# The sheep and the wolves: Smart investing made simple

Imagine that you’re a farmer. You live in a rural county where everybody raises sheep.

The county’s farmers, on the whole, prosper. Their flocks tend to grow by 10 percent every year. Some years are better than others. In the best years, the sheep population in the county grows by 40 percent. Little lambs are everywhere! But in the worst years — years filled with frost, famine, and disease — the sheep population can collapse to half of what it was before.

Further imagine that the county becomes home to vicious predators. Wolves, perhaps. The wolves descend from the mountains and begin to eat the sheep. Some farmers protect themselves from loss, but others don’t know how — and some don’t even realize their flocks are being attacked.

The farmers who take precautions aren’t able to prevent all losses, but they come close. On farms with vigilant shepherds, only 0.10 percent of sheep are lost to wolves every year. For every thousand sheep, the wolves pick off one animal.

The farmers who don’t take precautions, on the other hand, suffer terrible losses. During the initial onslaught they lose 5 percent of their sheep. (Plus, every time they add more sheep to their herds, the wolves manage to grab another 5 percent.) To make matters worse, the wolves steadily steal 2 percent of the beasts every year. For every thousand sheep, this group of farmers loses 50 in the initial attack, and 20 more each year thereafter.

Think of it: After the first year, the smart farmers will have lost just one of every thousand sheep. The other shepherds will have lost 70 sheep.

If the county’s flocks each grew at the long-term 10 percent average during that first year, the vigilant folks would now have 1,099 sheep for every thousand they started with. The unwary farmers would have 1,024 sheep.

Now imagine that in the second year, the same pattern continues. All flocks grow at the long-term average of 10 percent, and the wolves snatch 2 percent of the animals from those farmers who aren’t paying attention. At the end of the second year, the wolf-free flocks would have grown to 1,208 sheep for every thousand that were present at the start. The flocks where the wolves run wild would have just 1,104 sheep.

Both populations of farmers enjoy the same growth rate among their flocks. The difference is that one group loses fewer sheep to the wolves.

And at the end of 10 years following this pattern? The wolf-less flocks would have grown from 1,000 to 2,566 sheep. Those under attack would still have increased, but at a much slower rate. They’d have 2,013 sheep.

Things are even worse when you look at the farmers who add more animals to their farms every year. Remember that I said the wolves slaughter 5 percent of the sheep added to the unlucky flocks? Well, assume that wealthy farmers from both populations are able to buy 100 new sheep every year — but that the wolves snatch five of these from the one group.

At the end of a decade, these wealthy farmers will have contributed a total of 2,000 sheep to their flocks for each 1,000 sheep they started with. With average long-term growth, these flocks will have grown to 4,154 animals for the lucky shepherds and 3,374 sheep for those ravaged by wolves.

Which population of farmers would you prefer to join?

I won’t belabor this analogy any longer. I think most of you get my point.

Stock-market investors are like these sheep farmers. Collectively, they enjoy investment returns of roughly 10 percent per year. Individually, however, things are different. Most investors suffer severe losses from the wolves of Wall Street. Wolves, by the way, who don sheep’s clothing to convince investors to trust them. (These investors also have a tendency to make things worse by selling their flocks when sheep prices fall and expanding them when prices rise.)

If you want to be a successful farmer, you have to understand how farming works, and how to protect yourself from the wolves. Fortunately, it’s not as tough as it seems.

The financial industry wants you to believe that investing is difficult. If you buy into their message, if you accept the premise that you need help to invest wisely, they can charge you big bucks to handle your money.

The truth is somewhat different. Investing is simple. In fact, it can be one of the easiest things you do while managing your finances. How simple? Let’s boil it down to just a few sentences.

Here’s how to invest wisely:

• Set aside as much as you can in investment accounts. Prefer tax-advantaged accounts (like a 401(k) or Roth IRA) before taxable accounts.
• Invest all of your money in a low-cost stock index fund, such as Vanguard’s VTSMX or Fidelity’s FSTMX.
• If the stock market makes you nervous, allocate some portion of your money to a bond fund. Or invest instead in a low-cost combo fund like Vanguard’s VGSTX or Fidelity’s FFNOX.
• Continue investing as much money as possible. Never touch it.(Nothing makes a bigger difference to the size of your flock investments than how much you contribute.)
• Ignore the news and ignore your fund.

