Knowing what to invest in is of paramount importance. But it is also vitally important to know how to invest. Here are two things that I think you absolutely have to understand to succeed in the market.
Understand the power of compound interest
Albert Einstein once said: “Compound interest is the most powerful force in the universe”. He may have been right. The benefit of compound interest can be summarised as follows: the more money you have, the more money you will make in the future, assuming you deploy your capital correctly. This is a pretty simple idea, but one that many people seem to have trouble grasping.
One key impact of compound interest is that those people who start to save earlier, and invest their savings earlier, will benefit disproportionately compared to those who don’t. An initial £10,000, invested at 5% per annum, will compound to £16,407.09 after 10 years, assuming no deposits or withdrawals – a gain of £6,407.09.
However, investing that £10,000 for 20 years at the same interest rate will yield £27,126.40 for a gain of £17,126.40. You can see that doubling the savings period increased the overall gain by a factor of 2.67.
Investing that £10,000 for a period of thirty years at 5% will compound to £44,677.44 for a gain of £34,677.44. Tripling the saving period increased the final gain by a factor of 5.41.
So, it’s not just a case of the longer you save, the more money you will have, it’s that your money will compound faster and faster the longer you save. For this reason, it is advisable to start an ISA, and take advantage of pension matching schemes, as soon as possible.
Beware of people saying “this time it’s different”
In October 1929, Irving Fisher of Yale University, one of the most highly-respected economists of his day, declared that stock prices had “reached what looks like a permanently high plateau”. Nine days later, the stock market was hit by the most devastating crash in the history of the US in an event dubbed ‘Black Tuesday’.
“This time it’s different” is one of the most dangerous phrases that an investor can hear. Some version of this statement will typically accompany the formation of a market top. It is supposed to mean that, although valuations may be expensive by historical standards, investors should buy anyway because a paradigm shift has made the old standards irrelevant.
In the dot.com bubble of the late 1990s, it was believed that new technologies were going to usher in an era of unprecedented economic expansion that would push valuations to brand new heights.
Economists and commentators seem to have an uncanny ability to make such pronouncements right before the market breaks. In 1999, journalist James K. Glassman and economist Kevin Hassett co-authored a book titled Dow 36,000: The New Strategy From Profiting From The Coming Rise In The Stock Market.
Its core thesis was that stocks would soon be considered as risk-free as bonds and that the market would price them accordingly. When this happened, the fair value of the Dow would be around 36,000. Twenty years later, the all-time high for the Dow stands at 27,398 (set earlier this year).
When someone tells you that this time is different, assume it probably isn’t.
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Neither Stepan nor The Motley Fool UK have a position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.