EVERYBODY WITH MONEY
in the markets is after the same thing: superior investment returns. The method by which we pursue that goal, however, is unique to the individual. Each of us follows a different path. You become a competent, mature investor when you develop your own discipline that works over every market environment.
For example, when it comes to allocating assets, I'm always tickled by planners and online retirement engines whose investment technique comes down to plugging your age and asset size into a computer program which spits out the same unimaginative ideas time after time after time. You know the drill: You're 40 years old with $100,000? You should be 50% large-cap stocks, 20% small-cap stocks, 20% international stocks, 5% REITs and 5% cash. Never heard that before, right?
It's a cookie-cutter approach that's totally divorced from the market itself, designed, in my opinion, to diversify the client so much that his return won't deviate too largely from the major market indexes. As the old saying goes, nobody ever gets fired for buying GE. Far from thinking outside the box, those approaches represent the box itself.
Longtime readers know we're not afraid to venture off the well-beaten path when looking for investment opportunities. In fact, more often than not, it's the under-followed areas, such as the BDCs we wrote about a few weeks back, where the best ideas can be found. It's a big, wide world out there. Why put your entire investment plan solely in the S&P or Dow's hands?
The journey also includes the understanding that, strange as it may sound, success is not predicated on the quantity of profitable investment ideas you can generate. It's precisely what separates a newsletter writer or TV tipster from a money manager. The real skill comes not in picking XYZ, but following up the trade with the proper method of limiting risk and maximizing return.
A good percentage of my ideas, I'd say as many as 50% or 60%, actually end up as small losses or scratched trades. So you buy XYZ at $50 and it sits there for months and months. Or it drops a quick 15% and your position is stopped out. The point is not that you had a loser we all have those but that you were able to minimize it and move on. As we've often suggested, every wrecked account, from Enron employees' 401(k)s to the Amaranth hedge fund, starts with a huge position and a stubborn trader who just had to be right.
Yet the hardest part of investing is accepting that, from time to time, our analysis might not be immediately correct. And that's OK. On any journey, it's not uncommon to get lost now and then. If you're able to see XYZ as a position not your only position you're able to take a loss, re-group, and potentially revisit the trade in a prudent and clear-headed manner. I lost money a number of times by repeatedly getting stopped out on MarketAxess Holdings, for example, before finally owning the stock as it experienced a substantial move. But when we're unable to take a loss, when we're uncompromisingly sure that our analysis is correct and the market's wrong, that's when the real problems start.
Finally, I think the process of wealth creation gets easier when you realize that the journey is just that: a journey. We all dream of finding that one stock that'll put us on easy street, but the real coin isn't made by one huge score, but through the process of continual compounding over time.
It's not sexy, but neither is Albert Einstein, who's said to have called compound interest the "eighth wonder of the world." When interest is earned, not only on your principal investment, but on accumulated interest as well, your wealth grows exponentially, even at low levels of return.
So I've always had a lot of fun playing around with the free online compound interest calculators, including the one here at SmartMoney.com. It's amazing to realize that, even on $10,000, if you can make a historically modest 8% annually, after 30 years that figure will have grown more than 900% to over $100,000. That's without having added one additional dollar to the pie.
It's important to remember that compound interest doesn't work with negative results, which is why a portfolio strategy of absolute return is a must, especially for older investors at or nearing retirement. What destroys your ability to compound is, quite simply, losing money exactly why I believe a disciplined, conservative investor will, over time, far outperform the gunslinger who regularly experiences large losing years.
Beyond achieving positive returns, the other aspect that makes compounding work is time, which is why it's important to begin building a strong financial house as early as possible. Because while an 8% yield will turn $10,000 into $100,000 over 30 years, after five you'll have barely $14,000 and even after 15 you'll only have about $31,000. The longer you're able to wait, the exponentially larger the sum will grow.
Jonathan Hoenig is managing member atCapitalistpig
Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.