Table of ContentsIntroduction: Make Money No Matter What 1
Chapter 1: The Myths of Investing 11
Chapter 2: Rule #1 and the Four Ms 33
Chapter 3: Buy a Business, Not a Stock 39
Chapter 4: Identify a Moat 53
Chapter 5: The Big Five Numbers 65
Chapter 6: Calculate the Big Five 95
Chapter 7: Bet on the Jockey 111
Chapter 8: Demand a Margin of Safety 132
Chapter 9: Calculate the Sticker Price 145
Chapter 10: Know the Right Time to Sell 172
Chapter 11: Grab the Stick 186
Chapter 12: The Three Tools 196
Chapter 13: Take Baby Steps 216
Chapter 14: Eliminate the Barriers 246
Chapter 15: Prepare for Your First Rule #1 Purchase 259
Chapter 16: Q&A 274
Glossary 293
Acknowledgments 301
Index 303
Chapter 1: The Myths of Investing
An expert is a person who avoids small error as he sweeps on to the grand fallacy. —Benjamin Stolberg (1891-1951)
The gold standard of low-risk investing is a ten-year United States Treasury bond, which, at the time of this writing, has a return of about 4 percent. Invest in nothing but these bonds and youre guaranteed a 4-percent haul. The only problem with such a strategy, especially for the millions of soon-to-be-retired baby boomers, is that, at 4 percent, it takes 18 years to double your money. In addition, after 18 years, even with a low inflation rate of 2 to 3 percent, most of the gain is absorbed by higher prices, leaving you with only slightly more buying power than you had 18 years earlier. Despite this reality, investors buy billions of dollars of these 4-percent bonds.
Why in the world would anyone want to own a bond that barely keeps pace with inflation and realizes almost no real gain in wealth? Because almost everyone is convinced that a higher rate of return necessarily means a lot more risk. And theyre more afraid of losing money in an attempt to get a higher return than of their inability to retire comfortably.
The fact is, a higher rate of return is not necessarily contingent on incurring significantly more risk. Let me explain.
HIGH RETURNS DONT NECESSARILY MEAN MORE RISK
During a talk at the America West Arena in Phoenix, Arizona, I asked the audience, “How many of you drove your cars here today?” Most people raised their hands. “Okay, almost everybody. And how many of you took a huge risk driving here?” A few hands went back up. “You guys took a huge risk driving here?” I asked incredulously. “Either you drivers didnt really take a risk and are just clowning around, or at last weve found the problem with Phoenix traffic—you people with your hands up dont know how to drive. Is that it?” Everybody laughed. “Okay, so it wasnt so terrifying to drive down here. But now imagine that youre coming here but instead of you doing the driving, its your eleven-year-old nephew behind the wheel. Are you taking a lot of risk now?” People laughed and nodded yes. “The trip was the same—going from Ato B. But when you put someone in the drivers seat who doesnt know how to drive, a relatively safe trip becomes an incredibly risky trip.”
Exactly the same thing holds true for your journey to financial freedom. If you dont know what youre doing, your journey is going to be either very slow or very dangerous. Thats why most people think that going fast (going after a high rate of return) is dangerous—because they dont know how to drive the financial car, and not because going fast is necessarily dangerous. Its only dangerous if you dont know what youre doing. And the essence of Rule #1 is knowing what youre doing—investing with certainty so you dont lose money!
Now, youre probably wondering, “What about mutual funds? What about all those techniques we learn to minimize risk and maximize returns?” Well, folks, I hate to be the bearer of bad news, but heres the truth: Being a mutual fund investor is a whole lot riskier than being a Rule #1 investor. Investing in a mutual fund is, in many ways, like handing your car keys to that 11-year-old nephew.
THE MUTUAL FUND SCAM
If you own mutual funds that are attempting to beat the market, and youre hoping your fund manager can give you a nice retirement, youre highly likely to be the victim of a huge scam. Youre not alone—100 million investors are right there with you. Fortune magazine reports that since 1985 only 4 percent of all the fund managers beat the S&P 500 index, and the few who did it did so by only a small margin. In other words, almost no fund managers have done what theyre paid by you to do—beat the market. That significant fact went unnoticed through the roaring 1980s and 1990s as the stock market surged with double-digit growth, bringing your fund manager along for the joyride. But now the ride is over, and investors are starting to notice that their fund managers are pretty much useless. This is not a new observation.
