Principles of Wealth Preservation and Growth

The principles of risk management and wealth building that I outline below are nothing new. I borrow liberally from the past and current financial greats who have far more knowledge and experience than I do. Nevertheless, the swings of human nature are such that very few investors/wealth managers actually implement the following principles with discipline. We are striving to be one of those few firms, and we want to encourage our clients to practice the same disciplines with us. Given the tumultuous economy at hand, the time to do so is now more than ever.

Some of the greatest financial principles come from the likes of Benjamin Graham, Warren Buffett, Richard Russell, Jim Rogers, Bill Gross, etc. Many of you have read these authors or have at least been exposed to their most popular maxims. You will probably recognize many of the rules listed below–these are timeless principles that do not change–but you may not necessarily recognize the order in which I have them listed. My hope is to encourage greater financial discipline by first regarding the rewards that await us if we practice the principles necessary to enjoy them. That being said, these rules work in tandem and are important as a whole. Each rule ultimately depends upon the others to provide a comprehensive and robust wealth building strategy.

Rule 1: Behold the power of the law of compounding.

Albert Einstein said that the law of compounding is the eighth wonder of the world (My understanding is that Einstein apparently knew a thing or two about numbers). Wealth creation and preservation is built upon a proper understanding of the final destination as well as the path to arrive there–and the law of compounding is both. The power of compounding is probably best understood when illustrated practically. I formed the following table to mimic a study produced by Market Logic and published long ago in one of Richard Russell’s Dow Theory Letters. I credit them both for making a powerful concept so easy to understand.

In the table below, I track the progress of the investment accounts of Investor A and Investor B over a 59-year period. I assume that Investor A begins investing $5,000 a year for a period of only 10 years. Investor A invests no additional money after year 10. Investor B begins investing $5,000 each year starting in year 11 and continues to invest each year thereafter for the rest of the 59-year hold period. I have assumed that the accounts of Investor A and B both receive an 8% return per year.

<- PERSON A PERSON B ->

Investor A contributed a total of $50,000 over the initial 10-year period of time. Investor B contributed a total of $245,000 over the remaining period of 49 years. Even with an additional $195,000 of capital contributions, Investor B still trails Investor A by more than $500,000 by the end of the 59-year hold period. Even with ongoing annual contributions of $5,000 forever thereafter, Investor B would never close the gap with Investor A due to the law of compounding. Compounding is a powerful law indeed and perhaps should be the single greatest motivation to practice the other principles.

Rule 2: Do not lose the principal!

This rule has been repeated in so many variations that we can easily gloss over its foundational importance. Nevertheless, this principle cannot be missed, as it is the basis upon which the law of compounding works. When you lose your capital, you lose much more than just the initial money: You also lose all of the future compounding return potential of that principal. So, when it comes to building wealth, there is no good reason to put your principal at undue risk. Gambling rewards very few. Compounding rewards all who follow its guidelines with patience. When you understand just how much you have at risk when you lose out on compounding, the knowledge can help you adhere more strictly to this rule.

As an addendum to this rule, it is also important to reduce the tax burden on your investments wherever possible so as to compound your returns to a greater degree. We refer to taxes as “guaranteed losses.” These tax losses are reductions to your investment capital that you can generally see coming and prepare for ahead of time. On one hand, investments should be made on the basis of their economics and not their tax benefits. (The Tax Reform Act of 1986 should serve as a strong reminder of the problem with investments that only work based on the tax benefits. Once those tax benefits were removed, the investments collapsed in value.) On the other hand, tax benefits should be pursued and implemented where those benefits can be employed through a deferred-tax vehicle (such as an IRA, 401(k), etc.) or strategy without ignoring or negatively impacting the underlying value of a particular investment. Disregarding legitimate and applicable tax saving strategies is a violation of Rule 2, as it unnecessarily reduces the principal with which you have to work.

Rule 3: Emotions are your greatest asset… and liability.

