On May 25th, 2010 Dr. Paul Woolley of the London School of Economics laid out ten policies that he claims could increase annual returns (after inflation) by 25% and long term returns by at least 50%. As promised we are taking a few weeks to cover these points in more details. Dr. Woolley was addressing his steps to large institutional investors but we feel as if they are just as well suited for individuals.
Step 1 – Adopt a long-term investment approach (future dividend flows), rather than momentum (short-term price change).
Step one is all about a simple choice you have. You can decide to invest in a business as an owner, allowing the business to generate long-term wealth for you. Or you can decide to buy a piece of paper in hopes that someone will buy your paper at a higher price than what you paid for it.
As the owner of a business you are entitled to receive all the earnings that your company can generate through its day to day operations. These earnings can be paid to you in either a check, or as a reinvestment towards the future growth of you business.
For the past 100 years or so, businesses in the U.S. have generated about a 5% annual growth in capital through reinvested earnings, and in addition have paid about 4.5% a year in income to their owners. The funny thing is, the U.S. Stock Market has averaged an almost identical return with a 4.5% dividend yield and a 5% earnings growth.
The problem for many shareholders in adopting this long term approach is that many of you measure the value of your business by the daily market price of your company’s shares. Thinking only about the short-term price swings, instead of business operation performance, will place you into the momentum camp. Resist it and you will be rewarded.
Step 2 – Cap annual turnover of portfolios at 30%
Step two is all about reinforcing step one with a monetary payoff. Turnover is a term used to describe how often you buy and sell securities in your portfolio. If every investment you own is bought and sold once a year your turnover is 100%. This turnover creates two costs, one is the cost of trading and the second is taxes.
As a rule of thumb, a turnover of 100% will usually cost approximately 1% of your investment account due to trading costs. In addition, this 100% turnover rate costs about 1.8% of your investment account in short-term capital gains taxes, opposed to the 0.6% if taxed at the long-term capital gains rate. Think about this for a minute; if the market returned 10%, you would have to earn more than 12.8% just to break even with the market. It is possible, but highly unlikely.
Next week: Risk, return and measurements – Steps 3 and 4.
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