# The magic of compound interest

9 August 2008 Michael Szumielewski 154 Comments Investing

Compound interest is one of the most interesting things in the financial world. If you truly understand how it works, it can make you a lot of money. Check out this impressive quote:

Compound interest is the greatest mathematical discovery of all time.
Albert Einstein

Compound interest can be explained as the adding of accumulated interest back to the principal. Interest is earned on interest. Compounding depends on three factors: percentage, basis and time.
Example: You have a bank account with \$10000 in it and get 4% interest per year. After the first year you have \$10400, but ten years later you already have \$14802.44. Sounds great, doesn’t it?

## Even 0.5% make a difference

Let’s take the example from above and modify the percentage to 4.5%. After ten years you have \$15529.69. That means that you get 10.77% more than with a percentage of 4%. Amazing. Always seek for that extra 0.1% to 0.5% when searching for a good investment. Over time it changes a lot and you will see the difference.

## The more you have, the more you will get

It’s true, rich people get richer. We earn \$400 in our first example, but with a basis of \$20000 we would have earned \$800. The higher the basis, the higher the profits. Don’t forget to make regular payments into your savings account, so your basis gets bigger. Ideally you save money for a reason, for example your retirement. Then you need the endurance letting the money where it is for let’s say 20 years. But trust me, the motivation is great to pay in every month, because you will see amazing results and retire completely without financial problems.

## Time is on your side

How long you let your money earn money is up to you, but the longer the better.
Remember, you earn money by doing nothing. And the money you earned by letting it earn more money will earn you even more money. You just put money in your account and watch it grow over time. If you don’t need the money, let it multiply. Be disciplined and patient enough and don’t touch this money.

## The three factors have to work together

The whole concept of compound interest sounds great, but it is dependent on the three factors. They have to work together well, or you will get poor results. Basically, it is up to you how long you can do without the money you put in your account. It is also your choice how much you put in,dependent on how much money you have, of course. To get the max, the basis and time should be relative high, because the third factor “percentage” is aligned with risk. You get a small percentage with little to no risk but every percentage point more goes hand in hand with more risk. It is essential to find the right balance.

## Sometimes it is magic

To conclude this article, here is a amazing example on compound interest at work:
“If the Native American tribe that accepted goods worth 60 guilders for the sale of Manhattan in 1626 had invested the money in a Dutch bank at 6.5% interest, compounded annually, then in 2005 their investment would be worth over €700 billion (around USD \$1,000 billion), more than the assessed value of the real estate in all five boroughs of New York City. With a 6.0% interest however, the value of their investment today would have been €100 billion (7 times less!).”

Sources: Wikipedia

# Three investing misconceptions that are not true

28 July 2008 Michael Szumielewski 4 Comments Investing

Stock investing is hard work and inexperienced and untrained beginners have a lot of difficulties when investing for the first time. For some it looks easy during bull markets and incredibly tough during bear markets. But the main target is to make money even if the market is in a bad condition.
Of course there are always people who give expensive but useless advice about investing. I am sure, you heard of “Buy low and sell high”, which is indeed quite useless, because how would one know what is the expected low and the expected high of a stock. Some people just give wrong advice and you can get into serious financial trouble following their ideas.
Here are three stock investing misconceptions that you should definitely avoid:

## Wrong: Low price stocks are better than high price stocks

A widespread misconception is that a low price stock should be preferred to a high price stock, for example a \$100 stock vs. a \$10 stock. This is wrong. The value of a company is expressed by its market capitalisation (stock price * number of stocks), whereby the real value of a company differs from this value. It must be calculated by analyzing the company. So, the assumption that low price stocks are better is wrong because every company has a different number of stocks on the market. The price of the stock is the effect, not the cause.

## Wrong: Stocks that have fallen will rise again

We see the traders attitude here, because when a stock falls e.g. 25% on a single day, some will speculate that there will be an up rise of e.g. 5% the next day. This effect has been observed many times, but we discuss long-term investing here, so it is clearly a misconception. Stocks usually fall for a reason, even if it is not clear for everyone. But fallen stocks will rise only when the factors which led to the fall are corrected. For example, if a stock fell, because the company announced that it will suffer from a recession for the next years and earnings are down, then it won’t rise before those factors change to normal again.

## Wrong: The stock market is a place where you can get rich quickly

By investing intelligent you can for sure get rich on the stock market, but this is not supposed to happen quickly. Many people behave like gamblers on the market by making quick, impulsive and blindfold decisions. They lose money and again behave like being at the casino by increasing the amount of money in the game in the intention to wipe out their loses. Logic is dominated by emotion and the game is soon over.
However this misconception can be changed into a perfectly true advise: “The stock market is a place where you can get rich as quickly as possible”. This does not mean “Get rich slowly”, it means that you can get rich as quickly as possible. With the assumption of a historical return of 10% a year and a few years of your time, you get pretty good results. Never forget that the most important thing in investing is not to lose your money.

