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If you know only five things about investing, make it these By Morgan Housel
Should it bother me that there's so much about finance I don't know? I don't think so. As John T. Reed writes in his book "Succeeding":
"When you first start to study a field, it seems like you have to memorize a zillion things. You don't. What you need is to identify the core principles -- generally three to 12 of them -- that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles."
A handful of cognitive biases explain most of psychology. Likewise, there are a few core principles that explain most of what we need to know about investing.
Here are five that come to mind.
1. Compound interest is what will make you rich. And it takes time.
Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two-thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.
Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.
2. The single largest variable that affects returns is valuations -- and you have no idea what they'll do.
Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.
The dividend yield we know: It's currently 2 percent. A reasonable guess of future earnings growth is 5 percent per year.
What about the change in earnings multiples? That's totally unknowable.
Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?
If someone said, "I think most people will be in a 10-percent better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.
Every weekday JewishWorldReview.com publishes what many in the media and Washington consider "must-reading". In addition to INSPIRING stories, HUNDREDS of columnists and cartoonists regularly appear. Sign up for the daily update. It's free. Just click here. Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97-percent return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management or technical analysis, or suffer through a single segment of "The Lighting Round."
Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7 percent of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96 percent total return -- still short of an index fund.
Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.
4. The odds of the stock market experiencing high volatility are 100 percent.
Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility.
Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"
Nine times out of 10, the correct answer is the same: Nothing is going on. This is just what stocks do.
Since 1900, the S&P 500 has returned about 6 percent per year, but the average difference between any year's highest close and lowest close is 23 percent. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.
Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.
5. The industry is dominated by cranks, charlatans and salesman.
The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.
You need no experience, credentials or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.
This is perhaps the most important theory in finance. Until it is understood, you stand a high chance of being bamboozled and misled at every corner.
"Everything else is cream cheese."
(Morgan Housel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.)
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Morgan Housel, a columnist at The Motley Fool, is a two-time winner, Best in Business award, Society of American Business Editors and Writers and Best in Business 2012, Columbia Journalism Review.
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