As the years passed away, like leaves falling from a tree, the occupants of the manor grew older. The master’s face accumulated a few more wrinkles, but they couldn’t hide the twinkle in his eye nor did they dull his sense of humor. The lady of the house, the daughter of a real estate magnate, grew more radiant and graceful with time. And the servants continued to perform their duties admirably, with complete precision and humility.

At the end of each year, the master and lady of the house dressed in their formal best and summoned their servants to the great hall. It was there that they paid each servant their due and thanked each of them for their faithful service. Immediately following this payment ceremony, each servant would take his money and use as he saw fit.

The oldest servant spent every bit of his meager earnings and then some on spirits, merriment, and worldly indulgences. He had been heavily in debt for his entire adult life, but somehow, always seemed to find a way to keep his creditors at bay.

The second servant spent every cent he earned on a lovely maid who lived in a nearby cottage. For many years, the servant had desired to ask for the maid’s hand in marriage, but his perpetual lack of funds always kept him from proposing.

The third and youngest servant, however, was a simple gator. His needs were small and his indulgences few. But he had one great longing – to travel the world. So, each year after the payment ceremony, he had taken twenty dollars and invested it in a local dairy farm. This money was added to the tiny sum of five dollars that he had invested in the dairy before he began work for the master. The owner of the dairy, a friend and honest fellow, would report each and every year with a smile that the young servant’s investment had increased in value by twenty-five percent.

While the master frowned on the oldest servant’s debt, and couldn’t understand why the second servant was always broke, he applauded his youngest servant’s investment effort – even though the amounts were small and insignificant.

So things continued, until a wretched day in the dead of winter when the lady of the house passed away suddenly from a biting cold. The master was distraught and the servants beside themselves. But time, insensitive as it was, kept moving forward.

Slowly and steadily, the castle and grounds fell into a state of disrepair. The twinkle in the master’s eye and his jovial nature failed him. Many nights, the master couldn’t sleep and he simply wandered the long hallways. As the servants observed the perpetual grieving of their master and the toll it took on his health, the zest they had once felt for their responsibilities faded.

On Coconut Island, people buy and sell coconuts every day using money. In fact, all of the money on the island is used to buy and sell coconuts.

As you’re traveling to Coconut Island, you read in the Coconut Gazette (the island newspaper) that there was $100 and 100 coconuts on the island yesterday. So, the price of each coconut yesterday was $1.00.

But what the islanders don’t know is that you are bringing $20 to Coconut Island.

After a long trip, you finally arrive on Coconut Island. With your arrival, and the arrival of your $20, there is now $120 on the island. However, the number of coconuts on the island is still 100 (the same as yesterday).

What’s going to happen to the coconut price today? Move the sliders below to see what happens when the amount of money on the island increases to $120 and the number of coconuts stays the same at 100. After you’ve moved the sliders to their correct positions, select “Submit Answer” to see if you’ve got it right.

Tracking Income and Expenses

After you have created a budget, the first thing you have to do is closely track your income and expenses.

Tracking your income is fairly straightforward for most people. If you have a job that pays you every week or two, then you can simply look at the gross amount on your paystub and write down that number. And if you have income from other sources, then you can also jot down those numbers.

Expenses are a little trickier and more time-consuming to track. This requires noting every time money goes out the door. Whether that’s for food or housing or transportation, or any other expense you might have.

Even though it takes some effort to accurately track your expenses after you’ve generated a budget, it is very important to do so. For a budget to be useful, it needs to be reasonable. And the only way that it will be reasonable, is if the numbers inside the budget are reasonable.

Once you’ve accurately written down all of your expenses (including the infrequent ones) and you know how much money is going out the door, it’s time to determine whether or not these expenses are necessary (i.e., needs versus wants). After you figure it out what expenses are necessary, you can compare those expenses to your income and determine if you have funds left over to invest. Ideally, your expenses would be way below your income, so that you’re able to invest as much as possible into income-producing assets that will work for you.

With all that work done, you now have a baseline of how much money you can invest over a specific time period.

Detour

Let me take a little detour for a minute. I highly recommend that you have a short-term cash reserve in place for unexpected expenses. Things seem to creep up in real life, and you can never perfectly know what your future expenses are. So it’s best to have some money squirreled away for a rainy day.

It would be tragic if you had saved up some money and made an investment, and then shortly thereafter, were forced to sell that investment at a loss because an unexpected bill showed up at your door. To avoid this double-whammy (unexpected expense + forced selling of investments at the wrong time), it’s best to have perhaps a six-month cash reserve in case you run into something unexpected or you fall on hard times. This cash reserve will help you avoid selling investments at the wrong time.

Focus on Investable Funds

Okay, so now you have a budget in place, and that budget should be realistic because you have been tracking your actual income and expenses.

