With 2012 drawing to a close, 2013 about to begin and a good deal of uncertainty still hanging over the markets, it seems like an ideal time to take a look at “The 7 Wonders of the Investment World.”
Understanding how these 7 wonders work in relation to your investments will go a long way toward enhancing your long-term results and meeting your financial goals.
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 investments.
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).
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.
When Gennum rose 119% in one day on news of a takeover bid, it joined many other stocks recommended by Pat McKeough that have been taken over at a rich premium. To uncover values like these, Pat continually analyzes three different portfolios for readers of The Successful Investor—one for Conservative Growth, one for Aggressive Growth and one for Income-Seeking Investors. And subscribers get free updates and advice on the stocks they’re following every week in the weekly E-mail/Telephone Hotline. The Successful Investor—one for Conservative Growth, one for Aggressive Growth and one for Income-Seeking Investors. And subscribers get free updates and advice on the stocks they’re following every week in the weekly E-mail/Telephone Hotline.
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.
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.
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.
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.
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.
Have a happy, safe and prosperous holiday!
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Thank you for your comments, I always find them helpful and interesting!!
I am glad that you ended on a positive note!!
A Very Happy New Year to Patrick.
Take rule # 7 with a grain of salt, considering rule # 5.