(Page 7 of 7)

Doug and Susan can retire much sooner and/or far better than they thought they could because of the power of compound growth, which dictates that not only money earns a return on investment (ROI), but the ROI earns an ROI. (Recall the difference in compounding at 8 or 9 percent a year versus 23 percent.) This is how money can make even more money over time. Example: You invest $1,000 and it gets an ROI of 10 percent each year. After the first year your investment is worth $1,100. In the second year you get an ROI of 10 percent on that $100 profit as well as your original $1,000. This brings your total to $1,210, and so on. If you leave your investment to compound at 10 percent per year, 50 years later that $1,000 becomes $117,391 . . . and you are dead. So we need to speed this up a bit. To do that, we have to get a better ROI.

The reason we make Rule #1 the foundation of our investment philosophy is that we understand that the power of compounding money at 15 percent a year or more depends on not losing it - ever. A 50- percent drop in price requires a 100-percent rise in price just to break even. If the price of a stock drops 80 percent, it has to go up 400 percent to break even. Oracle was at $40 a share in 2000 and dropped to $10. That's an 80-percent drop. It has to double once from $10 to $20 and then double again from $20 to $40 just to break even. Four hundred percent! Think about that. For the market to go up 400 percent, the Dow, for example, would have to go from 10,000 to 40,000. And that could take at least three decades! Meanwhile, your portfolio is a permanent disaster and a 15-percent minimum yearly return is out of reach.

Let's return for a moment to Doug and Susan Connelly, but this time assume only Susan came to learn about Rule #1 and each has a separate portfolio (a stubborn couple, they both practice their own methods of investing and don't want to mix accounts). Let's also assume each has $20,000 to invest now, plus an additional $5,000 a year, as in the example above. After 10 years of investing and reaping 15 percent a year, Doug loses half his money in a market crash. Susan, a Rule #1 investor, does not. She then teaches Doug about Rule #1, and from the end of the tenth year onward, they both manage to make 15 percent a year. Twenty years from now, Doug has $420,000; Susan has $840,000. This means Doug has $63,000 a year to live on while Susan is living comfortably on $126,000 a year. The permanent $63,000-peryear difference in annual income 20 years later is Doug's one-time violation of Rule #1.

And this isn't even close to what's actually happened to thousands of students of mine who've related their investing horror stories. For example, I met Robert at a presentation I did in Texas. He had all his retirement invested in Enron stock at the urging of his trusted bosses. He was so angry about it that when I showed the class proof that Enron insiders were getting out even while they told their employees to stay in, he had to go out into the hall and cool off before breaking something. Such anger is very real, the outward manifestation of serious emotional problems that ferment when we work hard to build wealth and then see it taken away because of ignorance. There wasn't a person in that room who didn't see a piece of themselves in Robert's anger and pain.

Another guy whom I'll call Chris told me he started with about $50,000 in 1990 and built it up to more than $1 million by 2000. Then he lost it all simply because he couldn't believe it wouldn't go back up and his broker kept telling him to "double down" - put more and more into the stocks that were going down so he'd make his fortune when they went back up. But they didn't ever go up, and it wiped him out. He was starting over with $1,000 and the realization that even if the market does go up in the long run, the long run is longer than he has.

These are people to admire. They got knocked down hard and still got up. But although we salute their guts and perseverance, the truth is we don't want to have their experience if we can avoid it. My feeling is, learn Rule #1 and avoid making the mistake in the first place.

Get knocked down seven times. Get up eight times.

- Japanese proverb

[If you've never bought a stock before, don't know how to open a brokerage account, or don't know what an IRA is, don't worry. I'll be guiding you through the process in Chapter 15. First I want you to become very familiar with the Rule #1 methodology, and then we'll tackle those smaller issues and get you started on the right foot.]

The impact of compounding rates of return can work for you or against you. Which way it works depends on whether you're able to invest with certainty in companies that won't lose your money. Only then will your compounded rate of return be certain to be positive and high enough to make a difference in your life. Almost any sort of positive compounded rate of return will eventually make you rich. The question is when. Obviously, the larger the positive compounded rate of return, the faster you get rich - as long as you don't violate Rule #1.

Think of it like a board game in which if you land on the wrong square you get sent back to the beginning and have to start over. That's exactly what kills most institutional (mutual fund) portfolios. At some point the big guys - your mutual fund managers - all land on that square. Your job as a little investor is to learn how to avoid landing on that square. If you don't get sent back to the beginning, you're going to be very comfortable financially.

Ask yourself this question: If you thought you could retire in 10 to 20 years by working on it just 15 minutes a week with less risk than you're taking right now in your mutual funds, would you want to learn how? I'm guessing the answer is an enthusiastic "yes," so listen up as we turn now to a discussion of Rule #1's specific working method.

Copyright © 2006 by Phil Town.

Tags: Investing

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.