With a realistic budget in place, what I like to do is to start focusing on the investable funds that I get. In other words, while I still pay attention to my income and expenses generally, I don’t track them in detail.

What I like to do when I receive a paycheck, is take out the investable funds portion (that should be left over after all expenses) and put those funds into an investment account. Essentially, I like to take out the investable funds first (some people call this paying yourself first) and then simply live off the remaining funds from that paycheck. By taking out the investable funds first, and using the remainder of the paycheck for expenses, I have forced myself to live on the budget that I originally set, and ensured that I have the investable funds specified in my budget. This is critically important so that expenses don’t creep up over time, completely overwhelm your budget, and then shrink the amount of your investable funds to zero. This practice of withdrawing investable funds first introduces some discipline into your spending right off the top.

Additionally, by budgeting in this manner, you save yourself some effort. It takes a fair amount of time to consistently and accurately track your income and expenses; with this method of simply taking out the investable funds first, it helps you live on what’s left over.

Now, you obviously can’t completely ignore your income or expenses when you take out the investable funds first. But as long as you have the same income coming in, and your expenses are approximately in line with your budget, you should be able to make things work. And you should have the amount of investable funds that you budgeted for. This will help you know how much money you have available to invest over time.

Additional Thoughts & Conclusion

One thing that you also might want to consider is adding a little bit of cushion to the expense side of your budget. This will help you weather any small additional expenses that may come your way.

Also, you should probably revisit your budget once a year or so — because income and expenses do change over time. It shouldn’t take long to revise some of the numbers. Usually, it’s fairly obvious what changes need to be made. But with this revised budget you can now have a revised number for your investable funds. Hopefully, the investable funds number has gone up. The goal should always be to increase your investable funds number.

By following the suggestions mentioned above, you should be able to track your budget, make sure that it is realistic, and accurately determine the amount of investable funds you will have over time. This knowledge can help you formulate a more solid investment plan, and hopefully aid you in your goal of compounding at high rates.

To develop a budget, you need to know your income, your expenses, and the difference between your income and expenses. If this difference is negative then you have overspent your income (not good). If this number is positive, then you have extra money to allocate to anything you want (very good). If you’re trying to build wealth, this extra money is the amount you can invest.

So the math is very simple. Assuming your income is greater than your expenses, you have money left over that you can invest. This is the building block on which wealth is created. See below.

If, however, your expenses are higher than your income, then you have overspent your income and you have actually lost money. This is not a desirable outcome. Not only have you lost money for that time period, you’ve also lost the opportunity to invest any funds for that time period. So your wealth has been negatively affected in two ways.

Assuming that your goal is to build wealth, then you want to have the most money possible to invest for your own benefit. In order to do this, you need to either increase your income, decrease your expenses, or do both.

This sounds really easy. However, in reality it can be extremely difficult. Increasing your income means finding a new job or engaging in a profitable activity that may take you away from family, friends, or other activities that you enjoy. And reducing your expenses means that you don’t get to buy as much for yourself or your family, or go on extravagant trips, or participate in expensive activities. In other words, increasing your investable funds is a sacrifice for your future.

However, in my mind, the trade-off is more than worth it. For me, one of the things that I desire most is the freedom to spend my time as I choose. In order to do that, I need to become financially free. So, I’m okay giving up certain luxuries and working on extra projects to maximize my investable funds. This should help me achieve financial freedom earlier in life.

To help get you started with your own budget, I have included a sample annual budget below. Please feel free to use this budget as a starting point in your own budgeting.

In future articles, we’ll talk about individual expense categories and how we can reduce our expenses while not drastically reducing our standard of living. Additionally, we’ll talk about ways that we can increase our income without putting too much burden on ourselves or our families.

I can’t emphasize enough how important temperament is.  Temperament may be the sole distinguishing factor between an investor who has wild success and one who substantially underperforms the market.

An investor with the right temperament is one who can observe a situation logically and dispassionately.  It’s a person who is not swept up in the emotions of the market, and neither takes comfort in being part of the crowd or against the crowd.  This type of person is able to take advantage of unfounded market exuberance and optimism (by selling), as well as undue market fear and pessimism (by buying).

An investor with the right temperament is also someone who is good at exercising patience.  A successful investor needs to have the ability to wait, wait, wait, and then wait some more for the right opportunity. Patience is key. You make your money when you buy at the right price, and so waiting for the right opportunity is possibly one of the most important aspects of successful investment.

While waiting for that perfect investment opportunity (or fat pitch, as some people like to call it), an investor needs to be cautious and humble. An investor who wants to succeed needs to realize his limitations and be extremely aware of what he does and does not know. A purchase made at the wrong price can hurt investment results substantially; an investor’s goal should be to never lose money.

