Understanding how these 7 wonders work is a vital factor in portfolio management that will help you enhance your long-term results.

1. Compound interest — earning interest on interest — can have an enormous ballooning effect on the value of an investment over the long term, and lift the overall returns on your portfolio.
   
   This applies to equity investments like stocks, as well as to fixed-return, interest-paying investments like bonds. (In fact, stocks are generally preferable – see investment wonder #7.) When you earn a return on past returns, the value of your investment can multiply. Instead of simply rising at a steady rate, the number of dollars in your portfolio will grow at an accelerating rate.
   
   There are two conclusions you need to draw from this investment wonder in order to improve your portfolio management.
   
   First, you need to pay attention to steady drains on the capital in your portfolio, even seemingly small ones — like high brokerage commissions. This can eat up a surprisingly big chunk of your portfolio in a decade or two.
   
   Second, you can’t expect to earn an outsized return on an investment in your portfolio indefinitely. If you did, you’d wind up with a measurable fraction of all the money in the world, and nobody ever does that (see investment wonder #2).
2. Regression to the mean is inevitable.
   
   No investor and no investment can earn an outsized return indefinitely. Eventually, a high yearly return will come back down toward average. Sometimes, it will gain momentum and keep falling until it drops far below average, or turns into a loss in your portfolio.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

3. No investment can ever be so attractively undervalued or desirable that it overcomes a lack of integrity on the part of company insiders.
   
   If you have any doubts about the integrity of insiders, sell immediately.
4. As a group, investment long shots are invariably overpriced.
   
   If you have nothing but long shots in your portfolio, you are likely to make meagre returns or lose money over long periods, instead of the high returns you seek. That’s why you need to be particularly cautious and selective when adding anything to your portfolio that offers the potential of high returns.
5. Financial incentives have an enormous impact on the beliefs of otherwise honest people, particularly when it comes to what they will say in order to spur you to buy something. If you fail to spot these conflicts of interest, it could be very damaging to your portfolio.
   
   We’re not just talking about stockbrokers. As the saying goes, never depend on your barber to admit that it’s too soon for you to get your hair cut.
6. The markets for fungible goods like oil, interest rates and gold are inherently unpredictable.
   
   Markets like these are so enormous that there is no practical limit to how much you can trade in them. It follows that if you could predict them, you could wind up acquiring a measurable proportion of all the money in the world, and as we’ve already noted, nobody ever does that. That’s why it’s a mistake to build your portfolio in such a way that you have to accurately predict the future direction of fungible goods like oil, interest rates or gold.
7. In any reasonably healthy economy, equities will always give you a higher return than bonds over long periods.
   
   There is a self-regulating mechanism at work that guarantees this. If it didn’t work that way, everybody would prefer bonds (with their predictable returns) over stocks (which have variable returns). Interest rates would then fall down toward zero, and virtually all the economy’s profits would flow to stockholders.
   
   That’s why it pays to invest in bonds only when you must have steady returns, or when interest rates are unusually high. The rest of the time, with rare exceptions, you’re better off in stocks.
   
   Today’s economy does qualify as a reasonably healthy one, in spite of the many media headlines insisting we are in constant crisis. Thus, wonder #7 continues to operate in favour of equities rather than bonds.

We have long employed these 7 wonders of the investment world in our investment philosophy that allows us to achieve greater gains without unnecessary risk. If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you our specific advice on the fundamentals of successful investing. Each Investor Toolkit update gives you a fundamental portfolio management tip and shows you how you can put it into practice right away.

Today’s tip: “Invest for value, not on share price fluctuation.”

Stocks go up and down every day. Sometimes there is an obvious cause in good or bad news. But there’s a large random element to stock price changes, particularly over short periods.

Common portfolio management errors:

1. Becoming more “bullish” or optimistic because stock prices have gone up. Some investors only feel safe buying stocks after prices have risen. This is opposite to the way you make most purchases (cars, clothing, etc.) Ordinarily, it’s better to buy when prices go down, not up.
2. Becoming more “bearish” or pessimistic because stock prices have gone down. When other investors sell and drive prices down, you may wonder if they know something you don’t. However, random influences may be at work.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

To overcome these errors:

• Learn all you can about your investments. Frequently visit the web sites of the companies you invest in. Get on their mailing lists, and read their quarterly and annual reports. Ask your broker for research reports. Read the business news every day.
• Beware of advisor failings. Some advisors are “permabears” — perpetual pessimists. Others are blind to risk, so they recommend investing in speculative stocks at outrageously high levels.
• Take a broad view. Consider earnings, dividends and other factors in making portfolio management decisions. They matter far more than short-term stock-price trends.
• Invest consistently. Don’t follow a portfolio management strategy of trying to buy at the bottom or sell at the top. (As Bernard Baruch said, “This can’t be done, except by liars.”) Pick out a selection of well-established companies, and invest gradually over a period of years. Plan to hold indefinitely. You can always change your mind and sell if fundamentals deteriorate or your needs change.
• Practice “dollar cost averaging.” Invest the same dollar amount on a regular basis. That way you’ll buy more shares when prices are low, and fewer when they’re high. We analyzed the profit-generating potential of dollar-cost averaging in a recent Investor Toolkit update. Click here to read that article.

