Wednesday, May 27, 2015

Simple Investing Principles to Follow

I have been overdosing on everything about Warren Buffett in the past two-three years. This has spilled over to learning more about Warren’s business partner Charlie Munger. Charlie Munger is big on the so called mental models, which are principles on how to live your life.

In this article, I have outlined several simple principles on investing, which I think should be the foundation of your investment strategy, whether you are a dividend investor or choose to do something entirely different.

The first concept you want to understand is the power of compounding. Compounding is the process where you earn money on the money you invested a certain amount of time ago. You start with an initial amount and have a certain rate of return, and you reinvest gains and dividends back into your portfolio. As a result, you are exponentially increasing your net worth and income.

The second simple principle to take into account is that over the past 200 years, the US stock market has been going up almost every decade. This is a phenomenon not just limited to the US however. A study of most other countries show that equities outperform all other assets over time. This is because stocks represent ownership of real businesses, which over time have more consumers, raise prices, bring new products and gain efficiencies and know-how on how to do things better, cheaper and faster. Reinvested earnings drive growth in the businesses, while reinvested dividends compound your net worth and income even faster. While there are occasional blips that could last for years, equities should be the main cornerstone behind your investment strategy. These occasional declines in share prices, no matter how severe, should not scare the individual investor. On the contrary, they should be seen as opportunities to acquire more equity interests in quality companies at discounted prices.

The third principle to remember is that stocks represent partnership interests in real businesses.  Stocks are not just some blips on a computer screen. While investor sentiment drives stock prices in the short-run, underlying fundamentals drive whether you are going to make or lose money from your investment in the long-run. Over time, growing earnings, dividends make businesses more valuable, hence you will see 52 week highs and all-time highs most of the time. As a result, as a part-owner in a business, your goal is to determine whether the business can earn more money over time. The rise in stock price and dividend will follow if earnings increase.

The fourth principle is diversification. It is important to realize that things can happen to a business that cannot be even considered as a problem today. If you spread your capital in at least 30 – 40 businesses over your lifetime, you would do just fine in the long-run, while protecting your principle in the process. Having exposure to different industries, countries is a must in protecting investment capital from the destructive forces of time.

The fifth principle you need to take in consideration is that increasing investment activity is bad for your returns. The goal of the investor should be to buy or create an equity portfolio, and then sit on it for decades. If you try to time the market by trying to sell at what looks like a top, and try to buy at what looks like a bottom, you might be unable to achieve your investment goals and objectives. In fact, studies have shown that increased levels of activity among individual investors are correlated with extremely low returns relative to their benchmark. In addition, did you know that if you had simply purchased the original 500 components of S&P 500 in 1957, and then did nothing for the next 50 years, you would have outperformed the S&P 500? Therefore, if a company you own spins-off a subsidiary, just hold on to the stock. From a tax efficiency perspective, you should do just fine.

The sixth important principle to ingrain in your memory is to be unemotional about your investments as much as possible. Most investors are terrible at investing, because they lack the emotional characteristics associated with dealing with rising and falling prices. They get excited when stock prices have been rising for a long period of time, but get depressed when stock prices start going down. These investors are always afraid that they are missing out, which is why they frequently change strategies to chase the next hot fad. You should not let emotions run your investments. The successful investor should have a plan, and stick to it through thick and thin. The best plan is to buy, hold and occasionally monitor your portfolio. Remember, it is time in the market that can lead to success, not timing the market.

Another important principal to remember is that entry price does matter. For dividend investors who focus on selecting individual stocks, there are always some attractively valued opportunities available. There were quality companies available at fair prices during the 1972 Nifty-Fifty Bubble, and the 1996 – 2000 Technology Bubble to name a few. Dearly overpaying even for the best companies is a mistake. This is because your initial dividend yield will be ridiculously low, and the price you paid would have all the growth for the next decade already baked into it. In the case of Coca-Cola and Wal-Mart investors, who overpaid in 1999 – 2000, earned low returns over the subsequent decade. This was despite the fact that the underlying businesses produced stellar operating results during the same time period. In addition, one should focus on the current and future ability of the business to generate profits, and not focus on profits that were generated 5 or 10 years ago. In the case of the Nifty-Fifty, the companies generated returns close to that of a stock market index. Of course, investors would have had to patiently hold for a quarter of a century in order to obtain this result. This was difficult, because the first decade was characterized with heavy losses that were more severe than losses experienced by blue chips stocks as a whole.

Relevant Articles:

Buy and hold dividend investing is not dead
Fixed Income for dividend investors
The Pareto Principle in dividend investing
Why dividend investors should never touch principal
Dividend Portfolios – concentrate or diversify?

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