At this point, I’d like to add a few words about being a contrarian (a person who buys an investment simply because it appears cheap or because the market doesn’t like it).  Being a contrarian does not necessarily lead to investment success.  It’s not enough just to buy something that others don’t like or don’t want at that moment.  You have to buy something that is out of favor, and also be correct that the security is undervalued.  In other words, the price of the security needs to be cheap, and your facts and reasoning for purchasing the security need to be correct.  That is night-and-day different than simply being a contrarian.

When that perfect investment opportunity comes along, an investor needs to be able to act decisively and invest a good chunk of resources into that opportunity. Great investments don’t come along every day, and so when they do, you have to seize them with vigor and boldness.  Meaning, you have to put a good portion of your portfolio into those investments situations. This is a lot harder than it sounds, because the time when you should be investing is the time when everyone is extremely negative about a particular company or situation. The news media is probably emphasizing the negatives surrounding the company or particular situation, your friends are telling you how bad thing are, and even your own brain starts making up reasons for why you shouldn’t invest or why this may be a bad decision. It’s an uncomfortable situation to invest against the crowd and general consensus. However, if your analysis is correct, this is exactly the right time to invest.

As Warren Buffett has stated in the past:

Be fearful when others are greedy and greedy when others are fearful.
Warren Buffett

He probably also should have stated that to be greedy, you also need to be right.  In other words, you need to have the ability to accurately assess and value businesses and securities — which is a prerequisite to investment success.

As you can see, it takes the right mix of emotions and temperament to be a successful investor. This mix of patience, humility, confidence, and caution is rare when it comes to investing; and the right temperament may be one of the most important competitive advantages that individual investors have.  It literally pays to be aware of what you’re thinking and feeling while you’re making important investment decisions.

By exhibiting an even temperament, and becoming aware of your thought processes and emotions, it is possible to make better investment choices on a consistent basis; this should lead to better investment results and a faster compounding of wealth.

Mr. Buffett described punch card investing in the following way:

I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches–representing all the investments that you got to make in a lifetime.  And once you’d punched through the card, you couldn’t make any more investments at all.  Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about.  So you would do so much better.
Warren Buffett

So, punch card investing is only making 20 investment decisions over the course of a lifetime. The idea behind limiting the number of investment decisions that an investor makes is very rational. Financial markets are extremely competitive and you are not likely to find inefficiencies or mispricings very often. So, on the rare occasions when you do find mispricings or inefficiencies, you need to be ready to act in size. You need to be able to buy up a boatload of these investments. And if you’re only going to buy 20 or so investments over the course of your life, you need to know these investment situations very well and have a strong belief that they are going to substantially outperform over time.  (Please note that these 20 punch card investments would be considered active investments.)

These punch card investments need to be like shooting fish in a barrel. On the few occasions when you come across one of these investment opportunities, it needs to be so obvious that it should be purchased, it should be like shooting fish in a barrel. In other words, it should be a no-brainer.

Charlie Munger, Warren Buffett’s partner and Berkshire Hathaway Vice Chairman, had this to say about his success:

I didn’t get to where I am by going after mediocre opportunities.
Charlie Munger

So let’s take a minute and discuss what kind of investments would fall into these punch card  investments. These investments should have a few commonalities. At this point I’ll paraphrase some investment thoughts from Warren Buffett. He says that when you’re investing, you should look for four things:

1. The investment should be one that you understand completely.  In other words, you should be able to understand what the business does and the economics of the business and the industry.
2. The company should have favorable long-term economics.  In other words, it should have an economic moat around it that allows it to achieve high returns year after year.
3. The company’s management should be able and trustworthy.  Stated a little differently, management should be good at their jobs and honest.  (I can’t emphasize this one enough . You may think that you have a great business on your hands, but if people at the helm are steering the ship the wrong way, it may all end in disaster.)
4. The investment should be one that you can purchase at a reasonable price (or, if you’re lucky, at an unreasonably low price).  In other words, investments should be purchased at reasonable/attractive valuations.

The second part of punch card investing is just as important. It’s the level of thought that needs to go into these 20 or so investments that you make over your lifetime. The idea here is that if you’re only investing in 20 or so different situations over the course of your life, you will spend a lot of time thinking about these situations and understanding them completely — inside and out. This is extremely important because after you invest in a situation, you need to have the fortitude to stick out any price declines that may come your way. When these price declines hit, you’ll need to be sure that what you’re investing in has way more value than the current price. This will give you the certainty, fortitude, and patience to wait out any price declines and eventually realize a gain on your investment (assuming that your original thesis and research is correct).

Punch card investing is not exciting or flashy.  It requires diligence, patience and the right temperament.  However, this method of investing, if practiced judiciously, can lead to extraordinary investment results.

