Volatility matters

One thing my broker never explained to me: volatility matters. Average historic yields can be misleading to an individual who enters the market during a discrete year, and ultimately must "exit the market", or lock in the corpus of an investment account by converting to fixed income instruments at some point in order to secure principal and generate a stream of cash for distribution.

If the market (or a single equity, for that matter) declines 20% in one year, it takes a 25% gain the next to get back to even. If the decline is 25%, one needs 33% gain the next year to get back to even. That sequence means two years investment experience with ZERO appreciation. This observation leads to common sense rule number one: don't lose money. This concept stands behind the "margin of safety" of Benjamin Graham and Warren Buffet's rule number 1.

Try as I might, I have a hard time really understanding how one dissects a balance sheet and an annual report. I can follow the logic behind the various stock screening methods, but I'm not capable of the discipline to laboriously analyze equity after equity. So, some simpler logic must guide me in deciding how I will invest my retirement savings.

I know from experience that certain types of equities can fluctuate dramatically in value, particularly if the industry they work in is a "cyclic" industry, or if the company's earnings are variable from season to season and year to year. After all, the market is a very short-sighted, neurotic and over-reacting entity.

One principle that must guide me is choosing investments with very steady, hopefully rising earnings, year in and year out. Such an investments are unlikely to fluctuate dramatically in value from year to year. If the earnings trend is up, the valuation will generally also rise over time.

Each equity has a historical range in price/earnings ratios. It isn't prudent to purchase an equity at the north end of it's historic price/earnings range, unless there is some reason to believe that earnings will accelerate dramatically in the near term future. Otherwise, purchasing at a historically high price/earnings ratio may well be "over-paying" for those earnings.

So, without being too sophisticated in my company analysis, I am looking for companies, and industries that are "steady Eddy's" with respect to earnings and valuation. Where am I finding them? One sector is utilities. Another is in "certain" Master Limited Partnerships. A third is health-care entities. A fourth is certain REITs. One has to be careful to understand the underlying premise on which each business earns it's money and how it grows revenues and earnings over time. The best of these are those with a simple business model and easy-to- understand drivers of earnings.