Six tools that every investor needs
By
Deputy Editor
Tim Bennett Aug 27, 2010
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Every good tradesman has a number of tools at his disposal. Likewise, every good investor must get to grips with certain key financial concepts before playing the markets. Here are six of the most basic, but also the most important.
1. Profit versus cash flow
Most investors are just looking for "decent returns". But what does that mean? There are several ways of expressing a return. The simplest type of return is an absolute number – say a £200,000 profit. But, other than clearly being better than losing £50,000, by itself that tells you little about whether you should have invested or not. A much better concept is the 'return on capital', or yield – your return expressed as a percentage of the sum invested.
And what about actually getting your money back once you've invested it? That's where cash flow return – or payback – comes in. This is the length of time it takes to recover an initial outlay. So, in very simple terms, if you invest £100,000 now and receive £20,000 back every year, the annual return on capital employed (or yield) is 20% and the payback period is five years (although this doesn't take account of inflation or compounding – more on these below).
2. Opportunity cost
How often do investors make the mistake of accepting a return without considering what else they could have done with their money? For example, you might be pleased with a 10% return from emerging market shares. But if you could have earned 8% from a cash account, your premium for taking the risk of buying very volatile shares is pretty small.
So always measure the expected return from any investment against the minimum you could expect from something safe. For professional investors, that's the return available on medium-dated US or UK government bonds. But for you, it might be the interest rate you could expect from a decent savings account. In the hedge-fund world this gives rise to the "absolute return" concept. That's the idea that rather than try to be in the top quartile of his peers (given that all of them might be losing money), a fund manager tries to generate a minimum percentage over, say, a money market cash rate.
3. Compounding
This is a simple concept, but it's amazing how many people fail to understand just how important compound interest is. Say you invest £100,000 and generate an annual return of 10% for ten years. After the ten years are up, you won't have £200,000 (£100,000 + £10,000 x 10).
In fact, you'll have around £259,374. That's because you earn interest on interest for every year you are invested.
So in year one you earn £10,000 of interest. That means £110,000 is available to earn 10% in year two. So that year's interest is 10% x £110,000, or £11,000, and so on for every year after that.
There's one major caveat: you must stay invested for the full ten years to get the benefit. Draw off the interest you receive each year and spend it and you will not get rich. So for share investors it is crucial that any dividends received are reinvested in buying more shares.
4. Buffett's number-one rule
US investor Warren Buffett was once asked what the most important rules in investing are. He replied "Rule one: never lose money. Rule two: never forget rule one." Why? It's simple. If you invest £100,000 in shares and in year one lose 50% of your investment, you need what's left (£50,000) to double – so rise by 100% – in the next period, just to get back to breakeven. Lose 90% of your investment in year one and the equivalent gain needed is 900%. To reduce your chances of being wiped out, be prepared to pull out of the market altogether and sit in, say, cash when stocks are taking a beating. And use stop-loss orders to reduce the damage when a share tumbles.
5. Average performance
Everyone wants above-average performance – but what exactly is an average? For example, if you are told that a fund rises 10% in year one, then 20% in year two, and then falls 30% in year three, you might think the average return is (10 + 20 -30) /3, or 0%. Wrong. Or rather, it's only right if you assume you're selling up at the end of each year and then only reinvesting the initial sum. If you'd invested £100,000 at the start of year one and left it there, your fund will be worth £110,000 at the end of year one, £132,000 at the end of year two (£10,000 x 1.2), and £92,400 at the end of year three (£132,000 x 0.7). So you have actually lost money over three years.
Also, even when dealing with so-called discrete data, such as shoes sizes (where one person's shoes size is unrelated to another, unlike a fund where one year's performance directly affects the next), watch out for different ways of expressing the average. For instance, if you were trying to work out an average shoe size for five people with shoes sized 6, 9, 10, 12 and 12, you could add the sizes and divide by the number of wearers. That gives you the answer 9.8, which is the "mean". But that's clearly a ridiculous answer in practical terms. The "mode" is 12 (the most common shoe size in the sample) and the "median" is ten (the size right in the middle). That's a far more sensible average to use here.
6. Real returns
The challenge for savers at the moment is not finding a positive return – a short-term bond pays up to about 3%, according to Moneyfacts.co.uk. No, the battle is making a "real" return. That's the return after inflation. The problem is that the Consumer Price Index inflation rate is running at 3.1% just now. Anyone earning less than that isn't keeping up with the cost of living. Knock income tax off your savings income and the situation gets worse. So always ask your broker or adviser if the return they are quoting is "nominal" (ie, before any inflation adjustment) or "real". Then ask what rate of inflation they've assumed for any real rate and ask yourself if it seems realistic.
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