Several years ago, Warren Buffett said this about your fund manager: “Professionals in other fields, like dentists, bring a lot to the layman, but people get nothing for their money from professional money managers.” The key word here is nothing. And yet, what do you do? You give your hard-earned money to one of these guys and hope he can deliver those 15-percent-or-better returns, like the ones you got in the 1990s. Why? Because you dont want to invest your own money, and because youve been convinced by the entire financial services industry that you cant do it yourself.
Come on, get real. From 2000 to 2003, mutual funds lost half their value. You could have lost 50 percent of your money without the help of a professional. In fact, in 1996 a monkey was hired to compete with the best fund managers in New York. He beat them two years in a row. When I told this story one day to an audience in Los Angeles, someone from the upper deck in the Arrowhead Pond Arena yelled out, “Whats the name of the chimp?” This is proof that some people will do anything to avoid investing their own money.
Peter Lynch, one of the few fund managers who made above-market returns and then got out before the market leveled him, wrote in his book One Up on Wall Street that the amateur investor has “numerous built-in advantages, which, if exploited, should result in outperforming the market and the experts.” In other words, you should be doing this yourself. But you dont. The reason you dont is that the entire financial services industry perpetuates three myths of investing to keep people investing with them in spite of the industrys dismal performance over any long period.
THE THREE MYTHS OF INVESTING
Myth 1. You Have to Be an Expert to Manage Money.
The first myth I want to bust is that it takes a lot of time and expertise to manage your money. It would if investing were hard to learn or if getting the information to make a decision took a lot of time. Ill prove to you that it doesnt, even though the financial services industry wants us to believe it does. The industry stands to make billions from commissions and fees if it can keep you thinking you cant do it on your own.
The Internet has changed everything. Now the tools that used to cost $50,000 a year are available for less than two bucks a day and take only minutes a day to use instead of 50 hours a week. And the Internet tools are more accurate, more timely, and easier to apply than anything your fund manager had just a couple of years ago. All you need is a little instruction and a brief learning period. But dont bother to ask your broker, financial planner/adviser, certified public accountant (CPA), or fund manager if you should do this on your own. You know what theyre going to say. Something like, “But thats what I do for you, so you dont have to worry about it.” Well, you should worry about it. Alot. Its your money and youre the only one who really cares about what happens to it.
Even the pros like Jim Cramer, a guy whos in your corner and who wants to see you invest on your own, doesnt really know what its like to be one of us. Like the rest of the top of the financial industry, Jims Ivy League, incredibly smart, loves playing with stocks all day and night, lives it and breathes it and has no sense of what its like to be you and me out there digging ditches someplace and hoping we can retire. For these guys its a game. Aserious game, but still a game. Jims a trader and loves to speculate. Following his approach, youve got to put in five to ten hours a week minimum and youre playing a very dangerous game with money you cant afford to lose against really rich, really smart, and really motivated guys—guys just like Jim.
If you think you can win at that game, be my guest. And if you do win, my hat goes off to you. Youre a lot smarter than the rest of us. For everybody else, me included, there has to be another way. Most of us dont have five hours a week for investing. Lets face it. Weve got kids to raise, lives to live, and jobs that already take more time than we have. We also dont want to be chained to watching the stock market or to become frantic day traders. What fun would that be? Were just looking for something to invest in that gets really great returns without the risk of losing money and without spending a lot of time at it.
Rule #1 is investing for the rest of us.
Myth 2. You Cant Beat the Market.
Okay, its true that 96 percent of all mutual fund managers have not been able to beat the market in the last 20 years. But youre not a fund manager and youre not judged by whether you beat the market. Your
financial skill is judged by whether youre living comfortably when youre 75. You shouldnt care whether you beat the market. If the market goes down 50 percent but your fund manager loses only 40 percent of your money, he may have beaten the market, but does that seem good to you? Rule #1 investors expect a minimum annual compounded rate of return of 15 percent a year or more. If we can get that, we dont care what the market did. Were going to retire rich anyway. Judged by that standard, Rule #1 investors . . . well, rule.
