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Beating The Dow:
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Chapter 3: Becoming An Investor
An Introduction To Compounding or How To Get Rich Over Long Time Periods

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The Millionaire Next Door

The Armchair Millionaire

The Armchair Millionaire

by Lewis Schiff and Douglas Gerlach

For investors looking for a simple, yet effective, investment strategy, The Armchair Millionaire by Lewis Schiff and Douglas Gerlach provides just such a strategy. Schiff and Gerlach tell us that any investment strategy implemented by most individual investors should be automatic. It should not be complex, nor time consuming. Yet, the strategy must be effective in building wealth over the long run.

Schiff and Gerlach write: "We call our program the Armchair Investing Strategy. While it includes investing methods that have been around, and have been used successfully for years, they have never been brought together into one comprehensive strategy."

The above statement is inaccurate, for "The Armchair Investing Strategy" is simply a passive investment strategy utilizing the power of compounding, paying yourself first, dollar cost averaging, investing in the overall stock market via low-cost index funds, and taking full advantage of tax-deferred retirement plans. Such a comprehensive investment strategy has been well-known for quite some time. The best selling book, The Wealthy Barber, was one book to propound just such a strategy.

However, while Schiff and Gerlach weren't the first to integrate such a strategy, the advice in The Armchair Millionaire is solid. Schiff and Gerlach write that even the legendary investor Warren Buffett recommends index funds for 99% of investors. The solid grounding of such a strategy can't be denied.

First, Schiff and Gerlach say that you must max out your deferred retirement plans, whether your plan is a 401(K), IRA, Roth IRA, 457 Plan (a 401(K) equivalent for government employees), or a 403(b) (another 401(K) equivalent for non-profit organizations). This is common sense. Whenever you can save substantial tax dollars, your investment money grows much faster. By using tax-deferred retirement plans, there is more money to invest.

The Armchair Millionaire has an excellent discussion of the ordinary IRA versus the Roth IRA. Schiff and Gerlach note that one nice feature of the Roth IRA is that investors can remove their contributions if necessary without penalty. Thus, the Roth IRA can provide an emergency source of funds.

The Armchair Millionaire quotes members of the community, which is divided about whether the IRA is superior to the Roth IRA. For more information about deciding between the standard IRA or the Roth IRA, The Armchair Millionaire refers readers to the web site

Schiff and Gerlach also suggest starting and maxing out a SEP-IRA or other tax-deferred retirement plan for small business owners and the self-employed. Here, the situation isn't so obvious because contributions must come from earned income which is taxed as self-employment income.

Some business owners have formed S-corporations to minimize the amount paid in Social Security taxes. These business owners receive much of their money as dividends, not earned income. Plus, money retained within a business often grows much faster than money invested in the stock market. So, while the decision to fully fund a SEP-IRA isn't as clear-cut, it's certainly something to consider. The Armchair Millionaire seems geared more toward employees who have regular income.

Second, Schiff and Gerlach say that you must pay yourself first. After automatically funding your tax-deferred retirement plans, invest regularly on a non-tax-deferred basis, preferably using an automatic investment plan. In an automatic investment plan, your brokerage firm removes a fixed amount of money every month from your checking account and invests it in stocks or mutual funds of your choice. You don't need to invest much every month, but in time, your portfolio will grow greatly. The authors suggest investing 10% of your monthly income.

By paying yourself first, you guarantee that you are setting money aside every month to invest. Schiff and Gerlach suggest paying yourself is simple, and you will quickly find that you can easily live on the remaining 90% of your income, once you impose just a bit of discipline.

Many investors adopt budgeting to determine how much money to invest. Schiff and Gerlach claim "budgeting stinks" because it is too time consuming and the typical investor will abandon doing it. This is an excellent point. However, for those individuals with irregular income, such as some self-employed people, I feel budgeting is often superior. If you don't know how much income you will receive every month, you might not want regular deductions made from your personal checking account. In a low-income month that just forces you to come up with more money, which is often difficult.

Third, The Armchair Millionaire suggests investing 100% of your money into stocks, assuming you are a long-term investor who can ride out stock market volatility. This seems reasonable.

To show the superiority of stocks as an investment over the long run, Schiff and Gerlach write: "If your grandfather had put $1 in the bank on the first day of 1926, he'd have ended up with $16.06 by June 30, 2000. That's a 3.8 percent rate of return over 74 years. That's pretty dismal, but wait-it gets worse when you add in the effects of inflation. Inflation is nothing more than the rising cost of goods and services. Inflation is a loaf of bread that costs $1.79 today, the same loaf that your mom used to buy for a dime or a quarter when you were a kid. Over time, inflation in the U.S. has grown at an average rate of 3.1%, and it impacts your investments just as it impacts the cost of bread. Adjusted for inflation, that dollar your granddad invested in 1926 is now worth about $1.67"

That's a pretty strong case for not holding cash for long periods! Schiff and Gerlach go on to note that long-term government bonds have grown at only 5.2% and corporate bonds at 5.7%. However, stocks have yielded a much higher long-term rate of return.

(Incidentally, the above makes it clear that the Fed can't keep cutting interest rates to stimulate the market indefinitely. At a certain point, the rate of return on bonds is so low on an inflation-adjusted basis that investors will look for other places, such as abroad, to invest their money. Would you invest in bonds which are essentially giving you a zero percent rate of return? It's like opening the spigot on a hose. It only opens so far.)

