How a Second Grader Beats Wall Street: Book Notes

These are the key ideas from the book How a Second Grader Beats Wall Street by Allan S. Roth:

1. Applying the Golden Rule: 10(Market return)-2(Costs)=8(Average Investor Return). The main lesson is if you pay too much in costs you will have less return. Ask yourself how much are you paying in costs. The more you pay the less return you are going to get.

2. Apply the golden rule of diversification: By just owning three funds you can have the ultimate diversified portfolio. You have less expenses, less taxes, less risk and higher returns. The three funds/ETFs you need to own are:

  • Total US Stock Index
  • Total International Stock Index
  • Total Bond Index

This portfolio for different levels of risk can be made as shown:

Second Grader Portfolio for different levels of risk

3. Apply the golden rule of market immunity: Perception and reality are two different things. People(the financial industry) aren’t out to make you rich. They want to make themselves rich. They have, are and will devise new ways to separate you from your money. They want us to believe that they will provide superior returns, while buying a portfolio like the above will actually get you superior returns. Simplify your investing. The way to do is by investing in three asset classes mentioned above.

4. Apply the golden rule of not acting silly with your money: Admit that you are human and human emotions can prevent you from investing rationally. Some things that may help you to change your behaviour are:

  • Be greedy when others are fearful, and be fearful when others are greedy.
  • We are brilliant at predicting the past but no one knows the future.
  • The odds are that you don’t know the odds. Past performance is not indicative of future performance.
  • We are all not above average investors. If you own the entire market with lowest costs and lowest taxes you will beat most investors in the long run.
  • A pattern that has predicted the future is very different from a pattern that will predict the future. If everyone follows a strategy, that strategy will not work.
  • Find flaws in your logic and the logic of others. It is easy to consider certain information and leave out other information which may be critical.
  • Our mind believes what it wants to believe. If you think you are beating the market, then really compare your returns.

How to keep from beating yourself

  • Avoid the “sure” thing.
  • Don’t invest in what has been hot.
  • Think twice before you act.
  • Don’t follow the herd.
  • Track your feelings
  • Ask yourself whether you are making decisions from the emotional, reflexive side or the logical side of your brain?
  • Can you explain what you are doing to a second grader?

5. Apply the golden rule of going with the odds: Know the odds of the game you are playing because not knowing them will cost you. Don’t bet against simple mathematics:10-2>10. Costs matter. Decrease taxes by indexing. Stay the course. If you can’t stay the course, then be greedy when others are fearful and be fearful when others are greedy. Active investing is like smoking. You can smoke two packs of cigarettes and live to 100 but it is highly improbable. Not smoking however dramatically improves the odds of living longer and healthier. Make the choice that is healthy. It is simple but not easy.

6. Apply the golden rule of correlations: Adding REITs( maximum 10% of your stock allocation) and precious metals stock( maximum 3% of your international stock allocation) can decrease volatility. This means a maximum of 9% (6% REIT, 3% precious metal stocks) while 91% is invested in the three funds mentioned above.

7. Apply the golden rule of lending money to someone who will pay you back: Bonds stabilise returns. Buy low cost bond funds that are investment grade and intermediate term.

8. Apply the golden rule of lending money if it is guaranteed by someone trustworthy: Look for high interest CD rates from companies that are trustworthy.

9. Apply the golden rule of not betting your lunch money: Always keep at least 10% in stocks and at least 10% in bonds. Money that you need for the next 5-10 years should be in fixed income. Be fearful when others are greedy and greedy when others are fearful. Put about 1/3rd of your stock portfolio in international stocks. Say no to preferred stock, convertible bonds and derivatives. Stick to your asset allocation no matter what. Don’t look at your portfolio often. Rebalance periodically, perhaps when any asset class varies by more than 10% from its target. Buy the asset class that is underweight. Rebalance in tax deferred accounts first, realize long term gains first and don’t sell short term gains unless you really have to, which is probably never.

10. Apply the golden rule of paying less taxes: 

  • Taxable accounts: Broad stock index funds, low turnover stock funds, tax managed funds
  • Tax-deferred accounts: Taxable bonds, REITs, CDs, high turnover stock funds, fun gambling stock accounts

11. Apply the golden rule of staying away from something too good to be true: Make sure you can explain the following:

  • How does the product work?
  • How do others make money when you buy the product?
  • Does it pass the smell test? As yourself why are being pitched a product?
  • What is your exit strategy?
  • Never buy a product immediately

Some warning signs:

  1. It looks too good to be true
  2. It’s good for a certain time only.
  3. It involves signing something you haven’t read or understood.
  4. The person selling it uses religion or some other bond to build a rapport with you and win your trust.

Avoid insurance investing, investment newsletters, investor education and software and avoid gurus giving self-serving advice( like those who say to maximize your mortgage and that pretax retirement plans are bad)

12. Apply the golden rule of picking the low-hanging fruit: Get the highest interest rates for your cash. Get rid of expensive debts. But cheap index funds. Invest appropriately in taxable and tax-deferred accounts. Find cheaper options of buying things. Find tax savings wherever you can.

13. Apply the golden rule of second grader investing: Keep things simple enough to explain it to anybody.Be emotionless when it comes to investing. Remember that costs matter and a 1% increase in performance gets you to your goal 4 years earlier. Everyone cannot be over average. If the product is so good why are they not investing in it and offering it to me? If they really knew how to beat the market why should they tell others? Remember that Wall Street will always be developing new products and sales techniques to separate you from your money. Spread your nest egg across the globe. Investing is simple but not easy.

14. Remember the purpose of money:

money versus happiness

If you don’t have money to pay your bills, for food and shelter you will be stressed and miserable. Yet once your finances reach a secure level, each additional dollar brings less reward. Three purposes of money according to Jonathan Clements are:

  • Having money makes us worry less about money.
  • Money can give you freedom to pursue your passions.
  • Money can buy you time with your friends and family. Studies show that regularly seeing friends and family can provide a huge boost to happiness.

15. Don’t look at what the market is doing: Focus on the long term and not the short term. It is impossible to tell what the market will do over a short period. Investing is simple. Don’t believe people who say the stock market will never come back.