The 80/20 Principle: The Secret of Achieving More With Less (31 page)

Oddly enough, certain categories of investment, and certain investment strategies, are predictably much better than others at creating wealth.

80/20 INSIGHTS INTO MAKING MONEY

• You are more likely to become wealthy, or to obtain the greatest increase in wealth, from investment income rather than from employment income. This means that there is a premium on accumulating enough money early on to fund investment. Accumulating your stake for entry to the investment world usually requires hard work and low spending: for a period, net income must be higher than spending.

The only exceptions to this rule are acquisition of money from legacies or other gifts, marrying into a wealthy family, windfalls from lotteries or other forms of gambling, and crime. The first cannot easily be predicted, the third is so unlikely that it should be totally discounted, the fourth is not recommended, so only the second can be consciously planned and even then the outcome is uncertain.

• Because of the compounding effects of investment, you can become rich either by starting to invest early in life, or by living a long time, or both. Starting early is the most controllable strategy.

• As early as possible, develop a consistent, long-term investment strategy, based on principles that have worked well in the past.

How, then, do we obtain 80 percent of investment returns with 20 percent of the money? The answer is to follow Koch’s 10 commandments of investment:

Make your investment philosophy reflect your personality

A key to successful personal investing is to match your personality and skills to one of a number of proven techniques. Most private investors fail because they use techniques that, while perfectly valid, are not suited to them as individuals. The investor should choose from a menu of perhaps 10 successful strategies, to suit his or her own temperament and knowledge.

Koch’s 10 commandments of investment

1. Make your investment philosophy reflect your personality

2. Be proactive and unbalanced

3. Invest mainly in the stock market

4. Invest for the long term

5. Invest most when the market is low

6. If you can’t beat the market, track it

7. Build your investments on your expertise

8. Consider the merits of emerging markets

9. Cull your loss makers 10 Run your gains

For example:

• If you like playing with numbers and are analytical, you should become a devotee of one of the analytical methods of investment. Of these, the ones that I like best are value investing (but see the next point), detecting earnings acceleration, and specialist investments such as warrants.

• If you veer more toward optimism than pessimism, avoid an excessively analytical approach such as those above. The optimist often makes a poor investor, so be sure that your investments really are beating the index; if not, sell them and hand the money over to an index-tracking fund.

Sometimes optimists, who in this case deserve the epithet “visionaries,” make great investors, because they select two or three shares that they know have enormous potential. But if you are an optimist, try to restrain your enthusiasm and write down as carefully as possible why the shares you like are so attractive. Try to be rational before you buy. And be sure to sell any loss-making shares even if you are emotionally committed to them.

• If you are neither analytical nor “visionary” but a practical sort of person, you should either specialize in an area about which you know a great deal or follow successful investors who have a clear track record of beating the index.

Be proactive and unbalanced

Being proactive means that you take charge of your investment decisions yourself. The danger of advisers and money managers is not so much that they cream off a lot of the profit, but even more that they are unlikely to recommend or implement the sort of unbalanced portfolio that is the route to superior returns. Risk, it is said, is minimized by having a broad spread of investments in a wide range of different media, such as bonds, stocks, cash, real estate, gold, and collectibles. But risk minimization is overrated. If you want to become rich enough to change your future lifestyle, you need to attain above-average returns. The chances of doing this are much higher if you adopt an unbalanced portfolio. This means that you should have few investments: those that you are convinced will give high returns. And it also means that you should invest in one medium.

Invest mainly in the stock market

Unless you happen to be an expert in a very esoteric investment medium, such as nineteenth-century Chinese silk screens or toy soldiers, the best investment medium is the stock market.

Over the long haul, investing in stocks (also called shares or equities) has produced returns stunningly higher than putting the money in a bank or investing in interest-bearing instruments like government or corporate bonds. For example, I calculated in Great Britain that if you had invested £100 in a building society in 1950, you could have taken out £813 by 1992; but the same £100 invested in the stock market would have returned £14,198, more than 17 times as much.
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Similar calculations can be made for the United States and nearly every other major stock market.

Anne Scheiber, a private American investor with no particular expertise in the stock market, put $5,000 into blue-chip stocks just after the Second World War. She then sat on them. By 1995 the $5,000 had turned into $22 million: 440,000 percent of the original!

The stock market, happily, is a relatively easy investment medium for the nonexpert.

Invest for the long term

Do not move in and out of individual stocks, or your share portfolio as a whole, very often. Unless they are clear losers, keep your stocks for many years. Buying and selling stocks is expensive as well as time consuming. If you possibly can, take a 10-year view or, even better, a 20-, 30-, or 50-year view. If you put money into stocks for the short term, you are really gambling rather than investing. If you are tempted to take the money out and spend it, you are deferring expenditure rather than investing.

At some stage, of course, you may want to enjoy your wealth rather than wait for your heirs to do so. The best use of wealth is usually to create a new lifestyle where you can choose how to spend your time, to pursue a career or work activity that you would most enjoy. Then the investment period is over. But until you have enough money to make this shift, continue to accumulate.

