Friday, March 1, 2013

It Ain't Rocket Science

Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.
Peter Lynch

I tell people that what I am doing is not rocket science. Sometimes I practically beg people to get involved in investments, but they think success requires something they do not have, either they believe they lack basic math skills or arcane information obtained from the power of the dark side.

Here is all you need to get started. First get rid of your credit card debt. Next have AT LEAST! three months expense money in a boring federally guaranteed savings account. That’s it. Your next step could be as small as $35.00 (given the current price of silver) for a single American Silver Eagle. If you want to take your first baby step into a low cost index fund or an Exchange Traded Fund (ETF) you will need $3,000 to start with most Vanguard funds. You can find funds that only require an initial investment of $1,000. At Charles Schwab, my broker, there is no minimum investment requirement and no maintenance fees. To start buying all you need to have is the amount of money you want to put into your first investment.

Peter Lynch, the genius who built the mighty Magellan Fund said, “All the math you need in the stock market you get in the fourth grade.” He also stated, “Your investor's edge is not something you get from Wall Street experts. It's something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.”

Keep it small. Keep it simple. Although you will violate this rule in the earliest days of your journey, if you never invest more than 2% of your liquid net worth (liquid net worth: your net worth excluding the equity in your primary residence) in any single stock or less than 7% in any given sector, you will always be able to sleep at night. Barring a global crash (such as happened in 1929) it is unlikely you will lose your shirt. Consider the infamous Dotcom Crash of 2000. Shares in some Internet stocks lost ALL their value almost overnight. Even if you lost 80% of 7%, that is only 5.6% of your liquid net worth. Painful? Yes, but not the end of the world.

How does this investing in what you already understand thing work? My wife has no particular interest in investments. Her Master’s degree is in social work. She has no math skills beyond basic algebra. On two occasions she has actively promoted an investment. She practically begged me to buy shares in Yankee Candle. I couldn’t smell any difference between their scented candles and any other scented candles, but I followed her advice. Yankee Candle was a 3 banger. When Yankee Candle went private, we reaped a 300% increase in our initial investment. Her other recommendation, Johnson & Johnson, hasn’t been a barn burner, but it is a steady performer. Year after year it goes up in value and pays out an ever increasing dividend.

In our society, it's been the men who've handled most of the finances, and the women who've stood by and watched men botch things up.
Peter Lynch

Of course after you have received that flash of insight from the great beyond read the free research reports offered by your broker. Peter Lynch reminds us, “If you don't study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.”

As I encourage the frightened to take their first steps into the world of investing, I remind them, “Never invest in anything you couldn’t explain to a junior high school student. Peter Lynch is even more emphatic. He stated, “Never invest in any idea you can't illustrate with a crayon.” Today Chevron buys oil at $2.16 a gallon. It sells me mid-grade gasoline for my Acura at $4.05 a gallon. Chevron is a well managed company that makes a good profit, has a good cash flow, and pays a good dividend. Of course the same could have been said of British Petroleum until one of their drilling platforms caught on fire. That is why you don’t want to have more than 2% of your liquid net worth in any individual stock.

In baseball, a lifetime batting average of 300 will get you into the Hall of Fame. Just think about that for a minute. You are considered an immortal if you can hit the ball 3 out of 10 times. In investment you do need to do better than that, but even a batting average of 600 will reap a greater harvest than you can imagine. Your winners do not need to grand slam homeruns. In fact, most of them will be singles, just gradually drifting upwards in value over time, fluctuating up and down with the market, sometimes stalling out for a year or two along the way. You will have a few big winners. That is all you need. Remember, the most you can lose in a single investment is all of it. It is unlikely that you will ever lose more than 50% in any single investment even in a miserable year like 2008. With the use of automatic stop loss orders you can limit the amount you choose to lose.

There is no upper limit on your winners. Back in 1996 Apple sold for less than $5.00 a share. Today, even after losing more than ½ its value Apple still sells at $441.40. It doesn’t take but one big winner to buy that house South Kohala with a nice view of the Pacific Ocean.

Take your time. Start small. Keep it simple. Hold an age appropriate reserve in bond funds, CDs, and the like. Diversify. Diversify. Diversify. Most of what I buy is pretty safe, boring, and obvious. It is unlikely I will ever have my own TV show. However, over the course of 10 years, through savings and investments, I built a position that allowed me to retire at 62. It works. I promise you patience, persistence, and compound interest over time can perform wonders.

And remember: The journey of a thousand miles begins with a single step.

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