Investment Principles that will Stand the Test of Time

We live in a society where everyone strives to be the first of everything: the first with the new toy or gadget, the first with the latest car model, or the first to see the hottest upcoming movies. You get the picture. Well, the same is true in the investment industry.

However, in this case, there is some truth to being first. Getting in on the ground floor of a new investment idea (think internet, smartphones, and the personal computer) before everyone else can make or break a fortune. Once the market gets wind of it, the value and growth potential disappears. But fear not. There are some fundamentals that will always stand the test of time.

Know Your Risk Profile

This is your ability and/or willingness to take risk. Theoretically, the higher the risk, the higher the potential for greater returns. We wouldn’t expect a CD to return the same percentage as a start-up over the long-term. Ability and willingness is not the same thing. A millionaire has the ability to assume risk, but may not want to. Conversely, someone living paycheck-to-paycheck may be willing to invest in a start-up, but doesn’t have the ability to do so. The main factors that determine your ability to take risk are time, goal, liquidity needs, tax consequences, and current financial position. There are two ways to reduce risk (we can never eliminate market risk):

1. Diversification: Separate investments into multiple classes such as equities, real estate, fixed income, and alternative investments. Don’t put all of your eggs in one basket. There isn’t much benefit to diversifying securities within a specific sector. The goal is to create a portfolio with securities that aren’t correlated (related to each other).

2. Dollar Cost Averaging: One of the biggest mistakes investors make is trying to time the market. Usually, they end up buying high and selling low. Not to mention all of the extra commissions you’ll pay. Using this technique, you save the same amount each month. When prices are high, you get fewer shares and when they are low, you get more. It also eliminates an irrational response to market fluctuations.

Markets

The historical average of the S&P 500 is 12%. Use the Rule of 72 to determine how long it will take your money to double. Using the historical average, your money doubles every six years. I recommend taking a more conservative approach of 8% when calculating future values of your portfolio. Is there anything worse than outliving your savings?

Always consider the opportunity cost (what you are giving up for a certain action) of every investment decision you make. Every dollar you spend is one less dollar you have to spend on something else (like saving and investing!) Every dollar you spend must have a positive utility (meaning you gain something useful from it).

Investments (Stocks)

The most important thing to know about any investment is that it cannot exceed its intrinsic value over the long term. The ability to turn earnings into cash flows ultimately determines the value of any investment. These cash flows can either be reinvested in the business or returned to shareholders through dividends. In addition, no investment (after its growth stage) can outperform GDP over the long term.

Look for dividends yielding 4-5%. Calculate this by dividing the dividend by the current price. If Cocoa Cola’s price is $70 and its last dividend was $5, the yield is 7.14% (5/70). Some other things to look for are prices trading near their 5-year lows, prices close to book value, low P/E (price-to-earnings) ratios, and low ROE (return-on-equity). If bond yields are greater than stock yields, the market is overvalued.

Keep in mind one of Warren Buffett’s most famous sayings when investing: “if you aren’t willing to keep an investment for 10 years, don’t even think about owning it for 10 minutes.”

Let me know what other finance topics you’d like to see discussed!

See you next time