The myth that you cant beat the market was started in the 1970s by, among others, Professor Burton Malkiel of Princeton University, who did lots of research purporting to prove that nobody beats the market. (Well be going into greater detail regarding Malkiels theories later on in this book, but we must mention him here to debunk this myth.) His book, A Random Walk Down Wall Street, still sells. He influenced a generation of professors in business schools who, as a body, subscribed to what has become known as Efficient Market Theory (EMT). EMT says markets in general (and the stock market in particular) are efficient— that is, they price things according to their value. In the stock market, the ups and downs of the market are caused by rational investors responding minute by minute to the events that may affect their investments. According to EMT, the market is so efficient that everything that can be known about a company is already, minute by minute, figured into the price of its stock. In other words, the price of the stock at all times equals the value of the company.
If thats true, say the professors who believe in EMT, then its simply not possible to find a stock thats undervalued, and its equally impossible to pay too much for a stock. Why? Because price is always equal to value. So there are no deals in the market, and there are no rip-offs. This situation, EMT theorists say, accounts for the fact that almost no fund managers ever beat the market. These fund managers are smart guys, and if none of them beats the market for long periods, then the market must be perfectly pricing everything.
But some people do beat the market for long periods, and the point of this book is to show you how. Youll soon realize how false EMT really is.
[ In 1984, Warren Buffett gave a lecture at Columbia Business School in which he showed that at least 20 investors, who hed predicted would have high rates of return, all beat the target of 15 percent handsomely for periods longer than 20 years. All of these investors hailed from the same school of investing, which he called “Graham-and-Doddsville” because all had either learned from professors Graham and Dodd, from Buffett, or from someone who was copying Buffett—the same way I learned from my teacher and the way youre learning from me. (Benjamin Graham was Buffetts teacher at Columbia; David Dodd was another professor at the school.) The compounded annual rate of return for these investors over eight decades ranged from 18 percent to 33 percent per year. The point Buffett was making to the Columbia students was that the people he knows who make over 15 percent a year for long periods all do it similarly. They all start with Rule #1.]
After the 2000 to 2003 stock market debacle, when some very good businesses saw their stock values drop by 90 percent, Professor Malkiel was interviewed, and as well see in Chapter 8, he came as close to a retraction of his theory as an academician ever could when he admitted that “the market is generally efficient . . . but do[es] go crazy from time to time.” Oh. Its efficient but sometimes its not. Funny, but I thought that was what Buffett and Graham had been saying for 80 years. Buffett quips that he hopes the business schools will continue to turn out fund managers who believe in EMT so that hell continue to have lots of misinformed fund managers to buy businesses from when they price them too cheap, and to sell businesses to when theyre willing to pay too much.
The chart on page 18 shows how Rule #1 investors have fared over the last several decades, as compared with the performance of the S&P 500 and the Dow Jones Industrial Average.
(Chart shows How Rule #1 investors have fared in comparison with the markets most popular indexes. This chart may appear erroneous or exaggerated, but its not. Rule #1 investors outperform the S&P 500 and the Dow Jones Industrial Average by a long shot—routinely. The magic of compound growth is what explains the massive difference between compounding at 8 or 9 percent per year versus compounding a little over 23 percent per year. Such a huge difference isnt so obvious at first glance. Because 23 percent is just three times bigger than 8 percent, one would automatically think the dollars should just be three times bigger. But compounding growth is not linear, its what is called geometric. Compounding grows a rate of return not only on the original dollar invested, but also on the accumulating dollar returns (“interest on interest”). Because 23 percent produces a higher dollar return every year, which, in turn, has a 23 percent return on it, the accelerating dollar amount explodes after several years and rockets far from the lower 8-percent compounded return.
Cool, huh?)
Myth 3. The Best Way to Minimize Risk Is to Diversify and Hold (for the Long Term).
Diversify and hold. Everybody knows thats the safest way to invest in the stock market, right? But then again, at one time everybody knew the earth was flat. The fact is, a long-term diversified portfolio would have had a zero rate of return for 37 years from 1905 to 1942, for 18 years from 1965 to 1983, and from 2000 to 2005. Sixty years out of 100. If you know how to invest—meaning you understand Rule #1 and know how to find a wonderful company at an attractive price—then you do not diversify your money into 50 stocks or an index mutual fund. You focus on a few businesses that you understand. You buy when the big guys—the fund managers who control the market—are fearful, and you sell when theyre greedy. Shocking, no? (And if you dont know what I mean by this, you will by the end of this book. Promise.)
