Monday, April 24, 2006

Investment Home Runs and Singles

Consider the following four investment scenarios:
  1. You invest $1,000 in a company early in your life (age 25) and hold it until retirement (age 65) and this company gives you 16% annually for the 40-year period; your initial $1,000 will be worth $326,000 at retirement.
  2. You invest $2,000 in two companies ($1,000 in each company) and hold it for 40-years and these two companies give you 14% annually for the 40-year period; your initial $2,000 will be worth $331,000 at retirement
  3. You invest $4,000 in four companies ($1,000 in each company) and hold it for 40-years and these four companies give you 12% annually for the 40-year period; your $4,000 will be worth $332,324 at retirement.
  4. You invest $8,000 in eight companies ($1,000 in each company) and hold it for 4-years and these eight companies give you 10% annually for the 40-year period; your $8,000 will be worth $329,158 at retirement.

We can approximate from the calculations above:

  • $1,000 growing at 16% for 40-years = $8,000 growing at 10% for 40-years
  • $1,000 growing at 16% for 40-years = $4,000 growing at 12% for 40-years
  • $1,000 growing at 16% for 40-years = $2,000 growing at 14% for 40-years

In baseball analogy, the 10% returning investment is a single; the 12% returning investment is a double; the 14% returning investment is triple and 16% returning investment is an old-school non-juiced natural-power home run.

Consider investor X; X is a risk taker. This person always tries to find the next big thing. LetÂ’s suppose this person starts with $8,000 at age 25 and buys into 8 companies with home-run/strikeout type of potential. If 7 of his companies strike-out and go bankrupt, but if only one survives and gets 16% return for 40-years; this investor will have same amount of money as investor Y who invests $8,000 for 10% return. The investor X survives in the investment world even if the investment success rate is only 12.5% for investor X.

Now, the question is:
Since $1,000 invested at 16% gives you the same terminal value as $8,000 invested at 10% in 40-years, should an investor always try to look for the home runs? Should an investor only try to find the next Microsoft, Dell, Cisco, Coca-Cola, Home-Depot, Wal-mart type of stocks and latch on for the 16% ride? Or should an investor invest more money and hit singles with many stocks? Should an investor go for 3-4 yard conservative rushes or go for 50-60 yard bombs and risk interceptions? Should an investor go close to the basket to get a high-percentage two points or pull up at mid court every time for a low-percentage three points?

Your comments are always welcome.

4 comments:

Jay Walker said...

How many stocks are capable of returning 16% p.a. for 40 years? They'd actually be more likely, on average, to be the type of stock the risk-taker would avoid - i.e. Coke or Citigroup bought when unpopular and cheap.

Trying to find the next Microsoft is like looking for the needle in the haystack - at the early stage, there's lots of pretenders, later, they all become overvalued.

Ten years ago, Microsofts future looked great, but all you'd have out of this is just over a double - i.e. about 9% p.a.

Nice post, but tough to find those companies.

Anonymous said...

But, if you get lucky and do find that needle in the haystack, then your returns will be amazing.

Interesting post.

amit said...

really interesting post.
I'm not sure how this should change my investing, if at all, but it's something to think about.

Tom McGovern said...

Anything over 40 years would be virtually impossible to choose. There would be so few that could actually return 16% every year for 40. However, a well constructed portfolio of securities has a very real chance of accomplishing the goal.