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
flockinvestments 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.
Author: J.D. Roth
In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.