Investment fads come and go but here are our top 5 fundamental investment principles that all investors should keep in mind:
Investment Principle #1 – Compound Interest and Time are Your Best Friends
Compound interest can be thought of as “interest on interest,” and will make your capital grow at a faster rate than simple interest, which is interest calculated only on the principal amount. Rule of 72 is an easy way to understand the effect of compound interest. Simply divide 72 by your expected rate of return. The answer is the number of years it will take to double your investment.
For example, 72 divided by 6 equals 12, meaning that based on a 6% rate of return, you could expect to double your investment in 12 years.
Successful investors focus on stocks that grow their dividends and provide modest capital gains over time.
(Please note the Rule of 72 is an approximation. It works reasonably well for returns in the 4% to 8% range. For more accurate results, use this compound interest calculator)
Investment Principle #2 – Equities Provide the Best Protection against Inflation
If you buy and hold a bond for 10 years the issuer promises to pay you back your original investment, plus the accumulated interest. However, once you deduct the loss of purchasing power due to the effects of inflation, you will likely find that your gain is less than you might have expected.
If you hold a good quality dividend stock for 10 years, you are likely to be further ahead. As the business grows, its earnings should grow. A successful business is likely to be able to increase its prices to offset the effects of inflation. Over time, it will likely reward its investors by increasing its dividend. As the dividend grows, other investors are likely willing to pay more for the stock.
Consider the Bank of Nova Scotia. Ten years ago, its annual dividend was $0.96, today its $2.36. Over the same period, its stock has risen from the $37 to $72.
Investment Principle #3 – Understand the Concept of Reversion to the Mean
Reversion to the mean refers to the tendency for things to even out over time. It is a statistical phenomenon that can make natural variation in repeated data look like real change. It happens when unusually large or small measurements tend to be followed by measurements that are closer to average.
For folks who are not math whizzes can think of it this way: performance that is well above average usually doesn’t stay there forever; it usually comes back to earth. Performance that is well below average often gets better.
A great illustration of reversion to the mean is the so-called ‘Sports Illustrated Jinx’, an urban myth that suggests that a disproportionately large number of the stars that appear on the cover of the famous magazine go on to suffer a decline in their fortunes.
This has nothing to do with jinxes, but can be explained by reversion. A large number of cover stars should be expected to fall from their giddy heights, as the performances that led to their feature are extremes from which they should statistically be expected to regress.
Gamblers tend to ignore reversion to the mean. If they win a few hands, they think they are ‘hot’, or more foolishly that they have superior skills. They keep playing until their winnings and their initial stake are gone. Sadly, too many investors do the same thing by placing big bets on last year’s hot stock or star manager.
Investment Principle #4 – Market Indices are not Ideal Investment Benchmarks—Particularly Here in Canada
When investors are evaluating an investment product, they often ask, “How does its performance compare with the market benchmark?” This seems like an entirely reasonable question. Investors are willing to pay a manager for improving investment returns and comparing returns with market indices seems like a good way to judge the performance of various investment products.
The Oxford Dictionary defines a benchmark as “a standard or point of reference against which things may be compared.” For example, Octane rating is a standard measure of the performance of gasoline. It compares the quality of the fuel you buy at the pump with an ideal fuel. Regular gasoline with an Octane rating of 87 provides 87% of the performance of pure Octane.
While pure Octane is an ideal fuel for the engine in your car, market benchmarks are not designed as ideal investment vehicles. Consider the S&P/TSX Composite Index, an index of the stock prices of the largest companies on the Toronto Stock Exchange (TSX) as measured by market capitalization. Resource companies (combining the energy and materials sectors,) comprise about 50% for the market capitalization of the TSX Composite Index.
That concentration in the resource sector means that the S&P/TSX Composite Index is highly volatile. For example, as commodity prices rose in 2009, the TSX moved up sharply. When commodity prices fell, the TSX exhibited higher volatility and poorer performance compared with US markets.
Investors expect and even demand that fund managers earn their keep by out-performing market indices. In order to do that, managers must take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That’s exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly conservative large-cap equity funds declined by 40% or more.
How should investors evaluate their holding? Working with our clients, our goal is to earn a real return after inflation and management expenses, commensurate with the individuals risk profile.
Investment Principle #5 – Attempting to ‘Time’ the Market is Unlikely to Improve Your Returns
In searching for an advisor, some investors believe that they can find an individual whose experience and wisdom give them the ability to ‘time’ the market. Other investors think they can ‘time’ the market themselves.
The emotional appeal of market timing is obvious: if you could sell a stock that has risen before it declines and move your cash to another stock that is about to rise, you could consistently earn significant capital gains. Unfortunately, reality is a harsh mistress.
DALBAR Inc., a U.S. research firm, compared actual investor returns with market returns. Their study found that while the S&P 500 had returned 8.4% over a 20-year period ending in 2008, the average equity investor earned just 1.9%, which was less than the inflation rate of 2.9%. Bond investors fared no better. They earned returns of just 0.8% compared to 7.4% for the index.
Why do investors who try to time the market do so poorly? Consider the past few years: the market timer says, “if I had sold in the summer of 2008 and bought in the spring of 2009, I would have made a huge gain.” Unfortunately few investors had the foresight or intestinal fortitude to do that. Few sold in the summer of 2008, many sold after the markets had plunged, and fewer were willing to buy in March of 2009.
The problem is that emotions get in the way of rational decision making. Stock prices in the spring of 2009 were low because investors, scared by the experience of the previous 6 months believed that things were going to get even worse. If it was suggested that now was a good time to buy, their reaction was likely that they would prefer to wait until ‘things looked clearer.’ By which time of course, stocks had already risen significantly.
Warren Buffet: ‘The Stock Market is designed to transfer money from the Active to the Patient.’
The sad reality it that too many investor’s market timing strategy turns out to be buy high and sell low.
All too often, investors are distracted by the day-to-day noise of the market. This noise comes in the form of news releases, sell-side analyst reports, quarterly earnings announcements and, more recently, television broadcasts. Successful investors focus on the longer-term and try to shut out the day-to-day market noise.
We believe that investors are better served by following our three-part value investing strategy. In our view it is the best way to reduce risk and volatility and earn consistent returns over time. Our diligent, patient and opportunistic approach has served our clients well, through good and bad markets:
- Appraise the intrinsic value of each company over a business cycle;
- Seek long-term growth of capital by investing in companies that we perceive to be mispriced;
- Utilize a margin of safety to promote return of capital…not just return on capital.
Why does our value investing approach work? The prices of well-established, high-quality stocks tend to rise over time as the companies create value for shareholders. We believe investors are better off ignoring the day-to-day noise of the market, including the temptation to think you can time the market.
Download Our Free Special Report – How to Hunt For Value Stocks. Michael Sprung will share with you 5 stocks set for long-term gains.
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The opinions expressed here are ours alone. They are provided for information purposes only and are not tailored to the needs of any particular individual or company, are not an endorsement, recommendation, or sponsorship of any entity or security, and do not constitute investment advice. We strongly recommend that you seek advice from a qualified investment advisor before making any investment decision.