Today more than 80 percent of the money in the market is invested by fund managers (pension funds, banking funds, insurance funds, and mutual funds). As I indicated in the Introduction, this is what is known as “institutional money.” Out of $17 trillion, the big guys manage more than $14 trillion of it. In other words, the fund managers are the market; when they move billions of dollars into a stock, the price of that stock goes up. When they take their money out, the price of that stock goes down. Their effect on the market is so huge that if they decide to sell suddenly, they can generate a massive crash. Understanding this fact is central to Rule #1: The fund managers control the price of almost all the stocks in the market, but they cant easily get out when they want to. You and I, however, can be in or out of the market within seconds. In Chapter 11 well explore in detail what this means for us.
So what happens in the long run if the baby-boom money that drove the market up starts to come out as the baby boomers retire? Or what if some other event draws money out of the market? As mutual funds drop in value, investors react by withdrawing money faster from the funds, which ultimately puts the market into free fall. The irony is that while, in theory, investing for the long run in a diversified mutual fund lowers risk, such an investment strategy in this market actually raises risk. In this market theres no such thing as a “balanced portfolio” that reduces your exposure to market risk, no matter how loudly the financial services industry salesmen shout it. If this market crashes, fund managers who play these games may find themselves rearranging deck chairs on the Titanic.
If you dont think a total stock market meltdown can happen in a modern economy, think again. It just happened over the last ten years in Japan, whose stock market lost 85 percent of its value from 1992 to 2002. It hasnt recovered yet. And Japans boomers are about ten years older than Americas (political and economic factors prompted a baby boom in Japan prior to the start of World War II). If Americas market tanks 85 percent, the Dow will be at 1500. It happened during the 1930s. It can happen again.
Diversification spreads you out too thin and guarantees a market rate of return—meaning whatever happens to the whole market happens to you. Obviously there are hundreds of great businesses available to buy, but if you have a job and a family and dont want to be married to your computer, you dont have time to keep up with more than a few. If you buy businesses you dont keep up with, youll inevitably violate Rule #1 with respect to some, causing your overall return to drop.
As Rule #1 business buyers, we pick a few choice businesses in different sectors of the market. So even though we arent “diversifying” like mutual fund managers by buying dozens—if not hundreds—of different companies at once, well be setting up a portfolio that reflects different categories of businesses. But exactly how many companies you can buy into will depend on how much money you have to invest, and Ill tell you what the right proportional relationship is.
Diversification is for people who have 30 years to go, have no desire whatsoever to learn how to invest, and are going to be happy with an 8-percent yearly return and a minimum standard of living in retirement. Our goal is to find wonderful companies, buy them at really attractive prices, and then let the market do its thing—which means eventually the market will price these businesses correctly at their value; in a few weeks, months, or years were a lot richer than we are right now. Thats what we want to do. But to do that, we have to stop being ignorant investors being taken advantage of by the entire financial services industry and start being knowledgeable Rule #1 investors who, instead of being the prey, outfox the predators.
[ In the mid-1960s my dad suggested I put money in a diversified mutual fund. I invested $600 and forgot about it. Eighteen years later my investment was worth $400. Imagine if I were 45 years old in the mid-1960s and I invested $60,000 instead of $600. How depressing would it have felt 18 years later at age 63 to discover my $60,000 had become $40,000 instead of the $240,000 I was planning on for my retirement? A goal of this book is to spare you from ever having to look into that financial abyss.]
DOLLAR COST AVERAGING WILL NOT PROTECT YOU
Although dollar cost averaging (DCA) is technically not a myth, I get a lot of questions about it and constantly have to prove to people that DCAis not the investors lifesaver its purported to be. A favorite sales tool for fund managers and brokers, DCA is the strategy of buying stocks or mutual funds every month with the same amount of money, regardless of the price of the stock or fund. For example, you buy $100 worth of shares in Microsoft every month, no matter what the price per share is. So if the price is down, your money buys more shares. If its up, your money buys fewer shares. The objective of dollar cost averaging is to minimize your investment risk by making the average cost per share of stock smaller.