That’s it. Seriously. That’s all you have to do to earn returns better than 90 percent of other investors.

There are scores of books and published research papers that support this strategy. It’s also the strategy that Warren Buffett (and other top pros) recommend for 99 percent of investors. If you’d like, you can spend days or weeks or months reading about why this works. Or you can trust these folks and do it.

Longer ago, my own flock of sheep was crippled by predators and my own bad behavior. After many mistakes, I got smart. I moved to greener pastures far from danger. Now I can ignore my sheep and go about my daily life, comfortable that the animals will continue reproducing at the long-term average without any intervention on my part. And with no danger of being consumed by wolves.

Note: Photo by James Bowe.

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### There are 36 comments to "The sheep and the wolves: Smart investing made simple".

1. Jack @ SeeJackSave says 06 February 2014 at 04:41

I think the key to adopting this investment strategy is remembering the nature of investment firms and Wall Street types. For them profit comes from trading – not building companies. Motivation is important.

Investing doesn’t need to be complicated – it’s made to seem that way by people who want you to think that you need them to invest.

2. Vanessa says 06 February 2014 at 04:47

Which is worse: to invest badly or to not invest at all?

• Dave @ The New York Budget says 06 February 2014 at 06:17

It depends how badly. If you are just getting hit with high fees for a mutual fund, usually, it is better to invest. But if you are getting hit with high fees, always trying to time the market, and investing in home run/penny stocks, you have the POTENTIAL to lose a lot in the stock market.

Buy and hold Index Funds from Vanguard. Don’t sell when the market goes down (in fact, keep buying more) and you won’t have to worry about investing badly! You will be all set!

• Paul in cAshburn says 07 February 2014 at 06:37

Keep in mind that ETFs based on indexes can be even cheaper than index funds… even Jack Bogle stated that is true.
Yes, you have to pick the right ETFs, and you still have to have the discipline to buy and hold… but mutual funds are not necessarily better or cheaper than ETFs.
(From Investing 401, not necessarily for people new to investing.)

• David L. Wright says 07 February 2014 at 08:41

Yes, ETFs can be cheaper than their mutual fund equivalent. However, if you are going to rebalance your portfolio, you will have to pay transaction fees to your brokerage house. These fees, especially if your portfolio is small, can be considerable (on a percentage basis) – depending on the size of your portfolio. That outlay might exceed the expense ratio of the mutual fund.

Of course, if you never plan to rebalance, than yes, ETFs might be the way to go. I personally am a strong proponent of rebalancing (at least once a year or so), so I would stick with the mutual (index) fund.

David

3. William Cowie says 06 February 2014 at 05:20

Great analogy! I’d add one thing: although you end up with more if you start farming earlier, it’s never too late to start. A little is always better than nothing.

4. Matt says 06 February 2014 at 05:53

Good analogy – I would add that I like to buy sheep that like to, um, procreate. Sheep that have little children each quarter and then those children have children. Dividend payers are my favorite sheep.

5. Beth says 06 February 2014 at 05:58

Ha! Once again, J.D. manages to make it simple 🙂 This article is timely for me as I’m trying to figure out my RRSP top up.

I think the point to use tax advantaged accounts is a good one. I’ve been considering using my TFSA (tax-free savings account) to build up a tax-free income stream for “retirement”. The disadvantage in the short run is that I won’t get the tax rebate and I can’t write off any potential losses, but in the long run I see some interesting potential.

6. Matt Becker says 06 February 2014 at 06:15

Love those four points at the end! Couldn’t have said it better myself. The biggest enemy to the growth of our investments is our own behavior. Keep it simple, keep contributing, and get on with the rest of your life.

7. Amy says 06 February 2014 at 06:19

Odd analogy. You blithely assume that the farmers aren’t bound by any limits other than wolves for flock growth. No mention of how much viable pasture they have, no factoring in that the wolf population will grow as it feeds well off the less vigilant farmer’s flock, no mention of supply and demand and how that messes with the amount of money a farmer can command for his flock…..I’m not even a farmer, so it’s kind of laughable that I’m picking this apart, but, perhaps you’ll see the point that the analogy is entirely over simplified.

I’m with you on the investing points though. I try to follow those points. And have several funds that I just keep putting money into every month.

However, the more I read about limits of growth and the economics of the ecology, the more I realize how fragile and (dare I say it) not really attached to reality the stock market is. Read some John Michael Greer if you’d like more insight on that topic.