Warren Buffett stated this principle elegantly: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”

The thought behind this approach to investing is that if you focus on the downside, then the upside will take care of itself. Stated another way, if you can minimize the risk in your investments such that the downside is limited, the only other direction is up — which means you’re making money and at low risk.

The math behind this concept is simple, but very powerful. If you have $100 invested into a security, and that security loses half its value, you would be left with $50. In order to get back to breakeven, that $50 needs to grow back into $100. So, if you lose 50% of your original investment, you will need a 100% return just to get back to breakeven.  See picture below.  That’s not the kind a math that I like. For me, it is much easier to try to avoid losses and make good returns, then to lose a whole bunch of money and have to hit a bunch of home runs afterward just to catch up.

Let’s look at one more example.  Let’s pretend that there are two people who both have $100 investments.  After one year, the first person has earned 7% on his investment, and the second person has lost 50% of his investment.  From that time forward, the first person earns 7% per year.  Below is a table showing how many years it will take for the second person’s investment to catch up to the first person’s investment under various return scenarios.  As you can see, if the second person earns 40% per year after the loss, his investment won’t catch up with the first person’s investment until just before year 4.  If the second person earns 30% per year after the loss, his investment won’t catch up until around year 5.  Finally, if the second person earns 20% per year after the loss, his investment won’t catch up until just before year 8.  So, even under an extremely optimistic return scenario of 40%, the second person’s investment wouldn’t catch up to the first person’s investment until just before year 4.  And under the slightly less optimistic return scenario of 20%, it would take almost 8 years to catch up.  And there’s no guarantee that this second investor could achieve even close to 20% per year for that amount of time.  See graph below.

Let’s take this concept to the extreme.  Let’s pretend you have a string of fantastic investment successes where you’ve grown your money to 100 times what it used to be.  And let’s say you invest that money into something that turns out to be a complete loss.  At that point, all of your previous investment successes don’t matter, because you have no money now.  In other words, it’s critical that you remember that any number times zero equals zero.

Now, I’m not saying you shouldn’t invest in situations that have some amount of risk. All investments have risk.  What I’m advocating is that you 1) become extremely aware of what you’re doing with every single investment, 2) make sure all your investments compensate you for the risks you’re taking, and 3) size your investments appropriately so that you can handle any losses that come your way.

There are basically two ways to go: active investing or passive investing.

Active investing is buying specific investments in order to maximize return and minimize risk. Passive investing is buying an index fund or Exchange Traded Fund (ETF) that tracks the performance of some underlying securities.

The most popular index fund or ETF tracks the S&P 500. The S&P 500 is a grouping of the 500 largest companies in the United States by market capitalization. Market capitalization equals the number of common shares outstanding in a company times the price per share.

Getting back to the original question, how should one invest (actively or passively)? The answer is: “It depends.”

Warren Buffett, the Chairman and CEO of Berkshire Hathaway, provided the answer to this question. Mr. Buffett had this to say:

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry.  That investor should both own a large number of equities and space out his purchases.  By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.  Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.  I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential.  In the words of the prophet Mae West:  “Too much of a good thing can be wonderful.”
Warren E. Buffett, 1993 Chairman’s Letter to Berkshire Hathaway Shareholders

There’s a lot of wisdom in this quote. If you’re a person who knows how to value businesses and assets, it makes no sense for you to diversify widely by buying an index fund or ETF. You’re much better off spending your time analyzing companies and buying the most undervalued securities you can find. This will lead to much higher returns and a reduction of risk in your portfolio.

However, if you’re a know-nothing investor, meaning you don’t know much about business or valuation, you should seek to diversify widely. A great solution for this is to buy a low-cost index fund or ETF that tracks the S&P 500.

Now, it’s very important that you make a rational assessment of the type of investor you are: know-something or know-nothing. It can be financially devastating for you to think and act like a know-something investor, when in fact you are a know-nothing investor.

It is much easier to lose money in active investing.  You are exposed to company and security-specific risks, and your portfolio could also turn out to be too concentrated in a few investments or economic outcomes.

The decision between active and passive investing doesn’t have to be binary, though. In my mind, there’s a spectrum. You can do a little active investing while you’re investing the majority of your funds in a passive manner. This can be a good way to learn how to actively invest and potentially garner higher returns in the future.

If you are new to investing, however, I highly recommend that you start slow and invest passively (i.e., index). And then as you gain more knowledge and experience, you can start dipping your toe into the active investment pool. This phased approach should result in a decent investment return with minimal risk to start, and provide you with opportunities to learn how to actively invest, so that one day you could possibly hit a few investing home runs and achieve finance freedom early in life.  That seems like a pretty good risk/reward trade-off to me.