Business

Wealth 101

Our finance columnist, who normally deals in millions, offers advice to those starting out

DONALD COXE November 19 2001
Business

Wealth 101

Our finance columnist, who normally deals in millions, offers advice to those starting out

DONALD COXE November 19 2001

Wealth 101

Business

Our finance columnist, who normally deals in millions, offers advice to those starting out

DONALD COXE

You’ve bought your books, you’ve paid your tuition, you’ve budgeted for your other costs for the university year, and you have $500 left over. An admiring uncle says he’ll match whatever you put into long-term investments during your years in college. That strikes you as a good deal, so you start thinking about what to do with that first $ 1,000.

The most significant investments you will make in your lifetime—dollar for dollar—are the ones you make when you are young. Although the get-rich-quick mania of the 1990s temporarily obscured that reality, wealth accumulation comes from long-term compounding of investment returns. The $ 1,000 saved at age 20 at five per cent in real (inflation-adjusted) terms in an RRSP is $8,000 at age 62. (A five-per-cent real return may sound easily achieved, but that is roughly what leading

stock market indices deliver over the long term, so don’t sneer.)

You’ve heard the slogans—“stocks for the long run,” “buy and hold,” “invest for the long term”and their ilk—but you have a natural skepticism about clichés. Good. There is more to investing than sticking money into an asset and leaving it there. “Great oaks from little acorns grow” is an example of misleading “wisdom.” Which acorns? Few acorns survive to become little oaks, and few of those achieve greatness. Nature assumes high mortality rates, offset by high birth rates. So do capital markets.

Even buying a young oak and putting it into your backyard is no guarantee of shade in old age. You would need to plant several trees, of differing species, as a hedge (no pun intended) against diseases and pests to feel confident about hammockability in your reclining years. Diversification is wisdom in trees and in wealth.

Here are eight useful principles:

1. Stocks outperform bonds over the long term, but bonds have their years in the sun.

Example: stocks became sex objects in the late 1990s, as TV, books and seminars promoted equities as sure roads to gratification. After attending one of those extravaganzas in 1999, with glitzy slide shows and simplistic interpretations of long-term results, I began warning people that the risks in equities were being understated. This came as price-earnings ratios were at unsustainably high levels and future earnings forecasts assumed never-ending economic prosperity and never-ending earnings gains driven by never-ending productivity gains from a never-ending cornucopia of technology breakthroughs. Result: I recommended that investors scale out of stocks—particularly technology stocks—and buy longterm bonds. The recommendation made me unpopular in fashionable quarters. As the first step in building your own wealth, check out what happened to (a) investors who scorned my advice, and (b) those who followed it.

2. Never ignore the mathematics of investing. Example: when Nasdaq fell 70 per cent from its high, and Wall Street sophisticates told people to hang on for the inevitable recovery, how big a rally was needed for the gullible to break even—70 per cent, 100 per cent or 150 per cent?

Answer: none of the above—238 per cent was needed to break even, which would mean the rate of return for the persistendy patient was zero per cent for however many years—or decades—it took to recoup. If you lose big, plan on working very long and saving even more.

3. There is a world of opportunity: take it. No country’s stock market outperforms the rest of the world for long.

From 1960 to 1965, it was the U.S. Then the leadership shifted to Europe, then, in the oil and gold years, to Canada, then Japan, then Hong Kong. The U.S. regained its lead in the early 1990s, and may be entering a prolonged period of underperformance. If you had bought the U.S. stock market at its 1966 peak, you’d have had to wait until 1983 to break even in nominal terms, and until the early 1990s to break even in real terms.

4. One maxim does work:

“cash is trash.” Diversify among long-term asset classes, not among time horizons. Restrict your savings to stocks and bonds. Cash is for spending and for emergencies, not for saving or investing. Bonds reduce portfolio volatility and give you gains and income when stocks become too popular and too expensive. Over the long term, a good rule of thumb is 80:20 stocks versus bonds, but during periods of extreme bullishness, 50 per cent or 40 per cent stock exposure will protect your wealth and give you firepower for the next bull market.

5. Dollar averaging works.

If you have the discipline to put money into the market every month, or every quarter, then you can consider putting all your savings into stocks, because the inevitable bear markets will give you great buying opportunities. Two problems: you could be out of work during a long bear market, so you might have to cash in some of your savings, not add to them; second, extended periods of bad politics can make equity investing a losing game for decades. Example: long-term government of Canada bonds have, on a cumulative basis, outperformed the TSE 300 composite index since 1981. Why? Because the nation was mired for so long in big-government tax-and-spend liberalism that the damage inflicted on the corporate sector was too grievous to heal for many years. Had Ronald Reagan not won in 1980, U.S. equities, which had been lousy investments since Lyndon Johnsons era, would not have returned to capitalmarket greatness.

6. Heed demographics/

For your investment lifetime, demography will be,1 next only to politics, the most important determinant of comparative equity investment returns. By the time you have finished grad school and are entering the workforce, nearly all the advanced industrial nations will contain populations that are aging and shrinking. (Italy’s fertility rate, to choose a scary example, is 1.2 babies per female: merely to maintain the current population, the rate must be 2.1.) Motivated, trained people

of workforce age create wealth: people of other ages consume it. Today’s emergingmarket nations will be decisive for globalequity returns long before you are ready for the retirement you planned for so prudently.

7. “Where thy treasure is, thy heart shall be also.” Wise investing should give you more than just good long-term returns: it should stimulate you to keep educating yourself for life. Read, study and reflect. Your portfolio should raise heuristic questions in your mind about how the world works—and how to make it work for you.

8. Mutual funds or individually managed portfolio? Start with a group of mutual funds but plan on getting personally involved when you have the experience, the knowledge and the time to do it right. You may well be able to repair your car, fix your roof or heal your ailments without paying for professionals. But you’d usually be better off devoting your study and time to becoming expert in your career and paying the other professionals to do what they should be able to do better. Read their reports, watch their performance and learn to second-guess intelligently before you risk serious money competing with them. Never let your ego or your delight in gambling get in the way of patient wealth building based on expertise and professionalism. Choose a financial adviser who recommends mutual funds as the basis of your program.

When is a good time to start? Right now. We are in a low-inflation, low-interest-rate recession, so buy equities for your initial stake, with an emphasis on resource companies. The safest time to buy stocks is when a recession has begun and the bond market has staged a huge rally because investors seek safety. (For those who already have substantial wealth to protect, diversification remains necessary. Stocks are pretty expensive, and terrorism makes short-term market action problematic.) So give your uncle a call—and get going. E3

Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-based Jones Heward Investments