You can get our investing advice, plus buy/sell/hold advice on stock market picks you may be considering buying in our Successful Investor newsletter. You can get one month free when you subscribe now. Click here to get started right away.

Averaging down lowers your average cost per share, but can cost you money in the long run. At the same time, you run the risk of distorting your overall portfolio management strategy.

Portfolio management: 3 reasons to avoid “averaging down.”

Here are three problems that crop up with averaging down:

1. Averaging down ignores investment quality. Many investors have made lots of money by “averaging in” to the stock of a well-established, well-managed company — that is, buying more as funds became available over a period of years. “Averaging down” is different. When you systematically average down, you are zeroing in on your losers and running the risk of hurting your stock market returns. It’s true that good stocks can drop and stay down for lengthy periods. But bad stocks are more likely to go down and stay down. If you routinely buy more of any stock you own that goes down, you run the risk of loading up on your worst choices. That costs you money and lowers your stock market returns because it keeps you from buying good stocks, since your funds are tied up in bad ones.
2. Hidden problems can cause a stock to fall—and keep falling. Some investors go through a phase when they buy more of anything they own whenever it goes down. It’s as though they want to validate their decision to buy it in the first place. Stocks sometimes go down due to random fluctuations and misinformed selling. But they also fall due to festering problems that the public does not yet know about or appreciate.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

3. Averaging down can spell disaster with aggressive stocks. Hidden risks are more likely to lurk in aggressive investments. Even with conservative stocks, averaging down is risky. Good stocks do go bad. Stocks that are generally considered conservative sometimes turn out to be anything but.

Quality and diversification are key to successful portfolio management

Before you buy more of any stock that has dropped significantly, we recommend that you consult our investment newsletters (including our flagship publication, The Successful Investor) for changes in our buy/sell/hold advice. If we continue to recommend the stock as a buy, that means we think the stock will be okay at the very least, and perhaps much better. But keep in mind that no one can predict such things with 100% certainty.

Moreover, you should consider any purchase in light of your portfolio management strategy. What impact will it have on your portfolio? If buying more would put the stock above, say, 5% of your overall portfolio, we would often advise against it.

The secret of good portfolio management is to avoid investing too heavily in any one stock, no matter how optimistic you are about its future.

Let’s put it this way: The only time it pays to average down is when it’s a coincidence. You want to buy more of a stock because it’s attractive, not because you bought it at higher prices.

You can get our latest risk-cutting strategies and clear, plain-English analysis of dozens of Canadian stocks in The Successful Investor. What’s more, you can get one month free when you subscribe today. Click here to learn how.

We analyze ACI in Stock Pickers Digest, our newsletter that recommends investments for the aggressive part of your stock portfolio.

In March 2011, ACI bought ICD Corp. for an undisclosed amount. ICD has over 140 customers who use its software to authorize credit- and debit-card transactions through over 70 different payment processors, including banks and credit-card companies.

ACI’s revenue rose 22.7% in the three months ended June 30, 2011, to $113.4 million from $92.4 million a year earlier. The company earned $9.8 million, or $0.29 a share, compared to a loss of $150,000, or nil per share, a year earlier. The company holds cash of $170.8 million, or $4.98 a share.

As well, ACI recently announced that it will make a $540-million, cash-and-stock offer for S1 Corp. (symbol SONE on Nasdaq). S1 sells transaction software for banks, credit unions, retailers and other processors. The company has over 3,000 clients worldwide.

S1 already agreed to a merger with the Israeli company Fundtech Ltd. in late June, but that deal has not closed. S1 hasn’t said whether it will consider ACI’s bid.

We updated our advice on ACI and four other stocks that may be appropriate for the aggressive portion of your stock portfolio in our July 29, 2011, Stock Pickers Digest hotline, which you can immediately view when you take a 1-month free trial to Stock Pickers Digest. Click here to learn how you can start profiting from Stock Pickers Digest’s aggressive stock portfolio recommendations right away.

(Note: If you are a current Stock Pickers Digest subscriber, please click here to view Pat’s recommendation. Be sure to log in first.)