I just wonder if the mantra of invest, invest, invest is really the right answer. Perhaps it is for the moment, but for long term? I don’t know… As I don’t have a good alternate answer yet, I’ll keep investing, but I’ve got eyes wide open looking for alternate ways to keep afloat when/if the market bubble bursts.

• JN says 06 February 2014 at 07:02

Read Henry Hazlitt’s ‘Economics in One Lesson,’ it will only drive you further into thinking that our market is wildly inflated and that our economy is now smoke and mirror (not tied to anything significant or real).

I know that I am easily swept up with fear, and I do think we will see a MAJOR market adjustment (or meltdown) in my lifetime. That said, I think low cost index investing is a smart step in the right direction to healthy investing.

I love the analogy and advise in this article, but think we must begin to also encourage some diversification (outside of the market) – I am interested in hard assets such as real estate.

• J.D. says 06 February 2014 at 08:03

Haha. You’re right. Like any analogy, this one is imperfect. But I had fun thinking it through.

As for your specific arguments: Of course there are other factors that affect each farm, including pasture size, supply and demand, etc. My example intentionally dealt with averages, with the whole. Maybe in a future article I can discuss specific types of farmers and their situations?

As for your last point: People have been sounding the alarm about the stock market for decades. So far, they’ve all been wrong. It’s true that past results don’t guarantee future performance, and any time you invest in stocks (or anything else), you need to keep this in mind. But we have nothing better to go on than past results. Nothing else allows us to make better predictions.

For me, the fundamental question is this: Do I think that business can continue to thrive and prosper in the United States? At this point, yes I do. And so long as the business climate remains strong, businesses (and the stock market) will continue to grow.

• BrentABQ says 06 February 2014 at 10:21

Investing in the whole market is right especially in the long term. People will always need food to eat, homes to sleep in and transportation to get places. There will be more people needing these things than before and we will get better at providing them.

• Paul in cAshburn says 07 February 2014 at 06:40

The analogy also leaves out the Fed, which is entitled to at least 2% of your flock for “good” inflation. 🙁

8. Brian@ Debt Discipline says 06 February 2014 at 06:59

I’ll be adding some sheep after we finish our debt snowball. Thanks for the info!

9. Adam P says 06 February 2014 at 07:15

What about rebalancing? That’s sort of a key in the process of buy and hold investing. You should pick a time period, likely annually, and go back to the same split between equity and fixed income that you had when you began (eg 60% equity, 40% fixed income). This way you’re selling high and buying low in a robotic, emotionless fashion. This will add to your returns tremendously in the long run.

• David L. Wright says 06 February 2014 at 14:07

I agree with the idea of rebalancing. It’s a great opportunity to buy when the market tanks (think January 2014) or sell when the market gets over-bought.

That being said, there have been many different studies to done to see if rebalancing helps of not. The results are quite mixed.

Personally, I like the idea of rebalancing BUT only at regularly scheduled times or when your portfolio gets too out-of-balance. Don’t watch the market every day.

10. Stefanie @ The Broke and Beautiful Life says 06 February 2014 at 07:26

It’s funny… the analogy is more confusing than the investing strategy. Set it and forget it (mostly) is my motto and thus far it has served me well.

• Jeannine says 06 February 2014 at 17:10

Good post. I do agree, though – I got a little bogged down in the analogy, but the theme of the most and the investing advice was right on.

11. Crystal says 06 February 2014 at 08:20

Great reminder. 🙂 I’m heavily invested into target date mutual funds with my old 401k and my current Roth IRA…the ultimate “set it and forget it” strategy, lol. It has given me solid returns overall. Now I just need to open a SEP IRA or something similar to go along with it.

12. Jake says 06 February 2014 at 09:17

Would investing in a market index fund (like Vanguard’s VTSMX or VTSAX) be better in the long-term than a target retirement fund (Like the Vanguard 2050 VFIFX) with a similar expense ratio? The 1/5 year yield seems to be higher, so what are the advantages of the target retirement funds?

• David L. Wright says 06 February 2014 at 14:12

The expense ratio on many such funds is a bit high as the underlying funds tend to have higher-than-index fund expense ratios and they have an overriding expense ratio.

That doesn’t seem to be the case with this fund. The underlying components have low expenses and there’s no overriding expense.