Being able to understand and navigate the swings of human emotions is key to wealth building. I believe that the extremes of human emotion ultimately drive the larger peaks and valleys that we experience in the markets. Mass fear drives the majority of investors to exit investments as they reach the bottom, and greed drives the majority of investors to begin to buy an investment long after its price has far exceeded its intrinsic value. So, then, it should be a relatively simple matter to take advantage of these extremes for our own profit. Just buy when everyone else is running in fear, and sell when everyone else is convinced that they have found the best thing since sliced bread. Easy enough!

The only problem is that we too are humans with all of the attending emotional extremes. As a rule, we all tend to go along with the crowd. Of course, when we do it, we have brilliant reasons each time to justify why we agree with the masses. We hesitate to concede or are probably unaware that we may be making the decisions we do ultimately because our emotions reflect and are moved by larger crowd sentiment. However, regardless of the justifications, history has taught us that the crowd view is often the wrong view and the unprofitable view, and, yet, still so often our own view.

Thus, properly understanding the tendencies of human emotions en masse is certainly important, but the greater skill by far is found in understanding and resisting our own tendencies to go along so easily with the crowd. If we can both understand emotions and master our own, we will be far ahead of the vast majority of investors in building and protecting our wealth.

Rule 4: Value investing (or “using the swings of emotion to your advantage”) is key.

Though both value investing and patience deserve their own separate sections, they are inextricably linked, so I have included them together. Value investing maintains that an investment is considered prudent only when the intrinsic value of an asset is above the current price at which you can acquire it. Value investing assumes that the fluctuations in human emotion and the tendency for the vast majority of investors to enter and exit investments at precisely the wrong time will provide tremendous wealth-building opportunities to those who understand intrinsic value and who are patient enough to wait for the appropriate entry and exit points. Said more simply, value investing is the science of buying low and selling high; patient conviction is the means of resisting crowd sentiment in order to accomplish those feats. Due to and driven by the swings of human nature, markets swing from under- to overvalued extremes over the long-run. Value investing guides the investor in making sound decisions through times that would be otherwise ruled by emotion-driven extremes of fear or greed.

Value investing perfectly complements the other principles, as it protects capital by allowing investors to step aside some of the larger money-losing downturns and it further augments the compounding process by encouraging investors to participate in periods of historical discounts and higher risk-adjusted returns. Value investing has been proven over multiple markets and through millennia of investment history to be the investor’s best friend.

Rule 5: Pay attention to the macroeconomic trends.

One of the most important distinguishing values that we offer clients is our focus and research on the bigger economic picture. Analyzing and following the larger economic and consumer trends by tracking the demand-side characteristics of mass consumer sentiment is basically the same as applying value investing principles at the macroeconomic level. It is paying attention to both the forest and the trees. The scary thing is that this general focus should not be such a distinguishing feature in the investment world. It strikes us simply as common sense. Unfortunately, the majority of investors and investment advisors focus only on specific investments without much regard to the larger trends that may impact the sectors and markets in which those investments exist. We believe that we must diligently strive to apply value investing principles to particular investments, the larger markets within which those investments exist, and the domestic and global circumstances in which those markets function.

The technology stock boom and bust of the 1990s and 2000s serve as an example of the effects of the larger trends on particular investments and the problem with throwing valuation out the window. Just about anyone who owned stock in a technology-related company throughout the mid ’90s made lots of money through 1999. Initially, there was a tremendous amount of legitimate growth that occurred in the 1990s as technology expanded and as consumer demand expanded faster to buy the products created. However, towards the end of the boom, some of the worst business models in the world were able to slap “.com” on the end of their names and raise millions of dollars overnight by selling stock. The focus on valuation had been abandoned entirely by the end of the decade. Earnings no longer mattered, as the technology sector had taken off and was richly rewarding any along for the ride–even from weaker investments with no possibility of real profits in the foreseeable future.