All in all, there are always intelligent people with experience, who know what they are talking about. Do not follow the loudest voice in the crowd, search for the smart ones.
But most of all, always check thoroughly every advice which is given to you, because in the end it is your hard-earned money which is at risk.

# It doesn’t mean you’re right, when your stocks go up

3 May 2008 Michael Szumielewski 3 Comments Investing

Today’s article is about the reason to invest in a particular stock and the important fact, that just because a stock went up, it doesn’t mean you are right. One could argue, that when something works, the reason is unimportant, but that’s just not true. For example, if you jump into a lake and don’t know how deep the water is, there are two options: you break your neck or you enjoy your bath. Got it?

There are a lot of bad reasons to buy a stock, almost to much to mention. Let’s discuss a few.

Buying/Selling a stock because it went up/down: This is a common mistake. As written in Do not listen to Mr. Market, the stock market suffers from huge fluctuations regularly. If you want to buy a stock, don’t buy it when it’s totally overpriced. Instead search for great companies with a low price and it will be a successful investment. Also don’t panic and sell because the stock went down. Instead check the fundamentals again and make sure you didn’t overlook something.

Buying/Selling for the wrong reason: Today everything is linked to everything, so we call it globalization.This fact often makes it difficult to understand certain developments. It’s not enough to check out the product of a company and know the local business circumstances any more. You have to know exactly what the company does, understand the business model and figure out which variables are critical for success. The lack of understanding world economics like, for example, the euro/dollar constellation, might bring you into serious trouble and may cause unexpected surprises. Read Investment Research: What does the company do? for more information.

Bad investment advise: Especially dangerous for inexperienced investors who keep asking “What’s your favorite stock at the moment? What should I buy?” Again, check out our article Do not trust analysts and fund managers, which tells you why you should make your own investment decisions. Even if you have a good friend who invests successfully, you should probably not invest in the same stocks, because he buys them for specific reasons, which he monitors regularly. You will probably misjudge the case and make mistakes, because you don’t understand the company like he does. You know probably more about other industries.

Remember, we do serious long-term investing here, so if you have a trader attitude, this conclusions may not apply for you.

On the other hand, you’re not necessarily wrong, when your stocks go down. If you invest reasonably, but the stock market is not ready yet, you can also suffer months/years of falling prices, but in the end the attitude of value investing will be superior.

# Invest money you don’t need

2 April 2008 Michael Szumielewski 5 Comments Investing

Investing in the stock market is a long-term thing, so you shouldn’t put money in, which you will need in the next 2-3 years.

This is a very basic investing rule, you always have to remember: Only invest money you don’t need. Before investing you have to check out your financial situation first to know how much you can afford to lose. Yes, I said lose, because that’s the point. To keep it simple, only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.

## Short-term investing is risky

So how much would that be? It depends of course on your personal situation, but I will give you an examples. For instance, your child will go to college in 2 years, so it’s obvious that you have to save money. Don’t put it in stocks, not even in blue chips. Even blue chips can and some will almost for sure suffer periods of bad performance on the stock market. It’s to risky. You can’t afford to lose this money, because you will need it. Additionally, you can’t predict the stock market as a whole, so you will not be save from the next crash. That’s why you shouldn’t trade, for example, with the money you need for the rent. When you lose, you’ll have to sell at the end of the month again, because without the money you can’t pay your obligations. So, don’t be so foolish.

## You should always be invested

To invest money you don’t need, doesn’t mean you should stay out of stocks at all. You can and should invest at any time, unless you are under heavy debt or suffer total misfortune. There are all kinds of complicated formulas for figuring out how much you should put in stocks, but keep it simple and invest what you don’t need. The question always is how much you can afford. First save money, then invest in the stock market. You can start with \$100 a month. For example, save one tenth of your income no matter what happens and invest it wisely. When you have not much money, start small and grow big. Keep in mind, that your money will compound and the sooner you start to build a fortune, the sooner you will have what you desire.

# The Intelligent Investor by Benjamin Graham

20 March 2008 Sören Zschoche 4 Comments Books

The Intelligent Investor by Benjamin Graham, is a book which characterized the way many people think about the stock markets like no other book ever did before. Warren Buffett once called it “The best book for investors which has ever been written”. Probably this book also shows his point of view and perhaps without it he wouldn´t be that rich today. The author Benjamin Graham was Buffett’s teacher on Columbia University and the things he though and wrote down have remained valid until today, which nearly resembles a little wonder in the permanent changing economic world.

