I was having a discussion recently about investing where I used the rule of 72 to illustrate the effects of compounding in a way that was easy to communicate. For those unfamiliar or in need of a refresher, the essence of the rule is this for investing:
If you take an investment's expected rate of return and divide it into 72, the quotient will indicate the number of years it will take for the amount of money invested to double.
For example, if your expected rate of return is 3%, and you invest $100,000, in 24 years (72 divided by 3) your investment will have grown to $200,000. Using a rate of 6% would get you to $200,000 in half the time or 12 years.
That’s about where the conversation ended and the example had the intended effect of demonstrating the powerful impact of compound interest in a simple, yet accurate way. The thing that I considered afterward and thought would be an appropriate add-on is that the rule isn’t just applicable to investment returns. If you divided the inflation rate into 72, the quotient would indicate how long it would take for your purchasing power to be cut in half. For example, using the same $100,000 from above and assuming a 3% inflation rate, we could calculate that in 24 years, you’d need $200,000 to purchase what $100,000 would have purchased 24 years earlier. At 6%, your purchasing power would be cut in half in 12 years and at 8.5% (the current annualized inflation rate) it would only take 8.5 years for it to be halved.
So the next time you’re in the grocery store or the at a fast food restaurant and you notice the prices slowly (or quickly) creeping up, just know that’s inflation working its evil spell on your purchasing power and it won’t stop. Use that knowledge as a reminder of the power of compound interest in investing as a countermeasure for preserving and increasing your wealth/purchasing power over time.
Thing Two
Why The “Average Investor” Underperforms The Market
According to marketwatch.com, the 20-year annualized return of the S&P 500 was 7.68% while the average equity fund investor’s return was 4.79%. In trying to account for the gap, those researching it often look at fees as they assume they’ll account for the bulk of the difference there. What they are finding is that fees aren’t the biggest issue, human behavior is. Yes, there are times when competing needs for capital or lack of capital are the chief cause, but at least half of the time, psychology is the cause of the investment shortfalls.
Specifically, investors tend to make emotional decisions in both directions. When the market is going up, they get excited and follow the herd in. When the market is going down, they get nervous and follow the herd out. They buy high and sell low, in other words, because their emotions get the best of them. So what to do? Well, Dana Anspach of thebalance.com has four pretty good tips on how to avoid succumbing to bad investing impulses:
"1. Do Nothing
A conscious and thoughtful decision to do nothing is still a form of action. Have your financial goals changed? If your portfolio was built around your long-term goals (as it should be), a short-term change in markets shouldn't matter.
2. Know That Your Money Is Like a Bar of Soap
To quote Gene Fama Jr., a famed economist, “Your money is like a bar of soap. The more you handle it, the less you’ll have.”
3. Never Sell Equities in a Down Market
If your funds are allocated correctly, you should never have a need to sell equities during a down-market cycle. This holds true even if you are taking income.
Just as you wouldn’t run out and put a for-sale sign on your home when the housing market turns south, don’t rush to sell equities when the stock market goes through a bear market cycle. Wait it out.
4. Trust That Science Works
A disciplined approach to investing delivers higher market returns. Yeah, it’s boring; but it works. If you don't have discipline, you probably shouldn't be managing your own investments.
Thing Three
Just A Thought
"Someone with half your IQ is making 10x as you because they aren't smart enough to doubt themselves." - Ed Latimore