This method of protecting yourself has two huge flaws: (1) In a long sideways or down market, DCA is pretty much the same as buy-andhold; and (2) for DCA to work, you have to put in the same amount every month, no matter what. So between 1929 and 1930, when $100,000 of stocks became worth $10,000, youd still have needed to be willing to buy in. Between 2000 and 2002, when the tech stock index lost 85 percent of its value, youd have needed to be willing to keep buying all the way down to the bottom. First, that assumes you have a job and the spare cash to spend on stocks during a recession or depression, and, second, it assumes youd still be willing to throw in good money after taking that kind of a loss. Instead of trusting DCA, Rule #1 investors know the value of a wonderful business and buy it when its undervalued. In other words, as Ill shortly show, we buy one dollar of value for fifty cents and repeat. We do not buy one dollar for ten dollars and hope our profligacy will be counterbalanced by an opportunity to sometimes—maybe—buy the same stock for an inexpensive price.
[With DCA from 1905 to 1942, your rate of return in a Dow index fund would have been 1 percent as opposed to zero percent with buy-and-hold. From 1965 to 1983, your rate of return would have been 2 percent instead of zero percent. From 2000 to 2005, your rate of return would have been 3 percent instead of 0 percent. In other words, over the majority of the last 100 years of stock investing, it wouldve been better to just buy a government bond and forget about it than to DCA in a Dow index fund.]
Because Rule #1 investors require a 15-percent return, we have to throw out strategies that fail to achieve that minimum in all kinds of markets. And because DCA failed to achieve even treasury bond rates of return in several sideways markets in the last 100 years, it cannot be a useful Rule #1 strategy.
The truth is, the financial services industry cares about your money only because it takes commissions and fees whether it makes you any money or not. It perpetuates the Three Myths of Investing and extols the virtues of dollar cost averaging so you and I will give managers our money. The last thing they want is for you to invest successfully on your own. They want you to believe youll lose your money if you do this yourself. Theyre hoping your fear of loss will compel you to keep giving them your money in spite of the likelihood theyll be less effective than you are in reaping a high return.
The Three Myths vs. Rule #1
Myth: Its hard and it takes too long.
Rule #1: Its simple, taking at most only 15 minutes a week.
Myth: You cant beat the market.
Rule #1: You can take advantage of regular mispricing to reap a 15-percent return or more.
Myth: Diversify, buy, and hold
Rule #1: Buy a dollar for 50 cents, and sell it later for a dollar. Repeat until very rich.
RULE #1 VS. REAL ESTATE
Okay, so lets say you dont buy into the myths of investing, but you do buy into the myth about real estate being a better investment than businesses. You know Im going to shoot you down on this argument. If you think that because real estate lets you leverage your investment, the rate of return is much higher than a business/stock investment and is, therefore, a better place for beginning investors to put their money, think again.
This is a commonly held idea thats completely mistaken. Ive owned a lot of real estate, everything from subdivisions to huge farms, apartments, commercial property, and single-family homes. Ive bought into hot real estate markets like Del Mar, California, and Jackson Hole, Wyoming, and slow ones like Fairfield, Iowa. If were going to do a real estate versus business/stock ownership returns comparison, we could pit the hottest real estate markets against the hottest Rule #1 investors. But it seems better to use the average real estate market and the average Rule #1 investor.
A reasonably good growth rate in a real estate market over a 30-year period is about 4 percent. A reasonably good rate of return for a Rule #1 investor is about 15 percent. True, Jackson Hole and Del Mar real estate appreciated at 10 percent per year for 30 years (in big bursts). And its equally true that experienced Rule #1 investors nail 25 percent per year return on investments (ROIs) for 30 years. But these are exceptional cases.
[A return on investment (ROI) is simply the return you get from an investment—the dollars you put in and the dollars you get out within a certain time period—which can reflect either a profit or loss. Its usually expressed as an annual percentage return. For example, if you invest $100 into a business and it returns to you $150 after the first year, your ROI is 50 percent. Technically, ROI is calculated by dividing your total amount invested into your profit. (Extra tidbit: This is slightly different from ROIC—return on investment capital—which is a more complicated calculation thats very specific about what constitutes dollars in and dollars out. Youll come to understand ROIC very soon, as its an excellent indicator of the health of a business.)]
