Category: Investing

Blog posts about the art and science of investing.

Why 1% Matters

Why 1% Matters

The significance of one percent

Tell me if you’ve read something like this before:

  • By putting your money in X, you can make 1% more per year
  • ABC Fund charges 2% per year to look after your money, but XYZ only charges 1%.

Maybe you’ve run across statements like this before. Maybe you haven’t.

Either way, what was your reaction to reading them? Did you shrug, yawn and go back to your smartphone game? So did I when I first read them. I mean, saving 1% of something, so what?

Statements like these are thrown around a lot in financial literature, with authors assuming we know that 1% is important. The problem is that for most of us, high school math did a great job landing you with mathematical skills you may never use in your day job, and didn’t do a good job teaching us the skills we actually need in the real world.

Let’s break down why 1% is important in finance.

How do you use percentages?

I’m blowing some cobwebs off math memories here. Think back to when you were first taught about percentages.

It was probably in the context of something like: Q. Bill has a pizza he wants to share with his friend. He cuts the pizza in half. If Bill takes one half, how much of the pizza has he eaten? A. 50%. Boom, your first encounters with percentages use big numbers.

Now have a think about the percentage math you use in everyday life. Here are a couple of examples:

  • Your favourite clothes shop is having a 20% off sale today. You can buy that awesome outfit you were eyeing for $80 instead of $100. You just saved $20!
  • You use a smartphone app to work out the tip you’re paying at the restaurant for 10-25% of the bill.
  • You pay tax on 30% of every dollar you earn in that new job, so you will get paid 70% of your gross salary every month

We don’t sweat the small stuff

The percentages you use in everyday life will likely be large: 10%, 20%, 30%, 50%. Because of this, small percentages, like those stated in finance, seem really minor. Mentally, we calculate small percentages differently.

Here’s an example. Would you walk an extra few kilometres to buy a $100 item if you save 1% on the price and it’s $99? How about a 25% saving dropping the price to $75? I know I’d only walk extra to take the second saving.

So why do small percentages matter in finance?

Compounded change, large amounts, long timelines

Here’s the secret. Small percentages matter when the changes they introduce are compounded, when the amounts involved are large, and the timeframe is long. Let me show you what I mean.

Let’s say Ahmed has $10,000 he wants to invest. ABC Fund lets him invest it with them and after paying their fees, he’ll get 5% per year. He puts it in and doesn’t touch it for 10 years.

His friend Yolanda also has $10,000 to invest, but she goes with ZYX Fund, which has lower fees than ABC. As a result, she gets paid 6% per year. She also doesn’t touch the money for ten years.

You’ll notice this is the same situation except for the difference in fees of 1%. So who comes out ahead? I used this compound interest calculator to work it out. Ahmed comes out with $16,470 while Yolanda makes $18,194. Over this time frame, 1% results in over $2000 in different returns. That may not be a groundbreaking difference, but due to the power of compounding, 1% becomes much more significant than you might consider at first.

Let’s change a couple of features to show the significance to amounts and time. First, amounts. If Ahmed and Yolanda’s original investments were $100,000, there would be a difference of over $20,000 in their returns after 10 years ($164,700 and $181,940 respectively). Second, time. If we push the timeframe on the original amounts out to 20 years, Ahmed comes out with $27,126 and Yolanda with $33,102. Not a bad increase for the minor trouble of picking a fund with lower fees.

So while 1% may not seem like much for a short term purpose, it has powerful long term effects when it compounds.

Think for yourself!

Beating the Market Like Buffet. Really?

Beating the Market Like Buffet. Really?

The Buffett Dream

Warren Buffett. What’s not to like? For the money minded, he’s a billionaire, and one of the world’s richest people. For the business minded, he runs his own company culture in a sustainable and respectful way, and rewards good management by keeping out of the way. On the ethical side, he’s committed to giving away 99% of his wealth after his death. He’s also humble, continuing to live in the same modest home he originally purchased decades ago, and he’s funny, if you’ve ever heard him speak.

Buffett engages in value investing. That means he picks companies to invest in that have good track records of growth, good management, a great future, and they’re selling for a relatively cheap price.Amongst value investors, who seek out cheap, good quality companies to buy and hold for the long term, Buffett’s views on valuing companies, and the work of his mentors are the holy grail. Buffett is held up as number one on the value investing pedestal.

The dream breaks down

It’s when we start to look at Buffett in the context of replicating his success that this reasoning gets unstuck. Okay, put down the pitch forks and fire torches. I’m not anti Buffett. Hear me out here.

Buffett is the poster boy for getting rich through buying cheap, good quality companies. They say that if you want to achieve something, find someone who has done what you want to do and then do what they did. So how Buffett makes decisions is a point that is of great interest to value investors. I’m going to argue, however, that you probably won’t achieve Buffett’s success.I know that’s a big call.

You need to be Buffett to achieve his success

Buffett is as famous and followed as he his because he is an anomaly. He is really, really good at what he does, puts a lots of time into it (he reads company reports and other material for hours every day), and loves finding quality stocks. If you read, or watch anything about Buffett, it doesn’t take long to realise it’s more than just about money for him. Buffett’s a business person first, investor second. He loves reading, stock analysis, and researching good quality assets. He is surrounded by excellent minds (Charlie Munger, his vice Chairman at Bershire Hathaway, is intellectually brilliant). Buffett has enormous piles of patience. His wealth is the result of compounded returns over decades, and he has the patience to wait for years to pounce on a quality stock, and then wants to hold it forever.

