June 2003 NumberSMART Newsletter

June 2003 — NumberSMART Newsletter©
by Jason Orr

When proper temperament joins with proper intellectual
framework, then you get rational behaviour.

—Warren Buffett—

This is PART I of a four-part series that looks at the 10 Principles of Personal Investing. Although your job at work is to increase shareholder wealth, your ultimate objective of course is to increase your personal wealth. After all, we’re planning to retire one day…or are we? Will we have enough money saved, given all the confusing, contradictory, and downright misleading financial garbage we are fed daily?

Before we look at the 10 Principles of Personal Investing, a few observations are in order. You must wholeheartedly accept and live by these observations if they are to be of any value to you. They will fly in the face of conventional wisdom about personal investing and contradict everything you’ve heard from the financial industry.

Most people confuse speculating with investing. Buying a stock and holding it for three days, three months, or even three years is really a form of speculation. The investor is hoping that they are buying and selling the stock at the right time (timing the market). The truth is, there is no way of knowing whether the stock market is going to go up or down...nobody knows. If they did, they could see the future. And no one has ever consistently predicted the movement of the stock market!

Investing is really about maintaining a state of mind that is motivated by rational, consistent behaviour. The emotions of fear and greed are the biggest enemy of the investor. So is the false notion of making a quick buck. In a society where immediacy is rewarded and patience is considered old-fashioned, it’s not surprising that investors measure their investment time horizon in months, not years or decades. Let’s look at an example. Say you buy one hundred shares of Dynamo Corporation at $10 per share. You hold the shares for six months and then sell for $15 per share. Your return on the investment is 50%, not bad. On an annualized basis, that’s a 100% return. Wow! However, you’re now faced with a tax bill on the $500 gain (unless the investment was held in a tax-deferred account). And you’re also faced with the prospect of having to re-invest the $1,500 you just received from the sale of Dynamo shares. What if the market has recently taken a dive? What if you can’t find an investment with a decent return? You’re sitting on the sidelines with $1,500 in your pocket but can’t decide if now is the right time to jump back into the market. Worse yet, what if you blow the $1,500 on a vacation rather than investing in your retirement plan? The 100% annualized return sure was exciting, but the thrill was short-lived. The party was great, but the hangover lasts a long time. The really big, juicy returns come from a buy-and-hold strategy. Or simply by being patient.

What if you buy Dynamo at $10 per share and hold it for twenty years. Assuming the stock grows at the S&P 500 Index historical annual return of 12.2%, your original investment of $1,000 will be worth $10,000. And the tax bill will only have to be paid in twenty years if, and when, you sell the stock (assuming no dividends are distributed). This buy-and-hold strategy, which is much more tax-efficient than constantly buying and selling, let’s you sleep well at night because you’re not obsessed with swings in the market. Just consider how many people have been dumping stock, at a loss, over the past three years. Inevitably, the average misinformed investor (speculator) buys high and sells low.

As Warren Buffet says, doing nothing, or inactivity, is sometimes the most intelligent behaviour an investor can exhibit. Simply turn off the market and be reassured that over the long haul, stocks always appreciate in value. Here’s something to think about. If your grandparents bought you one share of Coca-Cola stock in 1919 for $40, it would be worth
$2.1 million (assuming reinvestment of all dividends) in 1993. That’s a compound annual return of about 15.8%. Sure, you can find investments with a higher return (remember the short-lived tech stocks). But would you rather own an investment that continues to glow over the years, or an investment with a bright but short life. Wealth accumulation takes time and patience.