(When you become a member of Pat McKeough’s Inner Circle, you get to ask me and my team of investment experts anything about your investments—from portfolio management strategies to questions about individual stocks. Read on to learn more.)

The main cost involved with buying on margin is the interest on the money you borrow. Plus, when you sell a security that you’ve bought on margin, you must first pay back the loan from your broker.

Interest rates remain low. That adds to the appeal of buying stocks on margin. However, there are a few things to keep in mind if you’re considering this portfolio management strategy:

• Maximize your margin investing with our three-part strategy. If you could follow a portfolio management strategy of buying on margin when the market hits bottom, stay margined as the market rises, and sell out at the peak, you could very quickly build a large fortune. But no one has the sense of superhuman timing necessary to consistently succeed in that.
  
  That’s why we continue to recommend that if you are going to use margin to invest, it’s all the more important to stick with our three-part portfolio management program: mainly invest in well-established companies; spread your money out across the five main economic sectors; and avoid stocks that are in the broker/media limelight.
  
  If you rigorously follow that advice, you stand to make money over long periods. With margin, you’ll make even more.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

• Increased leverage can work for or against you: The main risk of buying stocks on margin is that it increases your leverage. Leverage works two ways: It magnifies your profits when the market moves in your favour, but it magnifies your losses just as effectively when the market moves against you. That’s because the amount you owe on your investment loan stays the same, so every dollar your portfolio loses comes out of your equity.
• Buying stocks on margin has tax advantages: When you buy on margin, you’ll be able to write off your margin interest in full against ordinary income in the current year. However, you’ll pay less than ordinary income-tax rates on dividends from Canadian stocks, thanks to the dividend tax credit.
  
  Above all, you’ll defer all capital gains taxes until you sell, and only pay taxes on capital gains at half the rate you pay on ordinary income.

Portfolio management: A simple 3-part test to tell if you should buy on margin

Due to its increased risk, buying stocks on margin is certainly not for everyone. That’s why buying stocks on margin only makes sense if all 3 of the following apply:

1. You are in the top tax bracket and expect to stay in it for the foreseeable future;
2. You follow our conservative three-part investing approach (see above);
3. You invest consistently over a number of years, and resist the temptation to increase your margin borrowing when stocks have risen, or reduce it when prices have dropped.

If you’re looking for authoritative advice on investment issues, or fundamental analysis of stocks you’re considering buying (or selling), you should join Pat McKeough’s Inner Circle. It’s Canada’s most exclusive investment group.

Inner Circle members always get clear, concise investment advice that’s 100% independent, and untainted by commissions or other undisclosed influences. We guarantee it. Click here to learn more.

We analyze Tim Hortons in Stock Pickers Digest, our newsletter for portfolio investing in aggressive stocks.

In the three months ended April 3, 2011, Tim Hortons’ earnings rose 2.3%, to $80.7 million from $78.9 million. Earnings per share rose 6.7%, to $0.48 from $0.45, on fewer shares outstanding. That fell short of the consensus estimate of $0.51 a share.

Sales rose 10.4%, to $643.5 million from $582.6 million a year earlier. The company opened 31 new restaurants in Canada during the quarter. That brings its total number of Canadian stores to 3,169. Same-stores sales rose 2.0% in Canada.

In the U.S., Tim Hortons opened six restaurants and five self-serve kiosks. It now has 613 U.S. outlets. Same-store sales rose 4.9% in the U.S.

If your portfolio investing involves more aggressive picks like Tim Hortons, you should have a subscription to Stock Pickers Digest. What’s more, you can get the latest issue absolutely free. Click here to learn how.

It’s true that bonds do tend to reduce your portfolio’s volatility, since they tend to rise when stock prices fall. That’s why many brokers sell bonds to their clients. Of course, bonds also generate more commission fees and income for the broker, compared to stocks, especially if you buy them via bond funds and other investment products.

Bonds may make your portfolio more stable in the short term. But they are sure to increase your broker’s income, and reduce your long-term returns. Here’s why:

Portfolio management: Why we recommend that you stay out of bonds

Our view on bonds is a reaction to the times — to today’s economic and investment situation. Up till the mid-1990s, in fact, we routinely advised that as part of their portfolio management, conservative investors should hold anywhere from one-third to two-thirds of their portfolios in fixed-return investments, such as bonds.

Back then, fixed-return investments paid 8% to 10% a year. That was close to the long-term returns available from the stock market. Of course, fixed-return investments leave your portfolio management strategy fully vulnerable to inflation, unlike stocks.

