Lesson 4.4

Five Basic Rules of Investing

  1. Wealth Takes Time
  2. The odds of experiencing stock market volatility are exactly 100%
  3. Simple can be better than smart
  4. Forecasting market returns is close to impossible, worse, it’s dangerous.
  5. Most financial problems are caused by debt

  1. Wealth Takes Time
    • Charlie Munger, Warren Buffett's investing partner, put it best: "You don't have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time."
    • Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for seven decades. 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 skill is investing, but his secret is time.
    • Understanding the value of time is the most important lesson in all of finance. The single best thing we can do to improve the financial state of Americans is encourage people to save from as early an age as possible.
  2. Most financial problems are caused by debt
    • I have a family friend who earned several hundred thousand dollars a year as a specialist in an advanced field. He went bankrupt a few years ago and will probably need to work for the rest of his life. I know another who never earned more than $50,000 a year but retired comfortably on his own terms.
    • The only real difference between these two friends is that one used debt to live beyond his means while the other avoided it and accepted a realistic standard of living.
    • Just as saving gives you options in the future, debt takes options away. Not having the option of flexibility is the root of most financial problems. You can be a brilliant worker (or investor) and find yourself in financial ruin if you don't respect the power of debt. Income, wealth, and standard of living aren't as correlated as people think.
  3. Forecasting market returns is close to impossible, worse, it’s dangerous.
    • A stock's future returns will equal its dividend yield, plus its earnings growth, plus or minus changes in valuations (earnings multiples). That's really all there is to it.
    • Dividends and earnings growth for many companies can be reasonably projected.
    • But what about the change in valuations? There's no way we could possibly know that.
    • Stock market valuations reflect people's feelings about the future, swinging between optimism and fear. 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 9.26% better mood in the year 2024," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them Wall Street analysts.
    • We know a group of high-quality companies will build wealth for their shareholders over time. But we can never be specific when trying to guess what the stock market might do going forward. Assuming we can predict exactly what stocks will do in the future makes us blind to risk and uncertainty. Coming to terms with an unpredictable future forces us to be nimble and prepared. You can guess which group does better. 
  4. Simple can be better than smart
    • Someone who bought a low-cost S&P 500 index fund in 2003 and left it alone earned a 97% return by the end of 2012. That's great! And they could have spent the last 10 years at the beach, or hanging out with their kids.
    • Meanwhile, the average fancy professional market-neutral hedge fund -- many of which are staffed with PhDs and some of the world's fastest computers -- lost 4.7% over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average stock-trading equity hedge fund produced a 96% total return -- still short of a simple index fund.
    • There are no points awarded for difficulty in investing. Smart people who devote their entire lives to investing can (and often do) fail, while some of the simplest investing techniques you can think of are wildly successful. Good businesses run by good people purchased at good prices held for as long as possible. That's it
  5. The odds of experiencing stock market volatility are exactly 100%
    • Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time there's even a whiff of volatility in the stock market, the same cry is heard from investors around the world: "What the heck is going on?!"
    • The majority of the time, the honest and correct answer is the same: Nothing is going on. This is normal and just what stocks do.
    • Since 1900 the S&P 500 has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Volatility, even really severe swings, is perfectly normal and shouldn't be feared.

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