Many people are more comfortable working with numbers – in this case dollar amounts versus percentages. For many people in most situations that may work just fine.
However, there are situations where favoring the use of numbers does not work as well as percentages.
A short time ago, I met a young man who was investing using the Trend Following methodology offered by Trending Stocks. He was disappointed and was contemplating walking away from it all together.
When I asked why he was feeling that way, he explained that he had been using the strategy for about 6 months. He started with a portfolio of $10,000 and had, over that time, purchased 21 different trending stocks, placing a trailing stop behind each purchase.
I replied “that sounds pretty good to me. What’s the problem?”
His response: “the results”!
I asked him to share the results with me. I was expecting to hear about a string of small losses, but that wasn’t the case. He actually had a gain of about $400.
When I asked again, ‘what’s the problem?’ He said, “$10,000 dollars invested in trending stocks for 6 months and I only made $400. It just seems like a lot of work for not much gain”.
I realized that his expectations were quite high for just six months of investing – and they were measured only in dollars.
I explained that meager gain of $400 was actually a gain of 4% for 6 months. And he had not been fully invested the entire time as it had taken him some time to select and buy the 21 stocks.
When annualized, it would represent an 8% gain.
Low by Trend Following standards, but still a good result since the average return of the S&P over any given 40-year period has been 8%.
To which he answered “if that’s good, it’ll take me forever to make any real money”.
Now we know, that can be a dangerous attitude for an investor. The old adage “Slow and steady wins the race”, is an important one.
It can help the investor to keep perspective and manage emotions – the investor’s worst enemy.
Realizing that he was focused only on the dollar amount versus the percentage, I explained that if he were to continue investing for the remaining 45 years of his investing career, without adding any additional money beyond his original $10,000 and only averaged 8% a year, his final portfolio would amount to $320,000.
From $10,000 to $320,000!
That got his attention and brought a smile to his face. He asked how could I calculate that and do it so fast?
“Aren’t you familiar with the Rule of 72”, I asked. He wasn’t and wanted to know more.
The Rule of 72 works like this:
You take the annual interest rate that you are getting or hope to get and divide it into 72. That will give you the number of years that it will take at that interest rate to double your money.
In his case, 72 / 8% = 9 years to double.
Then you divide the number of years that you expect the money to grow.
Again, in his case 45yrs/ by 9 = 5 times.
Therefore, 5 is the number of times that your money will double over the next 45 years.
The result, starting with $10,000, is:
1. after 9yrs = $20,000
2. after 18yrs = $40,000
3. after 27yrs = $80,000
4. after 35yrs = $160,000
5. and after 45yrs = $320,000.
It’s a very handy tool that allows you to do some quick estimations.
It is a good idea to always think in terms of both dollars AND percentages.
We all know that some years that 8% might look meager and other years it might look spectacular.
The results of the last 10 years in the market have not been average and have led to a Super Bubble of epic proportions.
We will discuss compounding, the time value of money and opportunity cost and the impact of a long downturn in a future issue of The Trend.
In our experience – not our viewpoint or opinion – our experience, you do not want to ride a market or stock down and give up those gains.
We have been through a several of those. They can and will wreak havoc on your financial and emotional life.
That is why we believe in active, consistent, unemotional (we know that one’s tricky) Risk Management.
In other words: Ride Your Winners; Cut Your Losses.
“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will…bring on unwelcome after effects…..one likely consequence is an onslaught of inflation.” Warren Buffett
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