To The Moon

What should we invest in to get long-term gains to improve our lives?

Sometimes being able to lie flat (means reject Rat Race) is really a smart way to invest!

In 2007, “the god of stocks” Warren Buffett initiated a ten-year bet that any combination of funds chosen by hedge fund managers would not exceed the return of the S&P 500 index fund for ten years.

Ten years later, the bet ended up with the S&P 500 rising a total of 125.8% from 2008 to 2017, an average of 8.5% per year. Comparatively, the best performers among hedge funds had a total return of 87%, an average annual gain of 6.5%; the worst performer had a total return of just 21.7% and a 2% annual return. Therefore, Buffett was right and the S&P 500 was the last winner.

And for the success of this challenge, Buffett attributes it to two reasons.

The first is that in the long run, even the best professional investors can't beat the market. Maybe a certain investor will be more lucky one year, choosing the right investment target and therefore beating the market. However, if you look at the long term, it is almost impossible to accomplish the task. Therefore, as a long-term investor, we should not focus on how to beat the market, but to grow with the market.

The second reason is the management fees charged by fund managers. Hedge fund managers often charge according to the industry's prevailing Two Twenty rule, which is a 2% management fee plus a 20% commission on earnings. Warren Buffett chose an index fund with a management fee of only 0.04%. Don't underestimate the difference of a few percent. If we stretch it out over time, the effect of compounding creates a difference of several times that amount. Remember the challenge we just mentioned?

Annualized return of 7.1% and 2.2% may not seem like a big difference. However, over the course of 10 years, the difference in profits is four times greater. What if we take the time dimension to 20 and 30 years? This is the biggest difference between long term thinking mode and short term thinking mode. Under the influence of the compound interest effect, the small differences will be magnified, besides, the two golden rules of long-term investment, including growth with the market and low management fees, are perfectly adapted to the index fund, which is a financial product that may be most suitable for most common people.

What is an index fund?

Generally speaking, it is the portfolio containing an index of all the companies with the one-time buy. For example, in this challenge, Buffett chose the pioneer fund of the S&P 500 index fund; the $S&P 500(.SPX)$ almost covers the  strongest 500 companies in the world, in which the stocks $Apple(AAPL)$ , $Microsoft(MSFT)$  and  $Amazon.com(AMZN)$  account for the largest proportion.

The founder of the Pioneer Fund, John Bogle is the inventor of the index fund, launching this unprecedented and revolutionary investment products in 1976. His good friend Warren Buffett once commented him, “Bogle is the person I know who has created the most value for the average investor”. Why?

In Berkshire's shareholder letter, Buffett mentioned more than once that for most investors, investing in index funds is the most simply and effective way to build wealth. His practice were in line with his remarks. Buffett said to his wife,

“if I'm not around anymore, you are advised to buy 10% of U.S. Treasuries and the remaining 90% into the S&P 500 index fund”.

What kind of charm does this index fund have, so that the god of stocks Warren Buffett have given up the choice to invest in individual stocks? We can find the answer from Berg's (the inventor of the index fund) book, who has a series of writings to explain his investment philosophy. Here to give you a brief introduction to the highlights.

The first is that the individual investor we mentioned before will fail to beat the broader market in the long run. The reason for this is a concept called mean reversion.

We tend to hear that a certain investor get a sound reward this year, and then began to copy his investing strategies. However, the investor may be under-performed in the future by mean reversion , although he used to be strategical. Berg listed eight investment manager with bright performance, but they all turned to mean reversion without exception .

This iron law on the god Buffett is actually no exception. In the past few decades, Buffett's investment performance is pretty extraordinary, but began to mean reversion--- Berkshire's share price actually did not beat the broader market.

In the long run, if we know that investment returns will mean-revert, how should we improve our investment returns? We know that profit = revenue - costs, so  we need to find measures to reduce costs since revenue will be mean-revert.

What are the costs of a fund?

First of all, it is the management fees of fund managers. Earlier we mentioned the 2-20 rule that is common in the industry, that is, the fund manager receives 2% of the management fee as remuneration with the combination of 20% profit commission. The more investors earn, the higher the profit commission.

For larger transactions, we only pay a commission to the middleman, such as a real estate agent, who gets a commission only when the house is sold. Although the income is not so fixed, if managers do a good job they can get a extra return. The investment manager can take the benefits of both trading models-- fixed management fees and income commission. It's just the earnings on the surface. Most funds have a lot of hidden fees, which is the cost of transferring positions.

Since the investment manager charges the management fee, it is necessary to regularly carry out active management of the position, generating a turnover cost. As for the cost, Berg has a simple calculation method, multiplying the turnover rate of the fund by 1%, which is the turnover cost of the fund. For example, the fund with 100% turnover rate spends 1% turnover cost, which includes the spread of the transaction, commissions and the impact on the market price. With the combination of these costs, the explicit and invisible costs adding up, the final cost calculated to the investor is 3%-4% a year before the invention of the index fund. It seems to be moderate, but actually a huge cost.

Berg taught the lesson for us, assuming we save $10,000 and put it into the stock market at an 8% annualized return, it will grow to $470,000 in 50 years, which is a really sound return as retirement nest egg. But if we add the cost of 2.5%, guess how much the $10,000 we put in will turn out to be? The number may surprise you! You end up with only $145,000 in retirement, a full $325,000 less. If it was 3-4% of the average cost, the number would be even worse.

Albert Einstein said,

"Compound interest is the eighth wonder of the world."

Compound interest is incredibly powerful. Similarly, if it's compound interest on expenses, the results will blow our mind. When we invest we are often concerned about which stock has risen more and how much growth can be expected in the future, but forget the other variable of the formula. To improve returns, it not only need to see which stock can rise more, but also to see how to save costs.

Therefore, it’s the reason we mention how much the management fee on the ETF when talking about a particular ETF. The aim is to remind you of caring about on the impact of costs while focusing on growing your returns.

So which task is easier, picking soaring stocks or saving money?

Personally, I think it's the latter. If we pick a stock, we might pick a ten-fold stock, but most of us are afraid to put our eggs in one basket. We need to diversify our risk by buying more different stocks.

With more choices, the probability of picking a sound stock will naturally mean-revert to the same as the broader market. Don't look for a needle in a haystack, you should buy the whole haystack, which means that we should buy the whole broader market instead of trying to figure out which stock can beat the broader market! It’s advisable to buy the portfolio of the broad market to enjoy the compounding effect of time and avoid more impulsive trades.

$SPDR S&P 500 ETF Trust(SPY)$ $Vanguard S&P 500 ETF(VOO)$ $iShares S&P 500 ETF(IVV)$

Thank you for patience! Follow me to learn more about analysis!!