Schiff and Gerlach write: "So let's say that Granddad invested in the stock market in 1926. Perhaps you're familiar with the history of the stock market and know about a not-so-minor event that happened in 1929 when the stock market crashed. What you may not know is that 1929 wasn't the worst of it. Over the next three years, the market continued to decline, making paupers out of millionaires. Granddad's $1 investment in 1926 would have been worth $2.20 at the end of 1928 (doubling his money in two years), but that $2.20 would have been worth just 79 cents at the end of 1932. Ouch!... But your granddad was smart. He didn't get spooked by the market, and he remained invested in stocks, even though there were many more times when the market would jump and fall dramatically. By mid-2000, his $1 investment would have been worth $2,833.51. We'll do the math here-that's an 11.2 percent annual return on his investment over the seventy-four-year period."

Schiff and Gerlach go on to explain that falling markets and market volatility actually can help the investor who invests regularly because of the power of dollar cost averaging. Dollar cost averaging means that if you're investing a fixed amount per month (or annually), as the markets fall, you're able to buy more shares of stock.

To demonstrate dollar cost averaging, consider a stock or mutual fund which starts out at a price of $10 per share. You invest $100 every month. You buy 10 shares the first month. Then, next month, the stock drops drastically to only $5 per share. You continue to invest your $100 and buy 20 shares. The next month, the stock zooms up to $15 per share. You invest $100 buying 6.67 shares. Finally, the stock drops back to its original price of $10 per share, and the final month, you buy 10 new shares.

The average price of the stock over this period is (10 + 5 + 15 + 10)/4 = $10 per share. You invested a total of $400, and you purchased a total of (10 + 20 + 6.67 + 10) = 46.67 shares of stock which are now worth $466.70. So, despite the stock not increasing in value over the period, you actually have a positive rate of return. This is due to the volatility. You were buying more shares of stock when the stock was down and fewer shares of stock when the stock was highly-valued. Your average cost per share was $400/46.67 = $8.57 per share.

Schiff and Gerlach explain that dollar cost averaging is a powerful benefit to long-term stock market investors. So, we don't need to be able to time the markets. All we need to know about the stock market is that over long-time periods, the general direction is up. Then, we must invest regularly. Schiff and Gerlach write that the best time to invest in the markets is "All the time!" This is probably fortunate, because timing the market is impossible.

So, how do we choose which stocks belong in our portfolios? According to Schiff and Gerlach, we don't. They suggest buying 1/3 each of a U.S. large company index fund, a U.S. small company index fund, and a large company international fund. This is a great option for most long-term investors. It's simple and takes little thought. And, as Schiff and Gerlach note, professional money managers on average have a notorious time beating the market, so you will do reasonably well with such a strategy.

The Armchair Millionaire does a great job of explaining indexing. And, I must give it bonus points for unearthing and mentioning the obscure index, "The Bloomberg Football Club Index," which represents publicly-traded British soccer teams. That's a hoot and made my day! Not that you should invest in it, of course!

What about individual stock picking? The authors write: "All the academic research points to just one conclusion: It's impossible to build a portfolio based on individual stock picking, if you want to reduce your risk and still maintain a decent return." And, they invoke the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT) to justify the statement. I disagree very strongly here.

While index funds are a great option, the Efficient Market Hypothesis is pure B.S. The Efficient Market Hypothesis states that all information that can be known about a company and its stock are incorporated into the stock's present price, so superior knowledge and analysis can't lead to finding undervalued opportunities in the stock market. The Efficient Market Hypothesis says that all stocks are fairly priced according to the opportunity they represent.

Consider the example given on the investment index of this site. A rumor about BMC led to a rapid increase in stock price for a different BMC, one the rumor wasn't even about (not that you should be investing based upon rumors!). Is this an efficient market?

Or how about the new upstart (now bankrupt) with a few million in sales, no operating history, no profits, being more highly-valued than the established, much larger and profitable Toys R Us? Is this an example of stock market rationality?

Or how about another start-up,, which went from an excessive valuation based upon greatly optimistic growth prospects to being valued for less money than the company holds as cash in the bank and marketable securities? Is it possible, in only two short years, that the long-term outlook for the company has changed so drastically? Or, is it more likely investors overreact and behave irrationally at times? I tend to think the later.

The Armchair Millionaire doesn't give any advice about picking individual stocks. But, I feel individual opportunities can be found. Is searching for such opportunities interesting to you and worth your time? That's something only you can answer. But, for the core of a person's portfolio, the Armchair Investment Strategy makes great sense. Especially for busy investors who have little interest in the stock market, such a passive indexing strategy is an outstanding option.

The final point of The Armchair Investing Strategy is to get started now. Getting started early in your investing maximizes the power of compounding.

Overall, The Armchair Millionaire is an excellent book that provides solid advice. However, for many experienced investors who already understand the power of compounding, dollar cost averaging, paying yourself first, maximizing contributions to tax-deferred retirement plans, the book is a bit basic.

The Armchair Millionaire is also a fun read because it quotes many members, some of whom have great comments. My favorite: "I, on the other hand, am a saver and can pinch a penny until it begs for mercy." ( member debsan)

The Armchair Millionaire by Lewis Schiff and Douglas Gerlach
The Armchair Millionaire

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