So lets look at the difference between investing $50,000 right now in real estate versus $50,000 right now in a business with Rule #1. This is an especially interesting contrast considering real estate and the stock market might not go up at all for the next 15 years! (If that happens, the real estate example below will seem wildly optimistic!)
Here are the numbers: We buy a $250,000 house for $50,000 down with a 6-percent, 30-year fixed mortgage. Our payments are $1,200 a month, but we rent it for $1,200 and cover our mortgage payments. We are, however, in the hole for insurance, maintenance, advertising, and taxes.
On the other hand, lets assume we never miss a months rent and can increase the rent by 4 percent a year. By our ninth year, weve been able to increase rents enough to cover everything. From there on to the thirtieth year, its all cash flow. Then we sell the place. At that point the house is worth $811,000 and is totally paid for. Also, weve pocketed rental income weve reinvested wisely and made the same return on that as on our house overall—about 10 percent per year for an additional $230,000. Total return equals $1,041,000. Our compounded ROI for 30 years is 10.6 percent. Quite respectable, although I didnt deduct for management and maintenance, which I expect well do ourselves. This isnt an insignificant headache, and gathering up the investment dollars from such an endeavor isnt easy. We had to do a lot of work (and hoping) to get that 11-percent return. Nonetheless, lets compare that to our 15-percent minimum Rule #1 return.
First, as Rule #1 investors, we incur almost no management responsibility—a significant advantage. We have to spend about 15 minutes a week, and thats it. Were required to know how to do Rule #1 investing, of course, but its easier to learn than real estate investing once you see the advantages. We buy a wonderful business (actually a part of a business via shares of stock) at an attractive price with our $50,000. We then sell it when it gets unattractive and buy another. We do that for 30 years, averaging 15 percent. (And as with the real estate example above, were not being taxed on our gains—in this case, were buying and selling in a tax-protected IRA, which youll learn about later.) After 30 years, my investment is worth $3.3 million. My 30-year compounded ROI is 15 percent, only 4 percentage points higher than the real estate transaction, but I have $2 million more in my bank account.
It gets better. Now lets compare the two investments when youre 60 and retired. If you invested in real estate, what you do at this point is take the $1.2 million and put it into a nice 5-percent bond that pays you $5,000 per month. After taxes, you keep $4,000 a month. Thats a whopping $1,650 in todays money. Better hope Social Security is still working. Or you keep working your real estate, dealing with renters and fixing toilets, and the rent money is your income: about $3,800 a month. Your only other choice is to re-leverage your investment and buy more real estate—which is a whole lot different from being retired, isnt it?
But if youre a Rule #1 investor, its no big deal to spend 15 minutes a week on your investments, so youll continue to invest the $3.3 million at 15 percent andthen live on the 15-percent increase each year. Translation: Youre receiving about $40,000 a month. Thats not a typo. Of course, you do have to pay taxes on that, so youll end up with about $30,000 a month, which is only $12,000 in todays dollars. Do you think you can squeak by on $12,000 a month when youre retired versus $1,650 in todays dollars?
So theres how I look at it. You can stay ignorant of The Rule, opt exclusively for real estate, and try to live on the result the rest of your life—or you can become a Rule #1 investor.
WHY BOTHER LEARNING RULE #1?
