Andrew Hallam

This post is a ‘sneak peak’ at the book I’m writing…enjoy! Andrew

Jockeying with Bill Gates for the title of “World’s richest man” is a fellow named Warren Buffett.

He lives like a typical millionaire (he doesn’t spend much on material things) but he knows of a secret that I’m going to share with you: the secret of investing your money early.

Buffett bought his first stock when he was 11 years old, and the multi-billionaire jokes that he started too late. Starting early is the greatest gift you can give yourself. If you start early, and if you invest efficiently (in a manner that I’ll explain in the book) then you can build a fortune over time, spend only about 10 minutes a year on your investments (no, you don’t have to monitor your investments any more than that) and you can spend much of the money you earn from your job on the “finer” things in life.

Warren Buffett, however, chose to live modestly. He still lives in the same house he bought in 1957 for $31,500. And for Buffett—who’s often described as history’s greatest investor—he’s more interested in building his massive fortune so he can help the world by donating it to Bill Gates’ charitable foundation. Buffett and Gates are far more interested in spending their combined fortunes on Global Health, for example, than they are on the latest luxury items. Very cool.

But you can have a bit of both—enough money for a few luxurious goods today, and a small fortune that (if you’re so inclined) you could use to help the charitable foundations of tomorrow.

Again, it’s all about starting early—or what Buffett refers to sometimes as the “Noah Principle”, which allows for the magical work of compound interest (something I’ll explain later).

Most of us are aware of the Biblical story about Noah’s Ark. God told him to build an Ark, collect a variety of animals, and eventually, when the rains came, they’d sail off to a new beginning. Luckily, Noah started building that Ark right away. He didn’t procrastinate.

But let’s imagine Noah for a second. The guy probably had similar qualities to you and me, so even if God told him to keep the upcoming flood a secret, he might not have. After all, he was human too. So I can imagine him wandering down to the local watering hole and after having a couple of early Budweisers, whispering, “Hey, listen, God is saying that the rains are going to come, and that I’ll have to build an Ark and sail away once the land is flooded.” OK—some of them (maybe even most of them) might have figured that Noah had probably eaten some kind of naturally grown narcotic. A crazy story—they’d think.

Yet, somebody must have believed him. As crazy as Noah’s flood story might have sounded to his buddies, somebody had to have been inspired to build their own Ark—or at least a decent sized boat.

Despite the best of intentions, though, that person obviously never got around to it. Maybe he planned to build it when he acquired more money to pay for the materials. Maybe he wanted to be sure: to see that the clouds were getting dark. Or maybe he wanted to wait until it started raining. Pivotal moment.

Warren Buffett likes to say that Noah didn’t start building the Ark while it was raining. He started building it right away. And if you want to grow a fortune over time, you’ll want to follow this advice, because it’s far more powerful than you could ever imagine.

If you start investing early, you’ll leave many people behind in the financial race. Thankfully your friends won’t meet the same fate as Noah’s friends, but your ship will sail off into the distance while many of them will eventually scramble in the rain to assemble their own boats.

But starting early is more than just getting a head start. It’s about using magic. You can sail away slowly, and your friends can come after you with racing boats. But thanks to a force described by Albert Einstein as more powerful than splitting the atom, they aren’t likely to catch you.

In Shakespeare’s Hamlet, the protagonist says to his friend, “There are more things in heaven and earth, Horatio, Than are dreamt of in your philosophy”

Hamlet was referring to ghosts. Einstein was referring to the magic of compound interest. It benefits the early bird in a nearly supernatural way.

Breaking the magician’s code

Compound interest might sound like a complicated process, but it’s actually simple.

If $100 gains 10% interest in one year, then we know that it gained $10, turning $100 into $110.

During the second year, it would now be valued at $110, and if it increased 10%, it would gain $11, turning $110 into $121.

During the third year, it would now be valued at $121, and if it increased 10%, it would gain $12.10, turning $121 into $133.10.

It isn’t long before a snowball effect takes shape. Have a look at what $100 invested at 10% annually can do over the below time periods:

$100 at 10% compounding interest per year turns into—

• $161.05 after 5 years
• $259.37 after 10 years
• $417.72 after 15 years
• $672.74 after 20 years
• $1,744.94 after 30 years
• $4,525.92 after 40 years
• $11,739.08 after 50 years
• $78,974.69 after 70 years
• $204,840.02 after 80 years
• $1,378,061.23 after 100 years

Some of the lengthier time periods above might look dramatically unrealistic. But someone who starts investing at 19 (like I did) who lives until they’re 90 (which I hope to!) will have money compounding in the markets for 71 years. They’ll be spending some of it once they retire, but they’ll always want to keep some of their money compounding—in case they live to 100.

But you’re crazy to invest money if….

Before getting wrapped up in how much money you can save and invest, there’s one very important thing you need to clear up. Are you paying interest on credit cards? If you are, then it makes no financial sense to invest money. Most credit cards charge about 18% annually. Not paying them off in full at the end of the month means that someone else is compounding money at your expense, to the hungry tune of 18% a year. Money that you pay off on your credit card could be considered an “after tax” savings of 18%. Remember that if the banks are making 18% off you, but you cut their revenue stream off, then you are saving 18%.

Even if you’re paying a “low interest” credit card charging 12% annually, it’s still financially crazy to invest money if you’re keeping a balance on your credit card. After all, paying off the credit card debt is like making a tax free 12% gain on your money. And there’s no way that your investments can guarantee a gain like that after tax. You might make 12% annually after taxes, and you might not. But if any salesperson or advisor suggests that they can guarantee that you’ll make 12% annually, turn from them and walk away. I’ll talk about the empty promises many “advisors” make later, while discussing why they make those promises, and then trying to steer you clear of them in the future.

