Thursday, February 21, 2008

10 golden rules to become rich!

10 golden rules to become rich!

February 21, 2008 11:35 IST

Once you decide to put your money to work to build long-term wealth, you have to decide, not whether to take risk, but what kind of risk you wish to take. Here are 10 investing rules that can make you rich:

1. There's no escaping risk

Once you decide to put your money to work to build long-term wealth, you have to decide, not whether to take risk, but what kind of risk you wish to take.

Yes, money in a savings account is dollar-safe, but those safe dollars are apt to be substantially eroded by inflation, a risk that almost guarantees you will fail to reach your wealth goals.

And yes, money in the stock market is very risky over the short-term, but, if well-diversified, should provide remarkable growth with a high degree of consistency over the long term.

2. Buy right and hold tight

The most critical decision you face is arriving at the proper allocation of assets in your investment portfolio -- stocks for growth of capital and growth of income, bonds for conservation of capital and current income.

Once you get your balance right, then just hold tight, no matter how high a greedy stock market flies, nor how low a frightened market plunges. Change the allocation only as your investment profile changes. Begin by considering a 50/50 stock/bond-cash balance, then raise the stock allocation if:

You have many years remaining to accumulate wealth.
The amount of capital you have at stake is modest.
You don't have much need for current income from your investments.
You have the courage to ride out the stock market booms and busts with reasonable equanimity.
As these factors are reversed, reduce the 50 per cent stock allocation accordingly.

3. Time is your friend, impulse your enemy

Think long term, and don't allow transitory changes in stock prices to alter your investment program. There is a lot of noise in the daily volatility of the stock market, which too often is 'a tale told by an idiot, full of sound and fury, signifying nothing'.

Stocks may remain overvalued, or undervalued, for years. Realize that one of the greatest sins of investing is to be captured by the siren song of the market, luring you into buying stocks when they are soaring and selling when they are plunging.

Impulse is your enemy. Why? Because market timing is impossible. Even if you turn out to be right when you sold stocks just before a decline (a rare occurrence!), where on earth would you ever get the insight that tells you the right time to get back in? One correct decision is tough enough. Two correct decisions are nigh on impossible.

Time is your friend. If, over the next 25 years, stocks produce a 10% return and a savings account produces a 5% return, $10,000 would grow to $108,000 in stocks vs. $34,000 in savings. (After 3% inflation, $54,000 vs $16,000). Give yourself all the time you can.

4. Realistic expectations: the bagel and the doughnut

These two different kinds of baked goods symbolize the two distinctively different elements of stock market returns.

It is hardly farfetched to consider that investment return -- dividend yields and earnings growth -- is the bagel of the stock market, for the investment return on stocks reflects their underlying character: nutritious, crusty and hard-boiled.

By the same token, speculative return -- wrought by any change in the price that investors are willing to pay for each dollar of earnings -- is the spongy doughnut of the market, reflecting changing public opinion about stock valuations, from the soft sweetness of optimism to the acid sourness of pessimism.

The substantive bagel-like economics of investing are almost inevitably productive, but the flaky, doughnut-like emotions of investors are anything but steady -- sometimes productive, sometimes counterproductive.

In the long run, it is investment return that rules the day. In the past 40 years, the speculative return on US stocks has been zero, with the annual investment return of 11.2% precisely equal to the stock market's total return of 11.2% per year.

But in the first 20 of those years, investors were sour on the economy's prospects, and a tumbling price-earnings ratio provided a speculative return of minus 4.6% per year, reducing the nutritious annual investment return of 12.1% to a market return of just 7.5%. From 1981 to 2001, however, the outlook sweetened, and a soaring P/E ratio produced a sugary 5% speculative boost to the investment return of 10.3%.

Result: The market return leaped to 15.3% -- double the return of the prior two decades.

The lesson: Enjoy the bagel's healthy nutrients, and don't count on the doughnut's sweetness to enhance them.

5. Why look for the needle in the haystack? Buy the haystack!

Experience confirms that buying the right stocks, betting on the right investment style, and picking the right money manager -- in each case, in advance -- is like looking for a needle in a haystack.

Investing in equities entails four risks: stock risk, style risk, manager risk, and market risk. The first three of these risks can easily be eliminated, simply by owning the entire stock market -- owning the haystack, as it were -- and holding it forever.

Owning the entire stock market is the ultimate diversifier. If you can't find the needle, buy the haystack.