I cant reiterate this enough: The first reason you should bother to learn The Rule is that you can make 15 percent a year or more with very little risk, and thatll change the way you and your family live forever. You cant do that in real estate, in a mutual fund, or by randomly picking stocks out of a hat. The second reason is that when you invest by The Rule, it almost doesnt matter what amount of money you start with; in 20 years you can retire comfortably. Take a look at this chart:
Amount to start: $1,000
Monthly savings (additions to account): $300
Amount in 20 years: $470,000
Annual income in 20 years: $70,000
Amount to start: $10,000
Monthly savings (additions to account): $300
Amount in 20 years: $650,000
Annual income in 20 years: $97,000
Amount to start: $50,000
Monthly savings (additions to account): $300
Amount in 20 years: $1,450,000
Annual income in 20 years: $215,000
Similar to what we just went through in comparing Rule #1 returns to real estate returns, if you could retire with a permanent income of $70,000 a year 20 years from now, starting today with just $1,000, would you want to learn to do that? Its possible, as weve seen, if you accumulate money for 20 years and from then on consume only the gains, leaving the principle untouched. So if you start with $1,000 your principle is almost $500,000 in 20 years, and if you continue to make 15 percent a year, you have $70,000 a year to live on—without ever touching that half a million. If you start today with $50,000, your principle in 20 years will be $1.45 million, allowing you to live off a $215,000 (15 percent) gain each year. Think you can handle that kind of retirement? The key is to bank 15 percent or more returns a year from all that youve amassed over those initial 20 years (and beyond), which will beget ever higher returns. And if you dont think you have 20 working years left before your targeted retirement date, you can still generate a decent amount of money following The Rule, and make that money continue to work for you in retirement.
MEET DOUG AND SUSAN CONNELLY
Lets look at an overall picture of Rule #1 investing in the real world.
Its 2003. Doug and Susan Connelly are a couple in their late forties with two kids in high school. They live on a combined income of about $60,000 a year. Doug works as a salesman for a small business and Susan is a teacher in a private school. They listened to me speak at a motivational seminar and decided to learn The Rule.
Whats driving them to invest on their own is the simple fact that they must if they want to have a decent retirement. At this point they have only $20,000 in an IRA, although their $200,000 home will be paid for by the time theyre ready to retire. They think they can add about $5,000 a year pre-tax to their IRA. Heres the problem: They know that if they put the $20,000 plus $5,000 a year into a bond at 4 percent, theyll have only $190,000 to live on if they retire in 20 years. The $190,000 in their IRA at 4 percent will provide them with about $650 a month pre-tax. Add in Social Security and a paid-for house and they think they can squeeze by, but it isnt the life they want. They want to travel, eat in restaurants when they desire, and drive a car that wont break down. Doug likes to play golf, and it isnt getting any cheaper. Susan would love to go to New York and see a Broadway show once in a while, but at $100 a seat, dinner at $100 per person, and a hotel at $250 a night, she knows that kind of outing is too pricey on their probable income.
And even more important to Doug and Susan is being able to cover their medical bills. They know health care is getting more and more expensive and insurance doesnt cover it all. They read an article in Newsweek that featured interviews with retirees who were paying $600 a month out of pocket for medicine not covered by either their health insurance or Medicare. The Connellys dont want to burden their kids, and they dont want to lose everything they have or be forced to finish their lives in some government nursing home because of an unexpected health problem. They know they need more money.
They got excited about Rule #1 investing because of the math: If The Rule can get them a 15-percent-a-year return in their IRA where they dont pay tax, theyll have more than $840,000 in their IRA for retirement in 20 years instead of $190,000. Second, they can continue investing while retired, compounding the $840,000 at 15 percent. Thatll give them more than $10,500 a month to live on pre-tax, plus Social Security, without touching the $840,000. Thats significantly better than the $650 they can expect from a bond. Theyve decided its well worth learning The Rule to secure that better life.
Retirement Strategy Chart:
Retirment Strategy: Playing it "safe"
Year 2005 retirement capital: $20,000 plus $5,000/year
Year 2025 retirement capital: $190,000
Year 2025 income to supplement Social Security: $7,700 annually
Retirement Strategy: Rule #1
Year 2005 retirement capital: $20,000 plus $5,000/year
Year 2025 retirement capital: $840,000
Year 2025 income to supplement Social Security: $126,000 annually
THE POWER OF MONEY MAKING MONEY
Doug and Susan can retire much sooner and/or far better than they thought they could because of the power of compound growth, which dictates that not only money earns a return on investment (ROI), but the ROI earns an ROI. (Recall the difference in compounding at 8 or 9 percent a year versus 23 percent.) This is how money can make even more money over time. Example: You invest $1,000 and it gets an ROI of 10 percent each year. After the first year your investment is worth $1,100. In the second year you get an ROI of 10 percent on that $100 profit as well as your original $1,000. This brings your total to $1,210, and so on. If you leave your investment to compound at 10 percent per year, 50 years later that $1,000 becomes $117,391 . . . and you are dead. So we need to speed this up a bit. To do that, we have to get a better ROI.
