When it comes to saving and investing money, the first hurdle that most people need to overcome before they can start is often times a self-imposed mental block. The idea that managing their own finances is too complicated for them to understand can typically get in the way of just getting started. The Forbes/CFA Institute Investment Course: Timeless Principles for Building Wealth understands this and tackles that topic head on in its very first chapter. Much like a distance runner prepares for a marathon, everyone needs to take the same approach when it comes to managing and investing their money to build capital. Whether the goal is to invest for retirement, a child’s higher education cost, or anything else, sound management of personal finances is a long and steady journey, not a quick sprint.
As part of Equities.com’s mission to better inform and equip self-directed investors to handle the market, each week we will interview one of the co-authors of The Forbes/CFA Institute Investment Course to learn more about their background, and why the investing principles covered in the book are as relevant now as ever before when it comes to building wealth. You can read the first interview with co-author Vahan Janjigian, CFA here.
In this week’s interview, we spoke with Stephen M. Horan, CFA, to discuss the important steps everyone needs to take in assessing their own assets, goals and risk profiles before entering the market. He also discusses how a small amount of money–even as little as $11 a day–can help you become a millionaire over time. In addition to working as the head of professional educational content for the CFA Institute, he is also the editor of Private Wealth: Wealth Management in Practice as well as a frequent columnist for the Financial Times.
EQ: To start off, can you talk about your background and involvement with The Forbes/CFA Investment Course?
Horan: Before I joined the CFA Institute, Vahan Janjigian and I teamed up during the mid ‘90s to work on what was then called The Forbes Stock Market Course, which had been around since 1948. Personally, I’ve had a career in private wealth management, done a lot of expert witness support for securities litigation, and taught finance at the college level. All of that brought me to the CFA Institute, at which point, Vahan and I put our heads together and really thought that the parallel missions of Forbes and the CFA Institute made for a great opportunity to revisit The Forbes Stock Market Course, not just in terms of how it’s branded and presented to people, but also in terms of expanding the scope beyond just stock market investing. The book now has a broader mandate than what was originally envisioned in 1948. In fact, this is the first time the course is presented in book format. The way the previous versions were packaged before were really designed as a three-ring binder notebook. So this book has a lot more fit and finished to it, if you will.
EQ: The first chapter of The Forbes/CFA Institute Investment Course covers the concept of building capital. Why is building capital and investing a necessity for everyone?
Horan: The answer to that question is what makes this book so important, because the answer today is different than what it would’ve been 10 years ago. Now, more than ever, individuals are being assigned responsibility to prepare for their own retirement. Employers and corporations are pulling back on their defined benefits and pension plans, and replacing them with them defined contribution plans. Governments are finding it increasingly difficult to fund the social security obligations that they’ve made to citizens. Along the way, we see in Greece and Spain an increase in the retirement age. In the U.S., although we’re not fully engaged in that conversation, it’s an issue that’s been brought up from time to time, albeit not during this phase of the election cycle. As a result, it becomes very important for the individual to become properly educated and armed with the proper tools to make the appropriate investment decisions. That kind of planning, at least around retirement, is no longer being done for them.
Unlike a pension plan, however, individuals don’t inherently have access to a wealth of resources and expertise. That said, there’s a lot we can learn from how pension plans go about it. Pension plans start with an understanding of their balance sheet. So as individuals, we should think about what our own balance sheets look like. You have to know what kind of assets are on there, whether they’re financials assets like what you see on bank and brokerage statements, or physical assets like our homes, jewelry, art, and other possessions. There are also implied assets like the value of our labor, and what kind of human capital we have in economic terms. Once we have that laid out, we then can compare it against what we want to achieve with our investments. So what are your aspirations for retirement or for sending children to school? We need to have an understanding of that before we can understand how well-funded we are to achieve those goals and to determine whether or not we are in a good financial position and what our risk tolerance should be.
EQ: So taking that one step further, before jumping into the market, or any other type of investment, what are some critical steps that people must take? Why is understanding your financial position, outlining goals, and assessing risk profile important?
Horan: Before jumping into the market, we want to have a good inventory of what our assets are and compare those with what our liabilities are. Some liabilities that might offset your assets could be things like mortgages, car loans, and education costs for children. We need to be prepared for those costs and that will help us figure out where our net worth is. In the case of education costs, it may not be a debt for which we receive a monthly bill, but it functions very much like a debt when the kids are ready to go off to school and the bill come due. So you have to adjust accordingly. Also, you need to have a sense of what your personal income statement looks like. Ideally, our income exceeds our expenses and we have extra cash coming in on a periodic basis that we can use to help build capital. If that’s not the case, then we need to go back to our principles and think about some basic financial and expense management to ensure that we have the proper foundation to grow capital.
This type of basic financial management may not be what propels individuals into new wealth brackets, but it’s the backdrop for prudent investment decision making to help reach longer-term goals. It’s also critical to understand that a prudent investment is not the thing that ends up changing your life. If an investment changes somebody’s life (positively or negatively), it probably was not necessarily a prudent, diversified-based decision in the first place.
EQ: Given what has happened in the stock market over the past few years, why should long-term investors still prefer stocks over other asset types when trying to build wealth?
Horan: I don’t think it’s so much a question of preferring one asset class over another as much as it is viewing it from a context of having a balanced asset allocation strategy and viewing asset classes in a comprehensive manner. For most people, stocks are going to be an important part of their asset allocation, and it may vary from a large one or a small one. But as long as it’s going to be part of your asset allocation, you really need to have an understanding of how it is you’re going to go about implementing that part of your asset allocation.
