Albert Einstein was said to have described compound interest as “the eighth wonder of the world” and that it is “the most powerful force in the universe”. High praise from one of history’s greatest scientists about an elementary-level concept of finance. I mean, he’s right. Warren Buffet, widely regarded as one of the greatest investors ever, openly admits that most of his wealth is attributable to simple compounding.
Let’s talk about bonds for a minute. Occasionally, we get asked about what the future prospects are for bond investors. Sometimes with the implication being: “Should I be invested in bonds at all?” For the past decade, we’ve lived in a very low interest rate environment, relative to historical averages. (Click charts below to enlarge)
It’s been grizzly out there. Times like these give me a chance to share my absolute favorite quote about markets. From Bill Bernstein’s book, he recalls how investor Ralph Wagoner explained markets:
I had an interesting conversation with someone who was asking about the mutual funds we employ. Specifically, he asked if we use “Five-star mutual funds”. I probably shouldn’t have been surprised, based on how ubiquitous Morningstar is for investment research, but I had never been asked about Morningstar Star Ratings before. In the world of detailed analytics and minutiae, Morningstar star ratings are a throw-away metric. It is a crude approximation of a narrow slice of a mutual fund’s story.
Rules of thumb are common in the investment world. There’s the “rule of 72”, which gives us an idea of how often money will double. The safe retirement withdrawal rate lets us know how much we can “safely” draw from retirement portfolios without significant risk of long-term depletion. Finally, there is the your age in bonds rule, telling us how much of an investment account should be in fixed income at a given time.
Diversification is hailed as “the only free lunch on Wall Street”, based on the famous quote by Harry Markowitz. Some of us accept this as a fact and take a diversified approach to our portfolios. Then, a stock our buddy picked quadruples its value or the S&P 500 outperforms other asset classes over a multi-year period (as we’ve seen in the last few years). In times like these, it is easy to lose sight of why diversification is so important.