The reason we make Rule #1 the foundation of our investment philosophy is that we understand that the power of compounding money at 15 percent a year or more depends on not losing it—ever. A 50- percent drop in price requires a 100-percent rise in price just to break even. If the price of a stock drops 80 percent, it has to go up 400 percent to break even. Oracle was at $40 a share in 2000 and dropped to $10. Thats an 80-percent drop. It has to double once from $10 to $20 and then double again from $20 to $40 just to break even. Four hundred percent! Think about that. For the market to go up 400 percent, the Dow, for example, would have to go from 10,000 to 40,000. And that could take at least three decades! Meanwhile, your portfolio is a permanent disaster and a 15-percent minimum yearly return is out of reach.
Lets return for a moment to Doug and Susan Connelly, but this time assume only Susan came to learn about Rule #1 and each has a separate portfolio (a stubborn couple, they both practice their own methods of investing and dont want to mix accounts). Lets also assume each has $20,000 to invest now, plus an additional $5,000 a year, as in the example above. After 10 years of investing and reaping 15 percent a year, Doug loses half his money in a market crash. Susan, a Rule #1 investor, does not. She then teaches Doug about Rule #1, and from the end of the tenth year onward, they both manage to make 15 percent a year. Twenty years from now, Doug has $420,000; Susan has $840,000. This means Doug has $63,000 a year to live on while Susan is living comfortably on $126,000 a year. The permanent $63,000-peryear difference in annual income 20 years later is Dougs one-time violation of Rule #1.
And this isnt even close to whats actually happened to thousands of students of mine whove related their investing horror stories. For example, I met Robert at a presentation I did in Texas. He had all his retirement invested in Enron stock at the urging of his trusted bosses. He was so angry about it that when I showed the class proof that Enron insiders were getting out even while they told their employees to stay in, he had to go out into the hall and cool off before breaking something. Such anger is very real, the outward manifestation of serious emotional problems that ferment when we work hard to build wealth and then see it taken away because of ignorance. There wasnt a person in that room who didnt see a piece of themselves in Roberts anger and pain.
Another guy whom Ill call Chris told me he started with about $50,000 in 1990 and built it up to more than $1 million by 2000. Then he lost it all simply because he couldnt believe it wouldnt go back up and his broker kept telling him to “double down”—put more and more into the stocks that were going down so hed make his fortune when they went back up. But they didnt ever go up, and it wiped him out. He was starting over with $1,000 and the realization that even if the market does go up in the long run, the long run is longer than he has.
These are people to admire. They got knocked down hard and still got up. But although we salute their guts and perseverance, the truth is we dont want to have their experience if we can avoid it. My feeling is, learn Rule #1 and avoid making the mistake in the first place.
Get knocked down seven times. Get up eight times. —Japanese proverb
[If youve never bought a stock before, dont know how to open a brokerage account, or dont know what an IRA is, dont worry. Ill be guiding you through the process in Chapter 15. First I want you to become very familiar with the Rule #1 methodology, and then well tackle those smaller issues and get you started on the right foot.]
The impact of compounding rates of return can work for you or against you. Which way it works depends on whether youre able to invest with certainty in companies that wont lose your money. Only then will your compounded rate of return be certain to be positive and high enough to make a difference in your life. Almost any sort of positive compounded rate of return will eventually make you rich. The question is when. Obviously, the larger the positive compounded rate of return, the faster you get rich—as long as you dont violate Rule #1.
Think of it like a board game in which if you land on the wrong square you get sent back to the beginning and have to start over. Thats exactly what kills most institutional (mutual fund) portfolios. At some point the big guys—your mutual fund managers—all land on that square. Your job as a little investor is to learn how to avoid landing on that square. If you dont get sent back to the beginning, youre going to be very comfortable financially.
Ask yourself this question: If you thought you could retire in 10 to 20 years by working on it just 15 minutes a week with less risk than youre taking right now in your mutual funds, would you want to learn how? Im guessing the answer is an enthusiastic “yes,” so listen up as we turn now to a discussion of Rule #1s specific working method.
From the Hardcover edition.