty good with a balance of more than $350,000 in 1999. The market suddenly reverses and, at the end of 2002, your balance now stands at $219,000, and you figure that you've lost more than a third of your portfolio!

      Only you haven't. These are paper losses. By 2006, your portfolio has recovered. To demonstrate how the market can quickly give and quickly take away in the short term, refer to Figure 2.2. As you can see, the value of your investment account is subject to euphoria-inducing gains and gut-wrenching losses over the short term. But over the long term, you are well rewarded for participating. (This example is for illustrative purposes and is based on $100,000 invested in the S&P 500 Index with dividends reinvested. Your portfolio is likely to include bonds and cash reserves that will offset the short-term losses incurred by stocks.)

Graph depicts Growth of $100,000 Invested in the U.S. Stock Market (1994–2019).

       Figure 2.2 Growth of $100,000 Invested in the U.S. Stock Market (1995–2019)

      Sources: Vanguard, S&P

      If you believe that the economy will grow over the long term, time will be your greatest ally in accumulating wealth. That's because of the power of compounding. Compounding is what happens when you invest a sum of money and then reinvest the earnings instead of withdrawing them. Your nest egg grows much faster because those prudently reinvested interest payments, dividends, or capital gains in turn generate further earnings. My friend at a competitor firm, Mellody Hobson, aptly observes, “We talk about long-term patient investing, and that idea that slow and steady does win the race, that time can be your best friend when it comes to investing. That's why we have a turtle as a logo at Ariel.”

      So, think tortoise, not hare. The longer you invest, the effects of compounding are all the more astonishing. Consider the simple example shown in Figure 2.3. Suppose you invest $5,000 in a tax-advantaged account at the start of each year for 10 years and then contribute nothing more. Next, suppose that the account earns 8% a year, after expenses, and that you have all of your earnings reinvested in the account. After 25 years, you would have more than $248,000, of which only $50,000 came from your pocket. And after 40 years, that sum would have grown to more than $787,000. The power of compounding is absolutely amazing.

       Figure 2.3 The Power of Compounding

      Source: Vanguard

      Here's a point that requires special emphasis. If you're going to make the most of the power of compounding, you must reinvest all the income and dividends that you earn on your investments instead of taking them in cash. You must also keep your hands off the money in your accounts. If you repeatedly dip into your long-term accounts to pay for living expenses or big splurges, your wealth won't grow as efficiently as it could otherwise. Like a chef who keeps sampling the food while it's cooking, you're apt to end up with a lot less in the pot than you planned.

      For your safety and peace of mind, you need to establish a relationship with a financial services provider or two that you can trust. Or, a relationship with a financial advisor whom you can trust. (I will focus largely on firms in this section, although some of the lessons apply to financial advisors, which I cover in more detail in Chapter 12.) A trustworthy firm will serve you with integrity and help you accomplish your financial goals. And it won't push products and services that meet the company's quarterly sales goals but that do little for you, or seek to lure you with bait-and-switch tactics. Fortunately, there are plenty of good investment companies that offer sound products and quality services.

      Picking a trustworthy partner is important to your success in more ways than one. If you do business with a firm that you trust, you will be better able to endure the misgivings that come when your portfolio has an off year. Believe me, sooner or later, that will happen. It's one of the facts of investing. If you trust your investment partner, you'll realize that a mutual fund or exchange-traded fund with a strong long-term track record is still a good investment even after it's had a bad year.

      The firm's history is an additional consideration. An institution that has been in the business for many years will have a track record and experience serving clients effectively through up and down markets. For example, I've always believed an investment firm's greatest competitive advantage is its demonstrated trustworthiness through good times and bad. And the market agrees—the three largest fund families have roots in the business that go back for 75 years or more. There are plenty of newer firms with talent and ambition, but they must overcome the formidable advantage of tenure and credibility accumulated by established firms. It's very tough to earn marketplace acceptance in the absence of long-standing relationships with business partners and clients, along with a record of good service over the long term.

      Experience also counts in the professionals who manage your money. There's a reason that sophisticated institutions look for gray hair (figuratively speaking!) when they hire money managers. Those who have endured feast and famine in the markets have the wisdom of experience. Some lessons simply are better learned by living through them than by reading about them in a textbook. The performance records of tenured money managers are much more meaningful than those of managers with limited experience. A young money manager with a good track record for four or five years isn't necessarily a great stock-picker—he or she may have simply floated up with a rising market. Even in a falling market, a money manager can look better than the competition—for a while—by sitting out the market and holding considerable cash.

      For these reasons, I always want to know how a money manager has performed relative to the competition over the full cycle of a bull market and a bear market. An added advantage of experience is that it teaches humility. Investors who have been through up and down cycles tend to avoid overconfidence and are cognizant of risks. Anyone who's been in the financial business for a lengthy period of time has hit some rough patches and does not take lightly the unpredictability of the markets.

      So experience is important, but don't let it be the sole factor in your decision. Being the oldest doesn't make a firm the best one, nor should you rule out a young firm purely because of its limited experience. Experience is not a litmus test; it's just a factor to be weighed. Still, if you're thinking of dealing with a small organization that you know little about, it makes sense to seek references from others who have done business with the company.

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