By: Dividend Sensei
The number one reason that people under perform the market is trading costs. They trade too often, they pay too much in fees, and they attempt to trade the market. Thus in order to become a master investor here’s what you need to do:
- Determine what kind of investor you are, your goals, time horizon, and risk tolerance.
- Master your emotions, come up with a plan for how to build your portfolio, and more importantly when to buy and sell, based on pre-determined rules that take the emotion out of the decision. Believe me, when the markets are being crazy the last thing you want to do is fly by the seat of your pants.
- Choose a broker to minimize costs
This last part might be surprising for many investors but let’s look at it this way. If you are paying$10 per trade then in order to stick to the rule of thumb of keeping commissions to a maximum of 1% to 2%, you need to buy in increments of $500 to $1,000. Depending on your budget that might mean you can only buy one or two stocks a month; potentially missing out on a lot of great opportunities presented by markets going mad.
Personally I use Robinhood, which lets me trade for $0 commissions, and thus keep my costs to zero. While this is a bare bones broker, which currently only offers long only taxable accounts it meets my needs and will help me achieve my financial goals much faster.
Consider this: Since 1871 the S&P 500 has average a total return (meaning including dividend reinvestment) of 9.1% CAGR. Assuming that you use a low cost index ETF with an expense ratio of 0.1%, such as Vanguard’s S&P 500 ETF (VOO), that means you can expect, over the long-term, to earn 9% a year. Keep in mind that assumes you dollar cost average in every month and never sell; essentially ignoring the market.
Let’s say you can afford to invest $1000 per month and you buy VOO with a broker whose commissions come to 0%, 1%, or 2%. Your total returns, including expenses would thus equal 9%, 8%, or 7% CAGR.
Now assume that you begin investing at the age of 30 and keep investing $1,000 every month until you retire at 70. How much would you have?
With 2% commission cost: $2,563,314.77 portfolio value that pays $51,266.30 in annual dividends
With 1% commission cost: $3,357,372.40 portfolio value that pays $67,147.45 in annual dividends
With 0% commission (Robinhood): $4,419,502.54 portfolio value that pays: $88,390.06 in dividends
As you can see that 2% commission cost can make a huge difference, and over 40 years ends up costing you nearly 2 million. More importantly, the difference in dividends alone is basically equal to the maximum you can expect from social security.
And let’s not forget two important facts. First, you should try to save and start investing, even if only in a low cost, index ETF, as soon as possible to maximize the time your money has to compound for you. And two, just because you retire doesn’t mean you suddenly sell everything and go to cash. After all, you don’t know how long you’ll live and inflation will eat away at your buying power over time.
Which means that, ideally you should be investing for even longer stretches of time, and the longer your time horizon the larger the effects of low or no commissions become.
Here’s the same numbers but for a 50 year period.
2% commission costs: $5,219,831.31 paying $104,396.63 in dividends per year
1% commission costs:$7,436,061.06 paying $148,721.22 in dividends per year
0% commission costs: $10,661,293.30 paying $213,225.87 in dividends per year
Notice that over just another 10 years the difference between 2% trading costs and 0% grows from just under $2 million to $5.4 million. Also note that the dividends alone from the 0% portfolio, even accounting for 50 years of inflation, will be more than enough to fund a very comfortable retirement. In fact, you would be able to live on just 50% of the post tax dividends, reinvest the other half, and be 100% guaranteed to never run out of money no matter how long you lived.
That is the key to financial independence: Investing consistently, keeping costs low, and reinvesting the dividends. Note how timing the market, and avoiding big crashes, and catching the next “hot stock” are not on that list. That’s because, while all those things are great in theory, history teaches us that almost no one can do them consistently over time.
My goal is to teach you first and foremost how to invest better, so you can become financially independent. While I am passionate about individual dividend growth stocks, because studies show these to be the best long-term performing asset class ever discovered, at the end of the day even something as simple, and boring as an S&P 500 index ETF can make you rich, as long as you can be disciplined, patient, master your emotions, and keep your costs as low as possible.
Note: I have never received, nor would I accept compensation from Robinhood