Principles of Wealth #30* 

If you have realistic expectations, you can do very well with stocks.  

I’m what you might call a chicken-shit investor. But there have been a few times when I’ve taken a risk – invested good money in a speculative deal that promised big returns.

Most of them were direct investments in start-up businesses brought to me by friends. They all came with exciting stories, as well as the promise of huge gains.

Fortunately, I had enough sense to limit those investments to what I could afford to lose without feeling like an idiot. That was, depending on the level of the friendship, $25,000 to $50,000. The idea was to roll the dice out of magnanimity, but not to end up being angry with my friends or myself if the investments went south.

And they all went south.

I’ve had a similar experience with stocks. Several times, I plunked down $5,000 or $10,000 in some IPO or low-cap growth stock recommended by an analyst who made a very convincing case for it. Again, the stories were exciting and the projected returns were not only astronomical but seemed inevitable.

How did they do? Well, like most stock investors, I have a poor memory when it comes to losses. But I’m pretty certain that every one of them went bust.

These experiences were exceptions, not the rule – because my usual practice when investing has been, as I said, chicken-shit. I like to put my hard-earned money in the most conservative investments I can find.

My goal has never been to crush the market. I never tried to make double or triple typical returns. My primary goal was to not lose the money I had saved.

Following this chicken-shit strategy, I spent the first 20 years of my investing career doing what Warren Buffett recommends: putting my money into index funds designed to give average stock market returns.

The average return on large-cap stocks over 100 years has been about 10%, and that’s what I got.

Take 10%, Buffett would say, and be happy with it.

But that’s not what most individual investors do. Instead of playing it safe and making long-term profits of 10%, they risk their money on short-term, speculative “story” stocks with huge “potential” that they pick themselves. And they end up making, on average, only 3%.

As it turned out, 10% worked out pretty well for me. It was a whole lot better than my much smaller portfolio of speculative bets. Ten percent better, in fact.

Then, in 2010, with the help of two colleagues, I switched from index funds to a portfolio of individual stocks comprised of large-cap, dividend-giving companies. Those were Warren Buffett type companies – the kind that dominates their industries, have a distinct market advantage (a moat, Buffett calls it), and are so large that there is a 99% chance they will be around for 40 to 50 years.

In addition, because they are so big and so protected and have a history of giving dividends, they gave me the prospect of less volatility. In other words, I was hoping to squeeze out another point or two of ROI while reducing my risk.

It’s been almost 10 years since I started that portfolio, and it has been significantly less volatile than the general market. Plus, it’s given me average returns of more than 12%.

Two points may not sound like much. But if you let that modest advantage accumulate over time, it can be significant.

Let’s look at the math:

Twenty thousand dollars invested in stocks yielding 10% will grow to about $900,000 over 40 years. Over 50 years, it will grow to $2.3 million.

That same $20,000 invested in stocks yielding 12% will grow to about $1.8 million in 40 years and $5.7 million in 50 years!

As you can see, you can do very well with a stock portfolio earning 10%. But you can do much better – more than twice as well – at 12%.

The takeaways:

* It’s foolish to try to crush the market, and arrogant to think you can.

* Don’t risk your money on short-term bets. Set your goals at historically proven market rates.

* A modest increase in ROI over the long term can make a huge difference.

* In this series of essays, I’m trying to make a book about wealth building that is based on the discoveries and observations I’ve made over the years: What wealth is, what it’s not, how it can be acquired, and how it is usually lost.