But back in the 1990s, we saw little risk of inflation. In addition, we felt interest rates were likely to move sideways to downwards for an extended period, and that’s a favourable environment for bonds. (Remember, bond prices and interest rates move inversely. When one goes up, the other goes down.)

Fixed-return investments do lack the tax advantages that are available in the stock market, of course. But that doesn’t matter if your portfolio management involves holding your bonds in an RRSP or RRIF. In these and other tax-deferred accounts, the income from these two types of investments are treated the same for tax purposes.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

Bond prices are more likely to move down than up

A great deal has changed since the mid-1990s, however. Bonds yield less than half of what they paid back then. More important, the outlook is for higher inflation and higher interest rates, due to ballooning deficit spending by governments around the world. No one knows for sure what the future holds, of course. But the next big, long-lasting move in bond prices is likely to be downward.

Today, bonds remain within that rising trend that began 30 years ago, in 1980. This rising trend could, of course, continue for 30 more years—anything’s possible. If it does continue, however, it will have to slow down, since bond yields have dropped from 15% or so to below 4%. Bond yields just don’t have that much further to fall.

Portfolio management: If you want to hold bonds, stick with short-term maturity dates

If you are reluctant to hold a 100%-stocks portfolio—and many people are—then one alternative to consider is to keep a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.

These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value. You can hold them till maturity, then get your money back and reinvest.

You can get our latest analysis, including our clear buy/sell/hold advice, on dozens of Canadian stocks you may be considering buying in The Successful Investor. What’s more, you can get one month free when you subscribe today. Click here to learn how.

(The other two parts are to invest mainly in well-established, dividend-paying companies and spread your money across the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities.)

Portfolio management: Why “in the limelight” stocks are riskier than most investors think

It’s especially crucial to downplay stocks that are getting a lot of attention from brokers in the media. That’s because, in investing, familiarity can breed excessive feelings of comfort, security and performance.

Brokers get information from the media, investment journalists spend a lot of time talking to brokers, and company managers listen to both. A feedback loop can develop that spurs high expectations, derails criticism, and leads companies (and their investors) to make devastating mistakes.

You may get the feeling that these are can’t-miss investments, and you’re safe to follow a portfolio management strategy of adding them to your portfolio and forgetting them. That’s exactly the wrong thing to do with these stocks. Your “in-the-limelight” holdings are the ones you need to watch most closely.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

Broker/public-relations favourites can fall much more sharply than other stocks

Needless to say, lots of smart people work in the public relations and brokerage businesses. Many broker/public relations favourites go up more-or-less steadily for years at a time. But when they come down, they take a lot of people by surprise, and they can fall much further than you ever thought possible.

That’s why it’s a mistake to stuff your portfolio full of them. A high corporate profile may provide investors with a feeling of security, but it doesn’t pay them any dividends. Instead, in-the-limelight stocks trade at a premium.

Our portfolio management advice: Instead of familiarity, we think you should aim for investment quality and diversification. At any given time, lots of prosperous, well-established companies are out of investor fashion. Some of the biggest profits you ever make will come from buying these stocks before they find their way into the limelight.

Note that the broker/public-relations limelight can also create buying opportunities. When brokers and the media turn negative on an investment, they can ignore hidden value and stay negative for longer than they should. When that happens, it can give you the opportunity to add some good investments to your portfolio at bargain prices.

If you’re looking for authoritative advice on investment issues—including portfolio management—or fundamental analysis of investments you’re considering buying, you should join Pat McKeough’s Inner Circle. It’s Canada’s most exclusive investment group.

Inner Circle members always get clear, concise investment advice that’s 100% independent, and untainted by commissions or other undisclosed influences. We guarantee it. Click here to learn more.

Tip of the week: “Don’t let share prices distract you from portfolio diversification and investment quality.”

Sometimes a stock moves downward and creates what we consider a buying opportunity. We apply the term when we feel an attractive stock has dropped in price for reasons that are of a passing nature, or that are exaggerated in investors’ minds.

This shouldn’t be confused with “averaging down.” That’s when you buy more of a stock you own that has fallen in price, mainly to lower your average cost per share. However, following an “averaging down” strategy is almost certain to cost you money in the long run. Here’s why:

• Averaging down is entirely focused on share prices. The main problem with averaging down is that you are picking stocks based on a single factor: the drop in the price of the stock — and not the company’s overall investment quality or the stock’s place in your portfolio diversification. This focus on share price can be highly detrimental to your portfolio investing results over the long term.
• Unknown negatives can cause stocks to drop — and keep falling. Some investors go through a phase when they reflexively buy more of anything they own that goes down, as if to validate their decision to buy it in the first place. Stocks sometimes go down due to random fluctuations and misinformed selling. But they also fall because of negative factors that the public does not yet know about or appreciate.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

• Averaging down with aggressive investments is especially risky. In the case of aggressive stocks, averaging down can be one of the worst mistakes you can make. That’s because there are more likely to be hidden risks in aggressive stocks. With conservative stocks, averaging down is still risky. Good stocks do go bad. Stocks that are generally considered conservative do sometimes turn out to be anything but.
  
