Posts tagged " Dow Indices "

Safety of Principal

September 23rd, 2009 Posted by Stocks No Comment yet

Investing Principles and Methods Series, September 23, 2009.

Today we continue to explore Graham and Dodd’s definition of an investment and what is considered a “safety of principal”.  Let me illustrate why it is important to safeguard your principal.  If we are going to invest in the stock market our benchmark would be the Dow Industrial Average (Dow). It is one of the oldest indices comprise of a group of 30 leading stocks which suppose to represent the overall market.

The Dow in April 1, 1932 was at the lowest point in the history of the Dow, it was at 42.84, and by April 1, 2009 it was 8447.  If you were to invest from the beginning and never sold any of the stocks you had purchased and assuming your return mirrors the Dow your compound return (interest earning on interest) would be around 7 percent. That is an equivalent to investing $1,000 in April of 1932 and by April of 2009 your investment would valued at $183,000. Please refer to figure 1 below.

Figure 1.

AMOUNT

START

END

INTEREST

FUTURE VALUE

1,000

1932

1933

7%

1,070

1,070

1933

1934

7%

1,145

1,145

1934

1935

7%

1,225

1,225

1935

1936

7%

1,311

1,311

1936

1937

7%

1,403

1,403

1937

1938

7%

1,501

1,501

1938

1939

7%

1,606

1,606

1939

1940

7%

1,718

1,718

1940

1941

7%

1,838

1,838

1941

1942

7%

1,967

149,417

2006

2007

7%

159,876

159,876

2007

2008

7%

171,067

171,067

2008

2009

7%

183,042

To keep things simple, if we are going to invest in the stock market we have to try to beat that 7 percent mark.  That means to earn a higher return against our benchmark. Why?  It would be easier to simply buy an equivalent amount of each stock that makes up the indices and earn that 7 percent.  If we are going to have to do any more work than buying the indices than we need to be compensated for our time and effort.

How easy is it to beat the Dow Indices?  Logic tells us that the collective return of every market participant earns an average of 7 percent.  In essence you are trying to compete against everyone else and yourself.  The bigger you are or the more money you manage the harder it is to beat the average because you contribute a great deal to the average.  This is important to keep in mind.

I brought up the notion of the Dow to examine the issue of safety of principal.  Take two situations below, both earns an average return of 7 percent compound interest in the last four years.  However, the part that makes up the overall returns varies and it is important to note.

In Scenario 1, what must be going through your head if you are the investor?  In 2005, you achieved an average return of 7 percent.  Then, by 2006 you must be thinking to yourself, “Perhaps, I can beat the Dow”.  So you implemented your plans and by the end of 2006 your returns was 47 percent, amazing.  Your ego swells up, like wise cash in your account. With all the compliments, you might have thought, “This is easy.”  By 2007, yet another successful year, this time you earned 19 percent.  In the end, by 2008, you have done everything as before but this time you met your faith and loss 30 percent.  Your average is now 7 percent for the four years. Can you see how difficult it is to beat the market?

Contrary, in Scenario 2, your objective wasn’t to necessary beat the market but simply to earn the average return.  Your goal seemed much more obtainable and perhaps more realistic. Often, when you first got started with anything, you tend to be overly-optimistic.  In investing you have to make sure you have a reasonable goal. Do the work necessary to earn a desirable but realistic return compensated with the amount of work you are willing to put into investing.  This is what I believed your “satisfactory return” requirement should be – what do you expect to make in terms of returns on your capital, time, and effort?

Figure 2.

AMOUNT

2005

2006

2007

2008

COMPOUND INTEREST

FUTURE VALUE

Scenario 1

1000

7%

47%

19%

-30%

7.0%

1311

Scenario 2

1000

7%

7%

7%

7%

7.0%

1311

We all know that some short cuts in life actually take much longer to complete.  It is not how fast you succeed but if you can hold on to your wealth. The scenarios above highlight a theme similar to my favorite racing story of all time, between the rabbit and the turtle – there are many versions but in the end, the victor, always the steady turtle.  In life, things are less certain with all kinds of exceptions. However, if you stick to the norm, the notion of “steady wins the race” does apply to investing in stocks.

You don’t have to go after the incredible 47 percent gain if you take care to safeguard your investment by not losing your principal. The above example illustrated that even with a monumental gain of 47 percent in one year and a 19 percent in another, if there is a chance of 30 percent loss; you could stand to lose big, or at the best being mediocre.

Copyright 2009 by fartingcamel.com

Gallery

Shia_LaBeouf_Carey_Mulligan_holding_hands Shia_LaBeouf_Carey_Mulligan_Memorial_1 Shia_LaBeouf_Carey_Mulligan_Memorial_2 Shia_LaBeouf

Topics on Farting Camel