Last week, Selena Maranjian offered up 10 Shocking Stats about the financial state of affairs in America. Read it, and you will gain a greater understanding of your own personal finances.
In that same spirit, there are also some very basic concepts everyone should know about investing. To get a representative cross section about what good investors consider most important, I asked many of my Fool colleagues what they felt all investors must know.
Here's what we came up with, roughly listed in the order a person may encounter them throughout their investing career. There are links embedded under many of the points for further information.
As an investor, you must know:
1. The lottery takes away 50% of your money every year, on average. The market returns you about 10%.
This fact has some rather staggering implications. If you have your retirement all squared away and have so much money you don't know what to do, you can skip this part. Otherwise, listen up.
Let's say you spend $10 a week on lottery tickets. Not too bad, right? Well, after 10 years, the $5,200 you "invested" will have netted you about $2,600 in losses. If you'd dropped that ten bucks a week into an index fund that earned 10% annually, however, you would have about $9,116 in your account -- meaning you're up $3,916 instead of down $2,600. That means our investor has $6,516 more than our lotto player, and $3,916 more than someone who kept the money under his mattress.
That's pretty impressive over a 10-year period. But the results are even more dramatic as time rolls on. Which leads us to...
2. Time is your greatest ally.
Einstein has been credited with saying that compound interest is "the greatest mathematical discovery of all time." I still think his theory of general relativity tops it, but compound interest is a close second.
We'll continue our example from #1, but roll the time period out several years.
After 20 years, our investor has accumulated $32,761. After 50, that measly $520 in yearly contributions has ballooned into $665,756. The lotto player has turned that same $26,000 outlay into $13,000. (Unless he beat the 120 million-to-1 odds and hit the jackpot, of course.) (Like that's gonna happen.)
3. What you know and what you don't know.
Try to stay within your circle of competence, but aim to expand it by learning more and filling in the holes in your knowledge -- whether you need to increase your knowledge of an industry or learn how to read a balance sheet.
It makes so much sense, right? Yet time and again we're tempted to venture into unfamiliar territory, perhaps chasing a hot sector, perhaps chasing a hot tip.
4. What your company does.
Yet more simple advice. It sounds like a given, but I bet you'd be surprised at the number of people who have no real idea what some of the companies they own actually do. You must know your company's product or service, and how it stacks up against competitive offerings. Otherwise, it's just very hard to anticipate the future.
Do you own Qualcomm (NASDAQ:QCOM)? Do you know what Qualcomm does? How about General Electric (NYSE:GE) or Lucent (NYSE:LU)?
5. Your company's expected growth rate.
It dramatically affects how you should view and value a business. A P/E or price-to-free cash flow multiple is meaningless without some context.
6. Your company's market capitalization.
It's critical to have an understanding of its relative size, so you can gauge how big a business is in relation to its competitors and its industry -- and also what sort of multiple of return you could see on your money.
7. Your stock's relative strength.
It helps to always know the context of how a stock has performed. If you don't know that, you don't know, in a sense, the stock's (and the company's) story. Relative strength is simply a ranking of how well a stock has done compared to all others.
8. Your tolerance for pain.
A frequent mistake we see is someone putting too much money into one stock -- and then obsessing over it. It's probably better to have that large position distributed into four different stocks, which you follow quarterly. Thus, one good diversification policy is to spread it out as much as you need in order to rest easily if you only track your companies quarter by quarter (not day to day or hour by hour).
9. To focus on free cash flow, not GAAP or pro forma earnings.
After years of drum beating, the financial press is beginning to understand this -- and so should you. Always remember that net income is a fiction, and cash from operations is reality. And free cash flow (cash from operations minus capital expenditures) is perhaps the most important measure of a company's true profitability.
10. The strength of the balance sheet.
Know your company's cash and debt situation, and how accounts receivable and inventory are growing in relation to sales.
11. The safety of your company's profits well into the future.
Put another way, how strong are the competitive pressures facing your company? It's one thing to buy something with a great business idea that makes money hand over fist. It's quite another if there are no barriers to entry and anyone else can open up shop -- and eat into your company's profits. That's why you'll read quite a bit about "moats" and "sustainable advantage" here at The Motley Fool.
12. The way your company will continue to grow.
You must know the catalysts that will spur the business to greater and greater profits. Is it price increases? New products or services? You, in the corner... the Anheuser-Busch (NYSE:BUD) owner. How will this $40 billion giant keep up with its projected 10% long-term growth rate in an industry that only advances about 1% per year?
Just the beginning...
In investing, as in sports, strength in fundamentals is the first step in becoming great. Once you're familiar with the dozen must-knows in this column, you will have established a strong foundation -- and you'll have a better idea of the areas you need to work on in order to take it to the next level.
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Rex Moore owns Anheuser-Busch, and knows the company hopes to grow at a 10% rate through new products and the pricing power it's achieved by the strength of its brand. The rest of his holdings can be found in his profile. The Motley Fool has a crisp, cool, refreshing, beechwood-aged disclosure policy.
