Wednesday, March 9, 2011

Use Time in Your Favor

Investment Lesson #3


Time is your friend.

First, as you leave your money invested for a long period of time, you benefit from compounding: the gains of of one year are reinvested to generate more gains. Here's a simple example - the Rule of 72.

The Rule of 72 is a simple, quick way to estimate how fast your money will double assuming a rate of return AND compounding: divide 72 by the return as a percentage. Suppose you make an investment that will provide 10% returns and you can leave your money invested as long as you wish. Applying the Rule of 72 (72 divided by 10) gives the wonderful result that your money will double in 7.2 years (approximately). Leaving your money invested, your money will have quadrupled in 14.4 years and been multiplied by eight in 28.8 years! Simple, non-compounded returns over those 28.8 years could result in only a return of 288% (28.8 years x 10% per year), but compounding gives you a 700% return (800% less original investment = 700% return). You've done almost 3x better by simply sitting, riding that investment along to more profits.

Second, you need to be patient about putting your money to work. Simply barging into stocks or bonds or gold with all your money at any price or time is a very, very risky move. All those investment asset classes have returns that vary with time: the returns go up or down. One month, the total stock market index VTI might be 66 per share, in a later month it might be 70 or 62. Or the moves can be larger. Ditto for bonds, even US Treasury bonds. Ditto for Gold.

Remember Rule #0: we want to do just average and we want to invest for the long term. If you barge in and put all your savings into stocks, and they go down 10% in a normal fluctuation, you'll feel rather rotten. That pain might make you do something stupid, like pull all your money out & barge into bonds. Of course, interest rates might rise and those bond prices might go down 10%. You feel double rotten. You are now fodder for the Street and the hedge fund piranhas. They are going to whip & drive you emotionally every way and eventually to investment oblivion. Don't play their games.

Assuming you have no special knowledge (a very strongly supported assumption), you will be right 50% of the time. BUT the pain when you are wrong will be larger than the pleasure from being right. That's a fact of human behavior that underlies all economic theory. Almost all human beings are risk averse.

One can prove mathematically that by investing your money over time, in bits over the months and years, will reduce your risk a LOT. I saw this proof at MIT business school years ago; Fischer Black, the famous finance theorist, showed us the proof in class one day. I still remember it. He called it, time diversification. This is another free ride you can take, much like the asset class diversification.

Example: You receive $50,000 from a severance package. Don't put it all into your investments all at once. Put $5,000 a month into them, into whatever is cheap at the time (see rule #4), paying attention to your asset class percentages. You will reduce your risk and increase your chances of doing average.

The same applies to withdrawals, if you can wait. Suppose you know you'll need $50,000 in a year. Take out $5,000 a month from whatever is expensive - high prices, still paying attention to your asset classes.

Be patient. Use time as a tool for yourself. Get all the free benefits of compounding and time diversification. That's how you get the highest returns with the least risk.

Word of the Day

None today. I have to take the recycling out.


Spin-em said...

Arent the Libyan rebels Shiites?.....they want our help??....that club is Members Only...France says go so Barry gives Gates the gitmo bribe...F-------THAT

Spin-em said...

The Harvard men's basketball team will have to win one more game to get a spot in the NCAA Tournament for the first time since 1946.
Princeton defeated Penn 70-58 tonight to tie Harvard for the Ivy League regular-season title and force a one-game playoff for the league's automatic berth in the national championship tournament.

Harvard will face Princeton on Saturday at 4 p.m. at Yale University in New Haven, Conn

Bud said...

SAM ceo says surge in wheat prices affecting his beer prices

Bman does the common man drink SAM ?? still think QE2 was a good idea ???

'ranchers and farmers'

Bunkerman said...

No idea re Libyan revels ... but it's there fight; why should US get involved?

let Europe do it ,... it's in their backyard.

Bunkerman said...

uh ... I thought beer was made with barley?

he just wants an excuse to raise prices.

I'd guess the cost of ingredients is a very small part of the total cost of beer.