Smart Investing

It's been said that the magic of compounding is the eighth wonder of the world.

In the past I've talked about using compounding and how important it is to buy low. The example I used for those of you that may have not seen the column or have forgotten the details was buying a stock at $14 instead of $10. At $14, one wanted to wait to be sure things were better and the company was out of the woods and would receive only a 42 percent return when the stock hit $20, as opposed to the investor who did a lot of work and reading on the company and stepped in and bought at $10 when everyone else was dumping the stock because of all the bad news coming out.

The investor who did the research and bought at $10 would receive a return of 100 percent when the stock hits $20. You might think when the stocks goes to $28 then the investor who paid $14 would have a 100 percent gain, which is true, but again, the investor who made the buy at $10 would have a 180 percent gain at $28.00. So again, compounding is effective in growing a portfolio.

Another magic is the long-term effects of managing a portfolio. What do I mean?

Early this year, I was talking on my radio show and saying to people in general that now was a great time to invest. Many comments I got were, "Yes that's true, it is a good time to buy, but who has any cash left?"

While it is important to invest in the right companies, management of the overall portfolio is important as well. Back in 2007, I was having a hard time trying to find companies to buy at reasonable prices. The effect was that my cash position was naturally a little high; I would guess on average around 20-30 percent. And what the real number was, it is not as important as the fact that there was some cash in the portfolio. While I can't disclose what my loss was in 2008 for illustration of this column, let's just use a 30 percent loss. Let's also assume a portfolio of $100,000 -- a nice, easy number to work with. If the portfolio declines by 30 percent, that decline would only be on the equity portion, your cash would not decline. In addition to that, your percentage of cash would increase from 30 percent to 43 percent.

Also in this portfolio, not every company is down exactly 30 percent; some may be down 10 percent, some maybe down 50 percent. If that company that is down 50 percent that you paid $20 for is now at $10, it will only make up 3.6 percent of your portfolio. To bring that company back up to 6 percent of the portfolio you can now buy 168 shares for only $1,680. This would only reduce your cash position to 40.5 percent.

You don't have to just buy companies in your portfolio, you should now be able to buy other companies that are fundamentally strong and are currently available at a lower price. Using a 5 percent allocation in your portfolio you could now go out and buy eight new companies in your portfolio, still leaving 3 percent in cash. Can't find eight fundamentally strong companies to buy? Then buy only what you found to be companies worthy of your research. You see as the market goes down you will find more companies trading at reasonable levels. When the market increases in value you will find less companies that are worth buying.

This is not something that takes place over weeks or even months, it is over years. I've talked many times about a five- to seven-year cycle. One must be patient when investing, it not a quick get rich scheme but a long-term way to build your net worth. To invest right, first pick fundamentally strong companies. Don't become discourage if one or two stocks drop 50 percent or more, it's going to happen. If the fundamentals are still strong stay with the company, maybe buy more. On the other hand, don't get too excited if a company goes up 100 percent in the short term. If it hit its target sell price, get out and move on.

Second, stay diversified: While I like a concentrated portfolio of 15 to 20 stocks, never should any one company equal more then 15-20 percent of the portfolio. Nor should you have more than 20 percent of any one industry in the portfolio.

Third, be smart, but don't get too smart. Buying low and selling high works and it's important to stick to the discipline. It is work, it's not a game. As famed investor George Soros once said, "If you're having fun investing, you're doing it wrong."