The Three Myths of Investing, Part 2

Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week!
by Phil Town

(Page 3 of 7)

The chart on page 18 shows how Rule #1 investors have fared over the last several decades, as compared with the performance of the S&P 500 and the Dow Jones Industrial Average.

(Chart shows How Rule #1 investors have fared in comparison with the market's most popular indexes. This chart may appear erroneous or exaggerated, but it's not. Rule #1 investors outperform the S&P 500 and the Dow Jones Industrial Average by a long shot - routinely. The magic of compound growth is what explains the massive difference between compounding at 8 or 9 percent per year versus compounding a little over 23 percent per year. Such a huge difference isn't so obvious at first glance. Because 23 percent is just three times bigger than 8 percent, one would automatically think the dollars should just be three times bigger. But compounding growth is not linear, it's what is called geometric. Compounding grows a rate of return not only on the original dollar invested, but also on the accumulating dollar returns ("interest on interest"). Because 23 percent produces a higher dollar return every year, which, in turn, has a 23 percent return on it, the accelerating dollar amount explodes after several years and rockets far from the lower 8-percent compounded return.

Cool, huh?)

Myth 3. The Best Way to Minimize Risk Is to Diversify and Hold (for the Long Term).

Diversify and hold. Everybody knows that's the safest way to invest in the stock market, right? But then again, at one time everybody knew the earth was flat. The fact is, a long-term diversified portfolio would have had a zero rate of return for 37 years from 1905 to 1942, for 18 years from 1965 to 1983, and from 2000 to 2005. Sixty years out of 100. If you know how to invest - meaning you understand Rule #1 and know how to find a wonderful company at an attractive price - then you do not diversify your money into 50 stocks or an index mutual fund. You focus on a few businesses that you understand. You buy when the big guys - the fund managers who control the market - are fearful, and you sell when they're greedy. Shocking, no? (And if you don't know what I mean by this, you will by the end of this book. Promise.)

Today more than 80 percent of the money in the market is invested by fund managers (pension funds, banking funds, insurance funds, and mutual funds). As I indicated in the Introduction, this is what is known as "institutional money." Out of $17 trillion, the big guys manage more than $14 trillion of it. In other words, the fund managers are the market; when they move billions of dollars into a stock, the price of that stock goes up. When they take their money out, the price of that stock goes down. Their effect on the market is so huge that if they decide to sell suddenly, they can generate a massive crash. Understanding this fact is central to Rule #1: The fund managers control the price of almost all the stocks in the market, but they can't easily get out when they want to. You and I, however, can be in or out of the market within seconds. In Chapter 11 we'll explore in detail what this means for us.

So what happens in the long run if the baby-boom money that drove the market up starts to come out as the baby boomers retire? Or what if some other event draws money out of the market? As mutual funds drop in value, investors react by withdrawing money faster from the funds, which ultimately puts the market into free fall. The irony is that while, in theory, investing for the long run in a diversified mutual fund lowers risk, such an investment strategy in this market actually raises risk. In this market there's no such thing as a "balanced portfolio" that reduces your exposure to market risk, no matter how loudly the financial services industry salesmen shout it. If this market crashes, fund managers who play these games may find themselves rearranging deck chairs on the Titanic.

If you don't think a total stock market meltdown can happen in a modern economy, think again. It just happened over the last ten years in Japan, whose stock market lost 85 percent of its value from 1992 to 2002. It hasn't recovered yet. And Japan's boomers are about ten years older than America's (political and economic factors prompted a baby boom in Japan prior to the start of World War II). If America's market tanks 85 percent, the Dow will be at 1500. It happened during the 1930s. It can happen again.

Diversification spreads you out too thin and guarantees a market rate of return - meaning whatever happens to the whole market happens to you. Obviously there are hundreds of great businesses available to buy, but if you have a job and a family and don't want to be married to your computer, you don't have time to keep up with more than a few. If you buy businesses you don't keep up with, you'll inevitably violate Rule #1 with respect to some, causing your overall return to drop.

As Rule #1 business buyers, we pick a few choice businesses in different sectors of the market. So even though we aren't "diversifying" like mutual fund managers by buying dozens - if not hundreds - of different companies at once, we'll be setting up a portfolio that reflects different categories of businesses. But exactly how many companies you can buy into will depend on how much money you have to invest, and I'll tell you what the right proportional relationship is.

Diversification is for people who have 30 years to go, have no desire whatsoever to learn how to invest, and are going to be happy with an 8-percent yearly return and a minimum standard of living in retirement. Our goal is to find wonderful companies, buy them at really attractive prices, and then let the market do its thing - which means eventually the market will price these businesses correctly at their value; in a few weeks, months, or years we're a lot richer than we are right now. That's what we want to do. But to do that, we have to stop being ignorant investors being taken advantage of by the entire financial services industry and start being knowledgeable Rule #1 investors who, instead of being the prey, outfox the predators.

[ In the mid-1960s my dad suggested I put money in a diversified mutual fund. I invested $600 and forgot about it. Eighteen years later my investment was worth $400. Imagine if I were 45 years old in the mid-1960s and I invested $60,000 instead of $600. How depressing would it have felt 18 years later at age 63 to discover my $60,000 had become $40,000 instead of the $240,000 I was planning on for my retirement? A goal of this book is to spare you from ever having to look into that financial abyss.]

Copyright © 2006 by Phil Town.

About the Author

He isn't your typical Wall Street guy. An ex-Green Beret and former river guide, Phil Town is a self-made millionaire several times over and America's most widely sought-after speaker on investing. In his new book, RULE #1, he describes the Rule #1 personal financial strategy in detail so that anyone, even first-time investors,can get - and stay - rich.