So it seems like a good call

13. fred daily says 06 February 2014 at 09:21

The most dangerous wolves of all inhabit the wilds of Wall Street-and don’t all look like Leo DiCaprio. Unless you want to spend a lot of time learning about the wolf dens, and fruitlessly trying to beat the street, then investment history shows that index funds are the way to go. Right on J.D.

14. Kristin Wong says 06 February 2014 at 09:51

Needed to read this. I’m a control freak, and I’m always tempted to mess with my investments. This goes with William’s “buy and hold” advice the other day. I’ll have to learn to ignore a little more. Once again, slow and steady wins!

15. Simple Money Concept, LLC says 06 February 2014 at 10:17

The financial industry wants you to believe that investing is difficult. If you buy into their message, if you accept the premise that you need help to invest wisely, they can charge you big bucks to handle your money.”

Having spent more than a decade in the financial industry, I can probably understand and appreciate that statement more than most. You are absolutely right about investing:It’s simple.

Just like losing weight, the solution is simply watch what you eat and exercise. But if it’s that easy, all of us should be fit then. Are we?

I agree with your solution, and I think most people should simply take your advice, but a lot of them will never have the discipline to follow through. Sometimes they still need somebody to watch the sheep for them. If that means giving up a few sheep a year, so be it.

As long as you have enough money concept, you should be able to evaluate the person who’s watching your sheep.

Hopefully that person is not the wolf. Never trust the wolf!

16. Tyler Karaszewski says 06 February 2014 at 10:27

I currently contribute ðŸ‘17,500/year to my 401baa plan, and my employer matches another ðŸ‘4,000 on top of that. 90% of those sheep go to a stock index pasture, and the other 10% go to a bond index pasture. I sort of figure this is “pretty good” and if I want to try and tweak it later for better performance, I can, but I’m in a pretty solid situation as it is so there’s not real urgency to change it. In 20 years I hope to have much wool.

(not sure if the sheep icon will look right on every computer)

17. steve says 06 February 2014 at 10:57

J.D. – would recommend Fidelity or Vanguard, or is there much difference?

18. partgypsy1 says 06 February 2014 at 12:47

I kept looking for the comment of investors getting fleeced, but it didn’t happen. On purpose?

19. Mel @ brokeGIRLrich says 06 February 2014 at 21:34

I think one of the biggest perks of joining the personal finance community is learning about the stock market from people who actually use it. Initially I was more interested in learning how to live frugally and pay down debt, but more recently I’ve really enjoyed the advice I see about stocks and I take heart in the fact that real people, who seem to be doing ok, are all advocating a very similar strategy.

20. Lincoln says 10 February 2014 at 15:09

Kind of disappointed in this article. There’s a lot more that could be discussed here. How do different S&P 500 indexes differ from one another? Why does that matter? What if the S&P 500 doesn’t do well over the next 5-10 years — should you change your strategy? What opportunities do you potentially miss with an all index fund strategy? I’d love to hear what S&P 500 index fund JD actually uses, and I suspect someone can identify a better one that would perform better over time.

• Jacob says 19 February 2014 at 16:43

I think the reason you’re disappointed is because you’re looking for a different article. The point of this advice, and that of many others, is to KEEP IT SIMPLE. Pick a broad index that covers the market (there really isn’t such a thing as a “better one” considering you’re basically just tracking the market as is regardless) and is very low cost and then forget about it. Just keep adding money.

Changing strategies based on market performance is the definition of “timing the market,” which is one of the things this article is advising against.

21. Carlester T. Crumpler says 12 February 2014 at 08:03

A long winded way to make a point, but a great one indeed… that also makes a difference! It’s also interesting to note that wolves don’t just reside on Wall Street.

22. jason yale says 17 February 2014 at 18:35

Excellent article..

23. Julie says 28 February 2014 at 08:30

Isn’t FSTMX a mutual fund?

• David L. Wright says 28 February 2014 at 09:17

Yes, it is Fidelity’s total USA stock market index fund.

This fund will normally invest at least 80% of its assets in stocks in the Dow Jones U.S. Total Stock Market Index, which represents the performance of a broad range of USA-based stocks.

24. Reid says 18 April 2014 at 08:42

It’s a matter of time, and psychology. Stocks, in general, will always go up if you wait long enough.

At the same time, you have to remember that markets are controlled by humans and as such, are subject to some of the irrationality we all have. They often make disproportionate movements to the situation.. trying to guess what the markets will do is pointless.