But what is it that makes this book so unique, that even the richest man of the world calls it his favorite book? First of all we can say that the author was a really brilliant man who together with David Dodd. He discovered that markets are irrational and you can profit of it. Today this is also known as value investing and can, if you adopt it correctly, make you very rich.

The book is structured in 20 chapters, which respond to nearly everything you need to know to become a professional “intelligent” investor. Especially the difference between an investor and a speculator is one of the central points of the book. Other emphases are the margin of safety, and things which train you to make your own decisions and to build up the self-discipline you need for that. The only disadvantage of the book is that there isn´t said much about techniques of the share analysis, but for this area Benjamin wrote another book with the name “Security Analysis”.

So, I really suggest you to read this book, because it´s probably the best one which has ever been written about investing. Seriously.

3 March 2008 Michael Szumielewski 2 Comments Investing

In my last article Do not trust analysts and fund managers, I pointed out how important it is to make own investment decisions. But how to find that perfect company? I think, most investors have yet made the mistake to buy a stock because it was hot or sounded exciting, like microchips in the New Economy boom, for example. But that is exactly what your fund manager picks on a regular base: companies that sound exciting and hopeful. Unfortunately, he is often wrong with his picks. So you have to rely upon yourself to find good stocks and guess what, you are in a far better position than any analyst.

The most important thing here is really never to buy stocks from companies you have absolutely no idea of the business model. It is also only a first step in the investment process, but a very basic one. So, instead of buying that microchip firm, take a look around you. Everyday you are surrounded by a lot of companies either at work or at home. Your credit card is probably the only requirement to become an shopping mall analyst. Take advantage of what you already know! If you work in the steel industry, for example, you know how to estimate the current situation of your industry and even know which companies perform well. You just have to put your eyes open and pay attention. You got better sources than any analyst and so you have the chance to discover excellent companies before Wall Street does.

I have got two examples for you, the first one is Wal-Mart. I am not from America, but you surely must have noticed, that this company was doing extremely well for years. The stocks performed great between 1975 and 2000, in fact the chart went up for 25 years! It’s amazing how much time people had to notice that amazing development. This happens all the time, because there are always good companies with great products around. Let us take a look at Apple, a typical turnaround. In 2002, when the stock sold for \$12, you must have noticed the first people with this cool, white iPod music players on the streets. In December 2007, it sold for \$200, what an investment! And again, you had really a lot of time to notice that Apple is doing something right. Everybody who bough an iPod at this time, should have bought shares too

So, always ask yourself: What does the company do? I’m sure, you have specific knowledge of the industry you work in, so you know what is important to have success in this industry. Beginners often buy stocks in fast growing industries, because they think that there are no out-performer in industries with a low growth rate, but that is only true for cyclical industries. There are always great companies around and they are near you, you do not have to buy that hot Internet stock from China, just go to the local shopping mall or ask your children or some teenagers what stuff they bought the last 6 months. You will be surprised how many opportunities you will find.

# The difference between investing and speculating

24 February 2008 Michael Szumielewski 1 Comment Investing

Do you know the difference between being an investor and a speculator? Most people think, that at the moment of buying a stock they are investors. But after selling in 3 months with a 25% loss they should know that they are not, they are simply bad speculators. In fact, we talk about two absolutely different styles, so different like the night and day, or the men versus women of the financial world. They also typically attract specific personality types to each financial strategy, so not everybody can become a perfect investor or a perfect speculator.

A speculator is somebody who practices financial speculation, which involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculators are willing to take large, but calculated risks in search of large rewards over a short time period. Benjamin Graham once described speculation as “a rat race of trying to get the highest possible return in the shortest period of time.” Graham strongly believed investing should be in securities where the principal investment was reasonably safe and there were “satisfactory” returns.

An investor on the other hand is any party that makes an investment, which regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company. They also purchase real estate, currency, commodity derivatives, personal property, or other assets, always in hopes of achieving capital gain, not as a profession or for short-term income. An investor has a fundamental “buy and hold” approach and is interested in long-term investments that provide a steady source of passive income. Typically the investor is the “boring” guy, because he is not concerned about the daily movements of the market.

So, why is knowing whether you are an investor or a speculator so important? It is simple, because knowing if you are an investor or a speculator is essential for developing an matching investment strategy for you. Know Thyself! It is not recommended to mix this two types of money making, unless you are very skilled and experienced. You should know your own risk tolerance and it should play an important role in your investment planning. Upon other terms, your risk tolerance is defined by your financial situation, investment knowledge/experience and of course your age. Financial risk also strongly depends on your personality, so again it is very important to know yourself before investing your money.