Invest most when the stock market is low

Although its value goes up over time, the stock market is cyclical, partly as a function of the economic cycle but mainly because moods fluctuate. It is amazing, but irrational concerns driven by fashion, animal spirits, hope, and fear can drive prices up or down. Pareto himself observed this phenomenon:

There is a rhythm of sentiment which we can observe in ethics, in religion, and in politics as waves resembling the business cycle…

Whereas during the upward trend every argument produced in order to demonstrate that an enterprise will produce money is received with favour; whereas such an argument will be absolutely rejected during the downward trend…A man who during the downward trend refuses to underwrite certain stocks believes himself to be guided exclusively by reason and does not know that, unconsciously, he yields to the thousand small impressions which he receives from the daily economic news. When, later, during the upward trend, he will underwrite those same stocks, or similar shares offering no better chance of success, he will again think that he is following only the dictates of reason and will remain unaware of the fact that his transition from distrust to trust depends on sentiments generated by the atmosphere around him…

It is well known at the Stock Exchange that the public at large buys only in a rising market and sells in a declining market. The financiers who, because of their greater practice in this business, use their reason to a greater extent, although they sometimes allow themselves to be swayed by sentiment, do the opposite, and this is the main source of their gains. During a boom period any mediocre argument to the effect that this boom must continue has great persuasive power; and if you tried to tell man that, after all, prices cannot continue to go up indefinitely, be sure he would not listen to you.
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A whole school, that of value investing, has grown up around this philosophy: buy when the stock market as a whole, or an individual share, is low and sell when it is high. One of the most successful investors of all time, Benjamin Graham, wrote the rule book for value investing, and his rules have been vindicated time and time again.
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There are many rules to guide you in value investing. Simplifying greatly, but capturing perhaps 80 percent of their value in well under 20 percent of the space, here are three rules to help you:

• Do not buy when everyone else is and when everyone is convinced that the stock market can only go up. Instead, buy when everyone else is pessimistic.

• Use the price/earnings ratio (P/E) as the best single benchmark for deciding whether shares are expensive or cheap. The P/E of a share is its price divided by its after-tax earnings. For example, if a share is 250 cents and its earnings per share are 25 cents, the share is on a P/E of 10. If the share price goes up, in a period of optimism, to 500 cents, but the earnings per share are still 25 cents, the P/E is now 20.

• In general, a P/E of over 17 for the stock market as a whole is a danger signal. Do not invest heavily when the market is this high. A P/E of under 12 is a buy signal; one of under 10 a definite buy signal. Your stockbroker or a good financial newspaper should tell you what the current market average P/E is. If asked which P/E you mean, say learnedly “the historic P/E, bozo.”
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If you can’t beat the market, track it

It is quite possible to develop an investment approach that is superior to the stock market average by following certain precepts and developing an approach tailored to your own personality and skills. These possibilities are explored below. But it is more likely that selecting your own investments will lead you to performance inferior to that of the stock market indices.

In the latter case, or if you don’t even wish to experiment with your own approach in the hope of beating the market, you should “track the index.”

Index tracking, also called market tracking, means buying the shares that are in the stock market index. You then only sell shares when they drop out of the index (this happens to underperforming shares), and you only buy new shares when they are first included in the index.

You can track the index yourself, at the cost of some effort in following the financial press. Alternatively, you can put your money into a “tracker fund” run by fund managers who, for a small annual fee, will do it for you.

You can choose different funds depending on which market you choose to track. Generally, it is safest to choose your home market and to go for a fund tracking the index comprised of the largest and best-quality shares (called “blue chips”).

Index tracking is fairly low risk and yet, over the long term, should deliver high returns. If you decide to follow this approach, you need read no further than these first six commandments. It can be more fun and more rewarding, although at higher risk, to make your own selections. The next four commandments apply in that case. Remember, however, that this commandment requires you to go back to index tracking unless your own investment strategy generally beats the index. If it doesn’t, cut your losses and track the index.

Build your investments on your expertise

The whole essence of the 80/20 philosophy is to know a few things well: to specialize.

This law applies particularly to investment. If you are deciding yourself which shares to buy, specialize in an area in which you are a relative expert.

The great thing about specialization is that the possibilities are almost endless. You could, for example, specialize in shares of the industry in which you work, or of your hobby, your local area, or anything else in which you are interested. If you like shopping, for example, you might decide to specialize in the shares of retailers. Then if you notice a new chain springing up, where each new store seems to be full of keen shoppers, you might want to invest in those shares.

Even if you do not start out as an expert, it may pay to specialize in a few shares, for example those in a particular industry, so that you can learn as much as possible about that area.

Consider the merits of emerging markets

Emerging markets are stock markets outside the developed countries: in countries where the economy is growing fast and where the stock market is still developing. Emerging markets include most of Asia (but not Japan), Africa, the Indian subcontinent, South America, the ex-communist countries of Central and Eastern Europe, and the fringes of Europe such as Portugal, Greece, and Turkey.