The inspirational realities of starting early

After paying off your high interest loans (whether they’re car loans or credit card loans) you’ll be ready to put Buffett’s Noah Principle to work. The earlier you start, the better, so if you’re 18 years old, start now. If you’re 50 years old, and you haven’t begun, there’s no better time than the present.

The money that doesn’t go towards expensive cars, jewellery, and credit card payments(because these are paid off) can compound dramatically in the stock market if you’re patient. And the longer your money is invested in the stock market, the lower the risks.

We know that the markets can move up and down a lot. It can even move sideways for many years. But over the past 80 years, the U.S. stock market has generated returns exceeding 9% annually. And this includes the crashes of 1929; 1973/74; 1987 and the crash of 2008/2009. For the past 200 years (as long as we have records) the stock market has proven that it can take a licking and keep on ticking—upwards and upwards and upwards.

Ten years ago I figured I could beat the market.

Full of optimism and naivety, I used the formulas espoused in a number of Robert Hagstrom’s Buffett books

As well as the Buffett “systems” espoused by Mary Buffett and David Clarke:

Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett The Worlds Most Famous Investor 

Brian McNiven: A Wonderful Company At A Fair Price  – (& reviewed by the Australian Investors Association)  

Timothy Vick:  How to Pick Stocks Like Warren Buffett: Profiting from the Bargain Hunting Strategies of the World’s Greatest Value Investor

Not to mention Lawrence Cunningham’s compilation of Buffett letters: The Essays of Warren Buffett: Lessons for Corporate America

Beating the market would be easy, I figured.

My investment returns then reinforced what I thought—beating the market was doable. I was doing it.

Publishing an article in MoneySense magazine, in 2002, I wrote about how to invest like Buffett. And I was supremely confident. What added to my confidence was the stock list I put together of “Buffett-like buys” as well as recommended entry level prices. I laugh at the “exactness” of it now, but anyone following the advice would have done reasonably well a handful of years after I penned the piece, Patience, patience. 

The investment club that I run would have solidified my belief (at least you’d think it would) that I had some kind of talent.

With 100% equities, we’ve beaten the S&P 500 by more than 5% annually since 1999, despite, at one point, losing an entire 12% of our portfolio through a stupid private venture that I convinced the club to make, discussed in my post: I’ll Show You Mine if You Show Me Yours! 

And even that year, we beat the market, despite having a 12% deficit, no thanks to my stupidity.

Via email, I bombarded MoneySense Magazine’s founding editor, Ian McGugan, with every trade I was making for years, until he asked me to take the story public. …read the article

If we beat the S&P 500 this year, it will be the eighth year of doing so in a row.

Checking our 12 month return (as of today) also has us ahead of the S&P 500 index. This full equity portfolio is up 16.4% from June 2, 2009 to June 2, 2010, compared to 14.4% for Vanguard’s S&P 500 index. 

 (Using prices from market close for 06/01/2010) IRR Portfolio – The dollar for dollar tracking is courtesy of the online service at: bivio.com.)

I’ve put my own money in the same holdings as the club, but because I can take advantage of my bond allocation, I’ve beaten the investment club’s returns, as I’ve sold bonds during downturns to buy cheap stocks. Having 40% of my money in a bond index hasn’t hurt. (Note—all of my international equity exposure is indexed)

Now I’m going to tell you what I really think of this:

L…U… C… K…

OK—I believe that the markets are mostly efficient, and that some really bright and lucky people can beat the markets if they keep their costs down, but there are also people with long, market-beating track records who can thank lady luck, rather than their stock-picking ability.

I’m one of those guys.

And every year, I view myself as less “gifted” in the area than I thought I was the year before. Success is supposed to breed confidence, right? Then why aren’t I confident? What do I know that I don’t know I know? (Now that sounded like Gertrude Stein, didn’t it?)

And what about you?

How do you personally feel about beating the market? Is it really doable over the long term?

One of our investment club’s stocks is up nearly 10% in two days. Recently, another one of our stocks rose 4.3% in one day alone.

And only one of our stock holdings is currently priced less than what we paid for it.  Does this make me happy?  Absolutely not.

Contrary to what you might think, rising stock prices (and especially a rising stock market in general) really bum me out.

Why?

I’m a net purchaser of stocks.  The stock market doesn’t float up and down, long term, without making tremendous net gains.  If a family member had been able to invest $1 in the U.S. stock market in 1801, while reinvesting their dividends, it would be worth more than $5 million today.

There have been plenty of historical times when the markets plummeted.  There have been plenty of historical times when the markets soared.  But which do you think were the best times to be plowing in money most enthusiastically—when the markets were getting cheaper or when they were getting more expensive?

Warren Buffett says that most investors answer this question incorrectly.  He likens the stock market to the hamburgers he regularly dines on:

“If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?  Many investors get this one wrong.  Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.  In effect, they rejoice because the prices have risen for the ‘hamburgers’ they will soon be buying.  This reaction makes no sense” (Warren Buffett, 1988 Berkshire Hathaway annual report)

Most of the members in my investment club are net purchasers, and the equities in the investment club also reflect the holdings in my personal retirement account.  So I’m elated when our stock prices fall, and disappointed when our stock prices rally.

If you’re a retiree, or someone very close to retirement, then you’ll understandably prefer a rising stock market because you’ll soon be– or currently are– a seller of stocks, not a buyer.

But on a selfish level, I’m hoping that the stock markets cease their recent rise while returning to the mouth watering levels we saw in March.  I also hope that my current holdings plummet in value—so I can greedily load up on more.