Then came the tech bust in the early 2000s, and even some of the best companies in the world lost in excess of 50% of their stock values. The quality of the company mattered very little as the entire technology sector experienced a massive deflation. To this day, some of the strongest, most profitable companies in the world have not recovered to the high prices their stock enjoyed in the late ’90s. The point? The macroeconomic trend has a significant impact on investment sectors and markets, which in turn affect particular investments. Regardless of how good a particular investment is relative to other investments in the same sector, if that sector is in trouble, even the best investment in that sector may suffer due to the larger downtrend of the sector. On a positive note, if you pay attention to the trends and never lose sight of value investing principles, you can take advantage of early entry points of initially undervalued sectors that are poised to benefit from increased consumer demand and then know to step aside when those investments or sectors become overvalued due to the swings of consumer demand and sentiment.

Trends are merely expressions of consumer sentiment en masse. Just as with the extreme emotional peaks and valleys that attend market highs and lows, these strong sentiment swings do not last forever. Therefore, it is of utmost importance to continue to monitor those trends to make sure that you are not exposed to a bubble in search of a sharp point. When the fundamental reality of a particular market shifts, investors must be paying attention and proactive enough to protect themselves from the implications of those changes. While the value investor has the luxury of being less cocerned about the daily fluctuations of an asset so long as it was purchased opportunistically, he must not ignore the larger sector valuations and systemic shifts to protect the gains on his wealth.

Rule 6: Do not put all of your eggs into one basket. DIVERSIFY!

Diversification is so very basic to the wealth-building process that I almost failed to include it as its own distinct principle with a separate section. However, few people implement a truly robust diversification strategy though it is the simplest way for an investor to reduce risk and add value to a portfolio. Many investors believe that they are practicing good diversification by only spreading their wealth into multiple stocks, ETFs, or mutual funds in different sectors. Some take it a step further by adding bonds as a separate investment category. While it is important to diversify within the categories of stocks and bonds, diversification cannot stop there.

Stocks and corporate bonds are simply two parts of the same collateral. Stocks and bonds are both ultimately backed by a corporation. Just as you would not put all of your money into only one company, it does not make sense to put all of your money into only one investment category, backed by only one type of collateral. True diversification is implemented across separate and preferably non-correlated investment categories with separate types of collateral, as well as with the separate sectors and assets within each category and collateral. By spreading your wealth over multiple non-correlated assets/sectors, and then diversifying within those assets/sectors, you limit the risk of any one investment or sector devastating your portfolio with large, unexpected losses.

Take the most recent stock market drop as an example. If your portfolio was 100% in stocks, your net worth would have suffered a loss of approximately 40% or more across the board. If you had invested 50% into stocks and 50% into bonds, you would have sustained a portfolio loss of only about 20%. This is typically where most people stop. However, if you had a diversified portfolio of stocks, corporate bonds, government bonds, real estate, commodities, absolute return strategies (trading advisors/hedge funds), currencies, and insurance, your portfolio would have sustained losses of only about 5-6% due to stocks. If you had combined and applied all of the other principles mentioned above, your portfolio would have likely not been exposed to many of the overvalued sectors at all.

Conclusion

We believe that we have survived (and thrived!) as a firm where many others have not because we hold dearly to these principles. As opposed to promoting the typical “high-return” investment schemes that are tantamount to gambling, we believe that the principles contained in this newsletter offer a “get rich slowly” strategy that will benefit all who strictly maintain them. Unfortunately, there are not many people who will adhere to these principles for the very fact that they do not provide immediate gratification… which is also why you won’t see our latest book, “6 Strategies to Get Rich Slowly”, flying off bookshelves anytime soon! All of that being said, these very principles have positioned our firm and our clients to profit handsomely over the next few years as we take advantage of the deep discounts provided by the downturn in the market, ongoing recessionary environment, and tension between inflation and deflation.