Compound interest and Warren Buffett

 Warren Buffett's wealth has grown from $20K when he was 21 years old to over $100B today at the age of 90.[1] His wealth wasn't made from a single trade that turned him into a billionaire, but by growing steadily through compounding over 70 years. Anyone who wants to become as wealthy as Buffett can compare their net worth to his at some time in his life. By investing in stocks, they can grow their wealth similarly, but will require buying stocks with significant returns over years. Buffett's fortune wasn't created by some miracle that only happened to him, he just successfully picked stocks and held them over a long time period. He didn't retire at 60 and quit investing. His investments continued to compound for another 30 years after that date. Interestingly, he has publicly broadcast his investing philosophy at yearly shareholder meetings and through several biographies. In 2019, Charlie Munger mentioned Warren Buffett has also continued learning through out his life to continue this streak.[2]

1. https://www.marketwatch.com/story/from-6000-to-67-billion-warren-buffetts-wealth-through-the-ages-2015-08-17

2. https://youtu.be/YS7j0YrlceE

Margin of Safety for Growth

 With a growing company and rising stock price, it can be difficult to not want to jump in based on momentum and FOMO. However a margin of safety is important to establishing a stock position that won’t lose money. It is a common point emphasized by value investors like Warren Buffett, but less common for growth investors. Fortunately, growth stocks often have considerable volatility in addition to high returns, so it is advantageous to wait and buy these stocks when they fluctuate lower. If you expect the volatility it becomes a buying opportunity instead of a harbinger of a stock drop.

An additional mechanism I have for preventing establishing a large position all at once is to consider multiple stocks with slowly building a position and buy into the one that has the highest expected return plus the highest percentage difference from its 52 week high. The return for the past year can serve as an estimate of expected returns. 

Hidden Stocks

 I prefer to invest in the stock of companies that most people have never heard of, for several reasons. The first is that everyone has an opinion on popular well known stocks, and this can distract you from why you bought it, causing you to doubt your analysis and to lose your nerve.

Another is that financial pundits are always commenting on popular stocks causing them to run up and down on the latest commentary. Or it is easy to imagine that the stock is being swayed by commentary when it is just a generally volatile stock. I think it is easier to ride out the ups and downs when they seem random as opposed to caused by rumor or opinion.

Fad investments

One of the most alluring and dangerous investments is fad investments. These stocks offer the prospect of a quick return, but that return can disappear in an instant. They take several forms where the company sells a faddish product like clothes or the stock gets caught up in a strong momentum swell, or both. It can be particularly dangerous to be leveraged in these trades. It is hard to know how long the fad will last, and a single event like an after hours earning report can sink the stock.

These trades are the opposite of a long-term investment that compounds over years. They are also risky and time-consuming, because you have to constantly monitor them waiting for the momentum to change.

Barbell Investments

 A barbell is an interesting analogy for investing where the investor puts their money in two distinct and different investment types or strategies. Often this is a division of high and low risk investments common for dividing long and short-term investments. For example putting long-term investments in stocks and holding cash for monthly expenses. This division shows up in separating stock investments between taxed and tax-free accounts, in which certain investments make sense in one account or the other.

An interesting question is whether it might make sense to invest some money in more mid-tier investments to both cover expenses and generate more return.

Barbell Life Strategy: http://bitsbusiness.com/life/barbell-for-life/

Financial Independence-Retire Early (FIRE) Math

 Retiring early to leave the corporate world and enjoy personal passions or pursuits is a dream considered by many Generation X and Millennial individuals. Whether one wants to change professions or pursue an independent project, a certain amount of financial cushion is needed to bridge the gap. With a large enough cushion and the right investments, never returning to the corporate world is possible. The math isn't that complicated, but critical to having confidence in choosing early retirement.

The key to a sustainable retirement is earning a return on investments that are greater than your costs plus inflation, such that you aren't spending the equity of your portfolio. So, you will need a sizeable portfolio to begin with, such that the earnings on that portfolio cover all of your expenses and grows faster than inflation.

So starting with a $1 million portfolio, and annual expenses of $50,000 ($4167/month) you would need to earn on average a 7% return to cover a 2% inflation rate. The federal reserve usually targets about a 2% inflation rate. Inflation is a tricky number to estimate, so it is important to understand how you think prices for your most expensive expenses will increase. A 7% return means your portfolio must increase by at least $70,000, so minus your $50K expenses, you'll have $1.02M at the end of year 1. If you can generate extra income that will help cover costs or potentially allow investing in less risky investments.

Probably the two biggest threats to this financial model is unexpected costs or poor investment returns. So, insurance that can cover large bills or negative returns, will go a long way towards financial independence. Unfortunately, that can mean higher monthly costs or lower average investment returns, respectively.

Use of Capital and Growth

 A profitable business generates cash that it can deploy in four possible ways. It can invest the money back in the business to grow the profits of the business, or invest in unprofitable projects that squanders the money. To avoid the second of these two options, companies without profitable investments will return the money to shareholders through dividends and share repurchases. Squandering the companies profits is the worst possible option for shareholders and should probably go without saying that companies that do so should be avoided at all costs. Investing the money back in the business is often the most lucrative, because it is the most tax-efficient option. Corporate profits that require paying corporate taxes are delayed, and money re-invested in the business or other businesses after being distributed to shareholders is taxed as capital gains or dividends. Only the reinvested money can avoid taxes, temporarily, in a tax-free account, like an IRA. The trade-off of these two options is usually based on the current tax rate of capital gains vs dividends.

Investors should seek out businesses with investable opportunities that are aggressively plowing profits back into the business. The difficulty of recognizing these companies is that on the face these companies will seem like money-losing business never able to eek out a positive profit. However, in reality their current operations are quite profitable, but the added expenses of investing in the future look like costs. This is one reason focusing on growing revenues instead of profits can be beneficial for a growth company.

Value investors are anathema to these types of companies who don't have a long history of profits, and this poses the greatest opportunity for growth investors to out-perform them.