  That’s why we always recommend that you consult our newsletters and investment services, including our flagship publication, The Successful Investor, for changes in our buy/sell/hold advice before you buy more of a stock that has dropped significantly. If we continue to recommend the stock as a buy, that means we think the stock will turn out at least okay, or perhaps much better than that. But it’s important to note that no one can predict such things with 100% certainty.
  
  Moreover, you should weigh the impact that buying more of the stock would have on your portfolio diversification. If buying more would put the stock above, say, 5% of your overall portfolio, we would advise against it.

Our investment advice: Portfolio diversification is key to your success as an investor, and you should never make the mistake of investing too heavily in any one stock, regardless of how certain you are about its future. Let’s put it this way: The only time it pays to average down is when it’s a coincidence. You want to buy more of a stock because it’s attractive, not because you bought it at higher prices.

Next Wednesday, February 2, 2011, Investor Toolkit will look at the hidden pitfalls of stop-loss orders.

You can get our latest analysis, including our clear buy/sell/hold advice, on dozens of Canadian stocks you may be considering buying in The Successful Investor. What’s more, you can get one month free when you subscribe today. Click here to learn how.

For instance, one recent ad claimed that its model portfolio turned $100,000 in 2000 into more than $1.7 million by 2009. It says the model outperformed the S&P/TSX 60 market index in every one of those 10 years. It says the model returned 124.6% in 2003, compared to a 22.9% return for the market. For 2009, it claims the model returned 90.0%, compared to 27.9% for the market.

However, as the ad explains in the fine print, these calculations don’t reflect trading that actually happened. Nobody turned $100,000 into $1.7 million. Instead, the fine print explains that the results show “hypothetical or simulated performance” and are “not meant to represent actual performance results.”

Model portfolios can be managed much more aggressively than real money

Hypothetical model-portfolio accounts have a great advantage over real-world money management. For one thing, it’s safe to manage them much more aggressively than when you are playing with real money. This hyper-aggressive money management gives the hypothetical account great returns when it succeeds. It runs up much steeper losses when it fails, of course … but the losses are only hypothetical, and easily disposed of.

When the losses reach embarrassing levels, the broker can simply forget the old hypothetical account. It can then start over.

In today's turbulent economy, you need clear, personalized investment guidance more than ever. That's what you get when you become a client of my portfolio management services. When you hire me and my expert staff to manage your investments for you, we employ the same value-investing principles I've followed for my entire career. But hurry, space is limited. Click here to learn more about how you can profit from my portfolio management services.

Brokers may start up several hypothetical accounts, and eliminate all but the top performers over a period of years until they are left with just one hypothetical account that makes their money management look brilliant. Mutual-fund companies do the same. Fund company employees refer to the start-ups as “incubator funds.” These funds have little money in them, so it’s inexpensive to treat them in such a way that they build a great record. It’s even easier for a broker to build a top performance record for a hypothetical account where there’s no money involved.

Money management: “Front running” can further skew model portfolio results

Unlike a real-money account, a hypothetical account can legally profit from front-running. When a broker’s research department plans to issue a strong buy recommendation and a thick research report in a rising market, it will generally add the stock to the model portfolio and issue the report simultaneously. That means the model portfolio will “buy” the stock instantly, but the firm’s brokers will need time to scan the report and call their clients.

Over the course of a week, a $10 stock can rise to $10.50 or even $11 in a situation like that. These near risk-free 5% to 10% gains can have an enormous impact on the model portfolio’s hypothetical profit, especially when they compound over 10 or 15 years.

Model portfolio results are not always calculated in real time

Some model portfolios have an even more blatant advantage over real world money management: buys and sells in the portfolio are calculated as if they took place at the closing price of the previous day. This alone gives you the magic wand you need to claim extraordinary results without any investment analysis.

All you need to do is simply check the market just before the close every day for stocks that have risen 5% or more since the previous day. Then you “buy” the ones that went up, and “sell” any you own that went down, in each case at the closing price of the previous day.

As a member of TSI Network, you may have already seen Canadian Stock Market Basics: How to Trade Stocks and Make Good Investments in Canada. If you haven’t yet read this new free report, click here to download your copy today.