So let’s recap. To replicate Buffett’s success, you need more than his biography. You need lots of time to research companies, you need to love business, you need the patience to wait for stocks to come into your price range, even if it takes years, and you need to be surrounded by brilliant minds that love the same thing as you.

Boredom reigns

I’m a finance nerd, but unfortunately, even to me, the above paragraph sounds rather… boring. I don’t care enough about companies to spend that much time on them. So I’m unlikely to achieve Buffett’s success. As are you, if you also find the idea of that boring.

Now there will be some people that find Buffet’s life to be really exciting, and in that case, I say, go for it! You may yet become the next Buffett. I don’t think there will be that many of you though.

The secret of Buffett’s success

In this article we’ve outlined the real secret of Buffett’s success. He loves his job so much it’s not a job to him. That’s it.

So if, like me, you’re not that interested in business, you’re probably better off seeking to use your time to do work you like. Stick your money in an index fund and concentrate your attention on what matters to you. Oh, that’s right, that’s what Buffett suggests for average investors too.

Why parts of the investment industry want to screw you over

Why parts of the investment industry want to screw you over

Who wants to screw you over?

When you’re first introduced to investing, there are so many points to consider. It’s information overload. Not to mention that investing is one of those areas where it’s really hard to work out just who is coming out ahead: you or them. Who is trying to screw you over, and by exactly how much?

There is an entire investment market out there that is constantly bombarded with information: some of it helpful, some of it useless, some designed to make you money, much of it designed to enrich the people giving the advice. It’s like an extortion bonanza: so many people want to suck your money out of your wallet and into their third yacht.

If you line up over here, there’s someone selling dud property deals: ‘Just buy this great property from us in the middle of nowhere (because it is near a train line that will be built in 20 years time) and you’ll make a killing!’ Over there Wall Street has a fund they want you to invest in, and they’ll only charge you 2% of all your money in there, and 20% of any profit, if there is a profit.

How about those shady advertisements that pop up in the first three hits when you google ‘investment’. ‘Come invest with us!’ They say. “Forex trading”, “binary options”, and “contracts for difference” are all such great “investments” that you’ll be better off backing the miniature pony to win in a horse race.

Confusion by design

It’s irritating, confusing and bewildering. And that’s because it’s designed to be. The people selling them have a vested interest in making you confused.

Using other people’s money to make more of your own is big business. Have you ever looked at the towering skyscrapers of banks in major cities and wondered just what it is they do there? Grumbled at the terrible service you get from a bank to fix the simplest administrative problem, yet been amazed at their interest and dexterity when you apply for a loan? Been angry at the large pay-rates and golden handshakes?

And how about those finance documents? When was the last time you read terms and conditions, a privacy policy, your credit reporting rights, a product disclosure statement, or even the account from your superannuation fund? If your answer is ‘never’ or ‘hardly ever’, you’re in the majority.

In many cases, you and your money, are the investment. Their investment. They sell you the idea that simple investments (like shares, index funds, and bonds) take too long to make enough money. How?

Recipe

Here’s your recipe:

Method:

  1. Take a simple concept and repackage it as something more complex
  2. Wrap it up in several layers of legal sounding financial jargon
  3. Give it a nice title, one that suggests quick wealth
  4. Produce a website showing off photos of people looking happy at an exotic beach
  5. Ensure you barely meet legislative regulations, just enough to cover yourself when it all goes wrong
  6. Create a glossy brochure with graphs, lots of graphs ,with cherry picked data that show your great returns (you know, that one year you got 20%)
  7. Add in a hearty helping of fees and commissions that make you richer. Bury them down at the bottom of the financial statements so no one knows they’re there (they’ll never read the fine print).

If you follow these steps, you too can create a product that people will purchase in the hope it will make them a little richer. Especially if they don’t understand it.

Understanding the system

In investing, if you don’t know what you’re doing, you’re almost entering a casino.

So how do you cut out the jargon? A common investing maxim is ‘don’t invest in what you don’t understand’. But I suggest you take this much further. You need to know the difference between:

  • what you don’t understand, because it’s a gap in your financial education; and
  • what you don’t understand as it’s marketing bullshit and financial gobbledegook.

You owe it to yourself to get a basic investment education: what is the stock market, what are shares, what are bonds. For an example of what may be a gap in your financial education, many people aren’t familiar with index funds. Yet they generally make for good investments (I’ll be covering this in a future post, and there are several excellent books on this subject).

On the other hand, not understanding something because it’s marketing nonsense is more straightforward. Here’s an example of the marketing about a ‘structured product’: ‘this product allows an investor to purchase a single instrument, gaining exposure to a range of underlying assets, designed to either reduce exposure to falls, while retaining potential for returns, or to maximise the benefit from a flat or rising market.’

Do you know what they invest in? Yeah, me neither.

The next time you find your eyes glazing over on financial literature, remember to ask yourself: is this something I don’t know, or is this meant to be confusing? Am I investing, or are they investing in me?