Saving for retirement is a goal every investor should have, no matter what age. The earlier you start, the better.
Putting together your retirement portfolio is not an easy process, however. You need to make sure you invest in companies and funds that will be able to continue to produce returns for many decades, not short-term trades (unless you have the time and effort to devote to trading).
This is why I believe all investors who are saving for retirement should be value investors.
Value investing principles
There are two fundamental principles of value investing that make it perfect for retirement investors.
First of all, value investing is a long-term focused strategy that concentrates on a business' underlying fundamentals, rather than short-term market movements in the stock price.
Second, at the very root of value is the desire not to lose money; to only invest in companies where the risk of permanent capital impairment is low.
As Seth Klarman (Trades, Portfolio) has said:
"Right at the core, the mainstream has it backwards. Warren Buffett (Trades, Portfolio) often quips that the first rule of investing is not to lose money, and the second rule is not to forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance."
Focusing on the downside and what could go wrong is preferable to focusing on the potential upside if everything goes according to plan.
The benefit of using this approach is that it will maximize your ability to compound over the long term, which is vital if you want to retire with a healthy reserve of funds.
According to Klarman:
"Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose."
Understanding the importance of compounding and how it can influence your wealth is vital if you want to become rich. There is really no other way of putting it. But even if you do understand the math behind compounding, if you're not seeking to minimize trading costs and investment losses, your job will be much, much harder.
For example, say there are two investors who each begin with $100,000 portfolios. Investor A rushed into investing and didn't spend adequate time researching the best way to invest his funds. As a result, he suffers a 15% loss in the first year, but then, realizing his mistake, goes on to earn 10% per annum for 40 years.
Meanwhile, Investor B took her time, spent some time reading about the market and researching stocks before investing. She immediately buys an index fund and earns 10% per annum for four decades with no drawdown.
According to my figures, in this scenario, by avoiding the initial setback, Investor B will have accumulated $1 million more in wealth after 40 years than Investor A. That's a massive gap from the initial $15,000 loss.
Compounding is a fantastic tool for investors, but we need to be aware it works both ways. The more you lose, the harder it becomes to recover. A 5% loss requires a gain of 5.26% to get back to equal, which is hardly an impossible feat. A loss of 50%, however, needs an increase of 100% to recover, and a loss of 90% requires a gain of 900%. The chances of you finding this elusive nine-bagger are extremely thin.
So overall, when thinking about retirement plans, a strategy based on the principles of value investing should undoubtedly be used.
Value investing has gained a bad reputation due to the underperformance of so-called value stocks compared to growth equities. While it is true value has underperformed, investors should be concentrating on a value mentality rather than equity performance. If you want to achieve the best long-term returns, your focus should not be on beating the market but minimizing the risk of loss.