Are you going to index? Are you going to pick your own stocks? Are you going to follow recommendations of an advisor or broker? So, it’s not so much about it being exclusive, but more so being combination of each. The other thing I’d say with regard to where we are in the cycle right now is that rates on fixed income instruments are at historic lows. So, although the equities market might look tenuous to some investors right now, the fixed income alternative may look even less attractive. There is still an enduring expectation that investors are taking on additional risk in the stock market versus the bond market, and the only way to entice them to do that is to offer the expectation of higher returns, at least over the longer period. That’s no guarantee but that basic fundamental economic principle still holds true, maybe even more so given that rates on fixed income are so low, and in some sense, held artificially low by central banks.
EQ: The chapter discusses some ways investors can minimize risks from market swings. What are some common strategies discussed in the book that helps investors to do so as well as to help maximize returns on short-term volatility?
Horan: Some of the methods discussed are very familiar but no less relevant today than they were decades ago. The first one I’d have to point to is diversification. We talked about pre-investment strategies rarely propelling you to the next wealth level. That basically means that if you follow a diversified investment strategy, you’re unlikely to win the lottery, but you are doing a lot to manage your risks. That does not mean you’re going to be able to eliminate risk entirely, and I think part of the misunderstanding that has led to some serious challenges to the concept of diversification is the financial crisis. During the crisis, most investors lost a lot of money regardless of whether they were diversified or not. In that regard, I would ask people the question that if diversification didn’t work through the financial crisis, then did not being diversified and being concentrated in one asset work better? Your answer would be very different depending on where you concentrated your investments. If you focused heavily the auto industry, housing market or the banks, you probably did a lot worse than had you been diversified. Then again, if you were concentrated on some other sectors, you might’ve done better. So if I think about the areas where I might’ve concentrated my assets during the financial crisis, I still feel really good about diversification.
The other risk management concept that actually doesn’t get a whole lot of play is the notion of liquidity. You have to make sure you understand when it is you’re going to need money. You have to determine your liquidity needs because the shorter term your needs are, the smaller your window is to let your investment strategy play out. If you’re sending a child to school next year or you’re going to begin your retirement next year, then you want to be more thoughtful about the volatility of your investments. We don’t want to be in a position where we’re writing our first tuition check the week after the stock market decided to go down 25 percent.
EQ: A good example of how everyday investors can build wealth over time is discussed in the first chapter. What is the concept of dollar cost averaging, and can it really turn $11 a day into $1 million over time?
Horan: We are big fans of dollar cost averaging for a variety of reasons. First, $11 a day is $4,000 a year. That’s a reasonable investment by almost anyone’s standards. Beyond that, there are two other things that really help turn $11 a day into $1 million over a number of years, and one is the familiar concept of compounding. Starting early allows us to earn interest on our interest and returns on our returns, and we kind of let the market do the work for us. A really interesting anecdote I learned as a child from my mother is that if I started to save for retirement at age 18, and stopped at age 26, I would have more money at retirement than if I had started at age 27 and continued to save the same amount annually until the day I retired. That of course is an example of the power of compounding.
The other thing that helps turn $11 a day into $1 million is how dollar cost averaging capitalizes on getting volatility to work to our advantage. It basically turns volatility on its head because investors normally think of volatility a bad thing. However, in a dollar cost averaging context, volatility is actually a good thing because it allows us to purchase more shares at exactly the time we want to when the market is down, and when the market is up, we’ll purchase fewer shares at that higher price. So over time, we’ll get volatility working to our advantage.
Another benefit of dollar cost averaging that shouldn’t be overlooked—and it’s less mathematical but really important—is the discipline and the habit that it creates for us as investors. It just helps us to integrate capital accumulation into our day-to-day lives. We don’t have to worry about consciously making that decision at specific points in time. Just making the right financial management decision goes a long way to accumulate wealth.
EQ: So it helps to take human emotion out of the equation, which can have negative effects on investing most of the time?
Horan: No question. Sometimes we’ve seen the enemy and it is ourselves. it’s especially valuable for those of us who don’t necessarily have a lot of wealth in place at the moment. If you had a pile of money in hand, right now that’s ready for investing, I recommend putting that all to work right away. The evidence shows that on average it is the better strategy. With that said, dollar cost averaging is very valuable when we’re going to be accumulating wealth over time. It allows us to systematically put it to use.
EQ: Do you have anything you’d like to add in regards to the first chapter of the book and for people starting to build capital?
Horan: I would encourage investors to not start by focusing on expected returns. I get asked all the time, “Is this stock going to go up or that stock going to go down?” Or, “Is this stock a good investment?” I can’t answer the question of whether or not a stock is a good investment for you without a whole lot of other information about you. Investors need to consider risk of particular investments, as well, and whether or not it’s appropriate for their particular situation. That’s where building a personal balance sheet and building your personal income statement comes into play. It helps identify which risks you can absorb and which you cannot. Investing is not a one-size fits all activity because what’s right for you might not be what’s right for me and vice versa.
*Editor’s Note: Test your knowledge on building capital and other investing concepts with The Forbes/CFA Investment Course online quizzes. You can take the Chapter 1 quiz here. Access additional materials to enhance your financial education with webcasts, articles and more as well.