Where to begin?
Posted in Money by Klives
Thanks to George for allowing me to post here. I did enjoy reading Kilgore’s essays. I am not Kilgore, nor am I Warren Buffett, Peter Lynch Phil Fisher or John Neff. I am a hack investor and even worse writer. Nonetheless, by writing these posts, I hope to reinforce some basics points on investing and hopefully stimulate some conversation to develop some new and better strategies on how we can all increase our returns.
When I read a news article or report I fancy, I’ll bring it to the attention to others here and give my opinion. I am not interested in partisan politics. I am more interested in investing, so I can make some more dough.
My basic investment philosophy is not, as the quote goes, “Don’t just stand there, do something”. For the most part it can be summed up with the newer cliche, “Don’t just do something, stand there.”
Where to begin? I’ll start with some short points. Then maybe delve a little deeper into these ideas with posts later. I don’t claim that these are original ideas or my own. They are just points that I have picked up from reading books, articles, or heard over the radio. They come from people who I think are a lot more knowledgeable on the subject matter than I am.
Is investing an art or a science? It is neither. It is instead a very special problem in engineering, determining the most reliable and efficient way to reach a specified goal, given a set of policy constraints, and working within a remarkably uncertain, probabilistic, always changing world of partial information and misinformation, all filtered through the inexact factor of human interpretation.
How should someone start a plan to invest? The first thing an investor should do is determine their risk tolerance. This is very important factor to determine their asset allocation, which many people I talk to never develop and I believe should be the second course of action. In the trade-off between the conflicting goals “eat well in the future” versus “sleep well now”, the sage advice is to sell down to the sleeping point. An investor should be at sweet spot where their zone of competence and zone of comfort intersect.
Should an long term investor use index funds? In the 1996 Berkshire Hathaway Annual Report, Warren Buffett recommends that individual investors should consider indexing. “Let me add a few thoughts about your own investments. Most investors will find that the best way to own common stocks is through an index fund that charges minimum fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” I’ll spend more time on this one on a later post because it probably the most recommended strategy by advisors that I respect.
Archimedes is often quoted as saying, “Give me a lever long enough and a place to stand, and I can move the earth.” In investing, that lever is time (and the place to stand, of course, is on a firm and realistic investment policy). Time often transforms investments from least attractive to most attractive – and vice versa – because while the average expected time of return is not at all affected by time, the range or distribution of actual returns around the expected average is very greatly affected. The longer the time over which investments are held, the closer the actual returns in a portfolio will come to the expected average. This is another topic that deserves its own post.
Speaking of time, this is getting long and I haven’t even really said anything yet…
September 29th, 2006 at 9:14 am
Good points here. The idea of the “time lever” is one that can help a lot of people plan for retirement. Since people are myopic by nature, it’s difficult to convince someone to stash a certain percentage of their income away for a long period of time (20-40+ years). However, if one can be convinced to look at the wonder of compound returns, it makes “losing” some current income for future income more than worth it.
When you buy into an index fund, you buy into an index. Look at what would happen to your returns if you bought into a major index 30 years ago:
[graph].
Whether you invest in the Dow, the Nasdaq, or the S&P, you’re getting a return greater than 1000% over 30 years. This trend is evident for nearly every 30 year time period in recent history.
How to optimize that return to get the highest possible return is a different story. However, the lesson here is that the earlier you get into the market the better, and index funds are a beautiful way to do so.
September 29th, 2006 at 9:09 pm
Ditto on the time lever… I am only a couple pages into a book “Common Sense on Mutual Funds” by Vanguard Founder Jack Bogle, and it basically preaches the idea that balance is key. You can take risks but only with the money you allocate for risk taking.
September 30th, 2006 at 3:02 am
I want to read Bogle’s book. It is highly recommended.
For the years, 1920 to 2002, the geometric mean growth of the S&P was 10.0446%.
Maybe a more important number to look at is the equity risk premium. This is the difference between the return on stocks and the risk free rate a person could earn by buying T-bills.
For the same period, the realized equity risk premium was 5.78%.
Another key figure to note is the cumulative wealth index. Using the same data, the cumulative wealth index is (1+.100446)^83 (since 83 years) = $2823.97. This means that for ever dollar (we will call it q) invested in 1920, you would have q * $2809.95 dollars at the end of 2002.
The inflation adjusted cumulative wealth figure:
This is CWI = $2809..95/inflation index
The inflation geometric mean for that period was 2.53% so the inflation index was (1+.0253)^83 = 7.989.
So the inflation adjusted CWI = $2809.95/7.989 =$353.48.
It pays to have your money invested in the market even after factoring inflation.