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Tuesday, April 25, 2017

Poor Richard. The Tools.

Poor Richard invests into Standard & Poor’s 500 Index (ticker $SPX).

To be absolutely clear, Poor Richard Method (PRM) is designed exclusively to be used on S&P500 – Index of 500 best large-capitalization US stocks. It will not work on any other index, ETF, commodity or bonds, and most likely lead to massive losses if tried.

Many people call S&P500 ‘The Market’, but it is an erroneous assumption. ‘The Market’ is over 7000 issues traded on major exchanges, of which about 4000 are American stocks (and only half are really tradable). The rest of them are ETF’s, bond funds, foreign stocks and more of god knows what. S&P500 is not ‘The Market’, but it is an accurate representation of the leading, most prosperous and the biggest enterprises in USA, as well as true reflection of THIS particular slice of economy, at the time. Index is re-balanced quarterly so weak companies and declining stocks are removed and replaced with new rising stars. Weighting of stocks in Index also changes and shifts over time according to their methodology, which (understandably) is a closely guarded secret.
S&P500 is not a static, frozen in time list of stocks, but a dynamic rotational system – An Active Index.

S&P500 has been ‘fixed’ so good, that (on average) investment fund managers are not able to beat it performance for years, and may be at-all. It is really A System – very crude, but extremely robust if used correctly. S&P500 index was never intended for day-trading and short-term speculation, but unfortunately it’s all we ever hear about. What is mostly absent from discussion is the true purpose of Index: a meaningful and rational investment of savings into diversified group of best stocks for tax-efficient accrual of ultimate surplus value.

Poor Richard’s investment of choice is Vanguard 500 Index Fund (ticker VFINX) – a mutual fund closely tracking an Index itself. VFINX is passively managed - simply replicating weightings, composition and all the ‘voo-doo’ done by wizards at ‘S&P Dow Jones Indices’ (link at the top of article). Vanguard funds are very well managed and have some of the lowest expense ratios in the business. They are bought and sold without commission, offer free dividend reinvestment and can be traded on their easy to use website.

Mutual Fund is The Best way to reach a ‘Holy Grail’ of investing – a Compounding Interest. When investment pays a dividend, which is promptly re-invested by purchasing additional shares, these new shares will also accrue dividend in due time, and so on continuing to compound these by generating 'interest on interest’. Albert Einstein called Compounding Interest an 8th wonder of the World, the most powerful force in the universe and the greatest invention in human history. He also pointed out that those “who understand it – earns it; who doesn’t – pays it”. Mutual funds are traded in fractional shares, so entire dividend can be fully re-invested, making compounding even more efficient. Practicing Poor Richard Method will lead you to deep understanding of this (almost magical) feature of financial markets and give you a REAL EDGE for investing in stocks.

Poor Richard should be traded in tax-efficient account, where taxes are delayed for many years. The easiest way is to open a 'Traditional IRA' (Individual Retirement Account) at Vanguard, which will give commission-free access to all of their mutual funds. Money should be transferred from your bank account into Money Market Fund (ticker VMMXX) first, and stay in there until it’s time to make a ‘Trade’ – an ‘exchange’ between your Money Market fund (cash) and S&P500 fund. The ‘Trade’ of mutual funds happens once a day, on a close of market at 4pm ET, but you have to make sure to have your order in by 3pm. Mutual fund’s end-of-day price is called NAV (Net Asset Value). It’s published couple of hours after market close. NAV is kind of meaningless number, because trade is set in dollar amount (not a share count) – investor gets fractional shares to cover whole amount precisely.

Not all mutual funds created equally, especially when it comes to what they charge. All this great commotion isn’t exactly free, you ‘no. Vanguard is famous for ultra low cost funds. Their ‘500 Index Fund’ VFINX has expense ratio of 0.16%, meaning you pay them $1.60 for every $1000 invested per year. They require $3000 to get started with no minimum for additional contributions.
This and other information is available here:

Another popular kind of retirement account is '401K' – same thing, only you get it thru your employer. 401K will come with a list of different mutual funds, often from non-related providers. In this case your choices are limited by whatever somebody picked for investment options. Usually, there will be some kind of S&P500 fund, but don’t trust the name – find this fund’s information, its description and facts from their own website. By law, everything has to be explained in plain English.

401K from your job may be the way to get into some mutual funds you wouldn’t qualify for on your own. For example, Vanguard offers that same ‘500 Index Fund’ as Admiral Shares (VFIAX), that have even lower expense ratio, but require $10K initial investment. 401K removes this obstacle – they allow you to start from zero. And of course, there is a mother of all S&P500 funds – ‘Institutional Index Fund’ (VINIX), with 5 Million minimum and unbelievable 0.04% cost. That is 40 cents for $1000 invested per year… I have seen it. It was used in relative’s 401K without minimum requirements. No problem.

Vanguard family of S&P500 Index funds is the largest in the World, running nearly 500 Billion dollars!

Few more things.
     There are limits to how much of tax-deferred money can be contributed every year. You can’t just move a load of money into tax-deferred account – they have to be accumulated there over time, year after year. “Little strokes fell Great oaks”, as Poor Richard said.
     Many 401K offer ‘A Match’ – when your employer is matching some of your contributions. Make sure to set up an account in such way that all deposits/contribution go into Money Market Fund, otherwise they could just deposit it randomly into any mutual fund in account or even open a new one (I’ve seen it. Stupid, right).
     Don’t go buying mutual funds thru your local bank branch. They will charge you commissions, or there will be a ‘Load’ (fee for selling), or something else. It’s just not the way to do it. Be serious and treat this thing like your own little business on a side. Open an account at Vanguard or Fidelity. Consider it carefully. You may have this account for a long-long, long, long time.

I am not affiliated with Vanguard and not making an advertisement here.
I have been a client of Vanguard for many years and own VFINX because of reasons outlined above and some others. There are many other mutual funds based on S&P500 Index, so if you happened to get a different ‘Tool’, make sure to do RTFM – Read The Fucking Manual… (tips hat)

.this is a second article in 'Poor Richard' series.
Read Part 1: Poor Richard. Introduction.
-reading part 2-

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