August 2003 NumberSMART Newsletter

August 2003 — NumberSMART Newsletter©
by Jason Orr

I feel the same way about managing that I do about investing:
It’s just not necessary to do extraordinary things
to get extraordinary results.

—Warren Buffett—

To repeat what was said in the June 2003 NumberSMART Newsletter©: investing has nothing to do with intelligence, luck or ability; it has everything to do with disposition, character, and temperament. Here is PART II of the 10 Principles of Personal Investing.

PRINCIPLE # 1

Turn off the noise. Pay little, if any attention, to the opinions, admonitions, and advice of the so-called financial experts. They make money by selling you their products, not by making you money. Since when has a stockbroker’s compensation been based on a percentage of what you make on an investment? They receive their commission or fee regardless of how well or poorly your investment performs.

PRINCIPLE # 2

Invest in quality stocks or low-cost equity index funds. With a few notable exceptions, most mutual funds fail to outperform the S&P 500 Index. Why? For several reasons. It is very difficult for mutual fund managers to identify exceptional investment opportunities ahead of the rest of the market; the Management Expense Ratio (MER) charged to a mutual fund and the cash component that must be maintained to meet redemption’s collectively reduce the overall return of the fund; the high stock turnover rate of most mutual funds generates tax liabilities that must be paid.

PRINCIPLE # 3

Understand how taxes affect your investment returns. The return on an investment held outside a tax deferred account would get decimated by taxes. Let’s look at a simple example to demonstrate this point. If you made a $1,000 investment at the beginning of each year for five years, and earned the S&P 500 Index historical annual return of 12.2%, the total value of your after-tax investment would be $6,445. And the taxes on the capital gain would only be due when the investment is sold after five years. However, if you sold the $1,000 annual investment at the end of each year, and paid taxes on the capital gain, the total value of your investment would amount to only $5,410 (assuming a 33% tax rate). That’s a difference of $1,035 on a $5,000 investment, or 20.7%, simply by holding onto your investment rather than flipping it every year. As the investment horizon lengthens, the benefit of a buy-and-hold versus a buy-and-sell strategy grows even greater.

PRINCIPLE # 4

Don’t over-diversify your investments. One of the biggest myths propagated by the financial industry is that it’s dangerous to put all your eggs in one basket. If you buy only a handful of investments and sit on them for a long time, brokers and mutual fund managers won’t generate trading commissions and trailer fees. While it’s true that you should diversify your investments across different types of assets, e.g. real estate, stocks, bonds and cash, you don’t need to hold one hundred different stocks or bonds in your portfolio. By concentrating your financial investments in twenty to thirty good quality stocks or several index funds, you’ll get the dual benefit of adequate diversification and higher returns. And because you’re investing for the long haul, you shouldn’t be concerned about temporary blips in the stock market. People over-diversify their investment portfolios because they don’t have confidence in their investment choices.