6. Minimize the croupier's take

The resemblance of the stock market to the casino is not far-fetched. Yes, the stock market is a positive-sum game and the gambling casino is a zero-sum game . . . but only before the costs of playing each game are deducted. After the heavy costs of financial intermediaries (commissions, management fees, taxes, etc.) are deducted, beating the stock market is inevitably a loser's game. Just as, after the croupiers' wide rake descends, beating the casino is inevitably a loser's game. All investors as a group must earn the market's return before costs, and lose to the market after costs, and by the exact amount of those costs.

Your greatest chance of earning the market's return, therefore, is to reduce the croupiers' take to the bare-bones minimum. When you read about stock market returns, realize that the financial markets are not for sale, except at a high price.

The difference is crucial. If the market's return is 10% before costs, and intermediation costs are approximately 2%, then investors earn 8%. Compounded over 50 years, 8% takes $10,000 to $469,000. But at 10%, the final value leaps to $1,170,000 -- nearly three times as much . . . just by eliminating the croupier's take.

7. Beware of fighting the last war

Too many investors -- individuals and institutions alike -- are constantly making investment decisions based on the lessons of the recent, or even the extended, past. They seek technology stocks after they have emerged victorious from the last war; they worry about inflation after it becomes the accepted bogeyman, they buy bonds after the stock market has plunged.

You should not ignore the past, but neither should you assume that a particular cyclical trend will last forever. None does. Just because some investors insist on 'fighting the last war,' you don't need to do so yourself. It doesn't work for very long.

8. Sir Isaac Newton's revenge on Wall Street -- return to the mean

Through all history, investments have been subject to a sort of law of gravity: What goes up must go down, and, oddly enough, what goes down must go up. Not always of course (companies that die rarely live again), and not necessarily in the absolute sense, but relative to the overall market norm.

For example, stock market returns that substantially exceed the investment returns generated by earnings and dividends during one period tend to revert and fall well short of that norm during the next period. Like a pendulum, stock prices swing far above their underlying values, only to swing back to fair value and then far below it.

Another example: From the start of 1997 through March 2000, Nasdaq stocks (+230%) soared past NYSE-listed stocks (+20%), only to come to a screeching halt. During the subsequent year, Nasdaq stocks lost 67% of their value, while NYSE stocks lost just 7%, reverting to the original market value relationship (about one to five) between the so-called 'new economy' and the 'old economy.'

Reversion to the mean is found everywhere in the financial jungle, for the mean is a powerful magnet that, in the long run, finally draws everything back to it.

9. The hedgehog bests the fox

The Greek philosopher Archilochus tells us, 'The fox knows many things, but the hedgehog knows one great thing.' The fox -- artful, sly, and astute -- represents the financial institution that knows many things about complex markets and sophisticated marketing.

The hedgehog -- whose sharp spines give it almost impregnable armour when it curls into a ball -- is the financial institution that knows only one great thing: long-term investment success is based on simplicity.

The wily foxes of the financial world justify their existence by propagating the notion that an investor can survive only with the benefit of their artful knowledge and expertise. Such assistance, alas, does not come cheap, and the costs it entails tend to consume more value-added performance than even the most cunning of foxes can provide.

Result: The annual returns earned for investors by financial intermediaries such as mutual funds have averaged less than 80% of the stock market's annual return.

The hedgehog, on the other hand, knows that the truly great investment strategy succeeds, not because of its complexity or cleverness, but because of its simplicity and low cost. The hedgehog diversifies broadly, buys and holds, and keeps expenses to the bare-bones minimum.

The ultimate hedgehog: The all-market index fund, operated at minimal cost and with minimal portfolio turnover, virtually guarantees nearly 100% of the market's return to the investor.

In the field of investment management, foxes come and go, but hedgehogs are forever.

10. Stay the course: the secret of investing is that there is no secret

When you consider these previous nine rules, realize that they are about neither magic and legerdemain, nor about forecasting the unforecastable, nor about betting at long and ultimately unsurmountable odds, nor about learning some great secret of successful investing.

In fact, there is no great secret, only the majesty of simplicity. These rules are about elementary arithmetic, about fundamental and unarguable principles, and about that most uncommon of all attributes, common sense.

Owning the entire stock market through an index fund -- all the while balancing your portfolio with an appropriate allocation to an all bond market index fund -- with its cost-efficiency, its tax-efficiency, and its assurance of earning for you the market's return, is by definition a winning strategy.

But if only you follow one final rule for successful investing, perhaps the most important principle of all investment wisdom: Stay the course!

[Excerpt from Investing Rules from the Masters by John C. Bogle, a doyen of the American mutual fund industry who was designated by Fortune magazine as one of US investment industry's four 'Giants of the 20th Century.']

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