March 28th, 2008 by Matthew
Diversification can be a good thing, but I think too many people do it for the wrong reasons, and without enough thought.
Warren Buffett
I love listening to Warren Buffett because he always breaks things down into their simplest parts. He once said very plainly, “Diversification is protection from ignorance.” I don’t think he could have said it any better (and who would disagree with Buffett?).
Keep in mind, ignorance does not mean stupid, it simply means uneducated or not informed. It’s not a statement of general intelligence, but should be applied to a specific issue. So Buffett is saying people who don’t fully understand an investment protect themselves by diversifying in other markets.
The Undertone
Buffett is known for being very to the point, but his comments always should provoke thought. This is no exception…I think it’s a little back-handed, actually. I don’t think Buffet is telling us diversification is the solution. It’s just betting on many things instead of a few.
The solution is knowledge. The more we understand an investment, the less we need to “protect” ourselves. By doing the homework up front, and really understanding what will generate profit in a given investment, we make it just that - an investment, not a speculation.
Is it Wrong to Diversify?
No, I don’t think it is. I just think it’s wrong when people make diversification their strategy. Too many people diversify for the sake of diversifying. Just because you cover a lot of markets doesn’t mean most will increase. But if you don’t hide behind diversification, and take time to understand each investment before buying, it won’t hurt you either.
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March 11th, 2008 by Matthew
Ever wonder how long it would take to double your money? At first glance, many people might think, “Well, I need a 100% increase, so I’ll just divide 100 by my annual interest rate.” Try this method with 10% (just as an example) and you’ll get 10 years. This is wrong, because it doesn’t consider the power of compounding interest. The real length of time is actually quite a bit less.
The Rule of 72
Enter the rule of 72. Simply divide 72 by your expected average annual interest rate! This gives you a very good estimate of how long it will take to double your money, including the effect of compounding interest. So, for our example above, to double your money given a 10% yearly return, it would take a little more than 7 years. If you could manage a 24% interest rate, it would only take 3 years to double your money! Below is a table summarizing this for several rates.
The Rule of 72 Derived
I’ll explain it in words, as the equations are written below. First look at Equation A. This equation says I want a value (V2) to be equal to another value (V1) times itself plus an interest rate (1 + r). Because I want to compound this over multiple years, and it will always be multiplied by the resultant, this term is raised to the t power to express the number of times (or years) it is compounded.
Next, look at Equation B. This states the second value will be two times the first value (ie. we want our initial value to double).
If we substitute Equation B into Equation A, we get the next line. The V variables then cancel, and we only have to solve for t. This is done by taking the natural logarithm of both sides. The natural logarithm of 2 is approximately 0.693. The natural logarithm of any small number plus one can be approximated as that small number (in this case, r). Because our rates are in percentages, I multiplied numerator and denominator by 100 to get the 69.3.
Now we have an expression showing the time, t, to double our money is about 69.3 divided by our rate, r. Because 69.3 is not easy to use with mental math and approximations, 72 is chosen. We’re merely looking for an estimate, and 72 is a close number that’s easily divisible by many numbers (ie 2, 3, 4, 6, 8, 9, 12, 18, 24, 36). Thus, the rule of 72!
To Triple or Quadruple your Money
You can use the same method to figure out how to double or quadruple your money. For tripling, divide your rate into 110; for quadrupling, divide your rate into 140. How were these figured? Hint: ln(3) = 1.10, ln(4) = 1.39.
