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If you only know 5 things about stock market investing, make it these…

World stock markets, including our own ASX, have suddenly turned a little volatile.

If your portfolio’s anything like mine, it has taken a bit of a battering over the last week or so.

Smaller-cap stocks in particular have been taken to the cleaners, and I’m not just talking about mining services companies.

That group of poor beggars — including companies like Boart Longyear (ASX: BLY), Fleetwood (ASX: FWD) and Transfield Services (ASX: TSE) — have been tripping over themselves to warn over profits.

I trust alert Take Stockour free email newslettter — readers have avoided the carnage in that particular sector.

It seems investors have been in the mood to shoot first and ask questions later — taking profits regardless of underlying value.

And the one winner is…

It’s precisely this type of stock market environment in which we Motley Fools like to play. When irrational selling meets business-focused investing, there is only one winner.

Motley Fool Share Advisor Investment Analyst Scott Phillips put it well in his most recent email update to subscribers of our market-beating stock picking service…

Remember, Fools, volatility is one of the best ‘free lunches’ for Foolish investors.The ability — and temperament — to buy great companies when others are selling will stand us in good stead, when it comes to long-term returns.

Sometimes, as is the case with QBE Insurance (ASX: QBE), we have to wait a while for those returns to come. We’re also honest enough to know — and tell you — that we’ll make some mistakes as well. Overall, though, these are the times Foolish, long-term investors should be excited.

I want to turn over the rest of today’s Take Stock to our Fool colleague Morgan Housel.

Morgan is a finalist in the Gerald Loeb Awards, which are often called “the Pulitzers of Business Journalism.” Winners in his category in the past two years have been Felix Salmon and Paul Krugman.

Over to Morgan…

Five things every investor must know

I own one finance textbook, and I occasionally open it to remind myself how little I know about finance.

It’s packed with formulas on complex option pricing, the Gaussian copula function, and a chapter titled, “Assessment of Confidence Limits of Selected Values of Complex-Valued Models.” I have literally no idea what that means.

Should it bother me that there’s so much about finance I don’t know? I don’t think so. As John Reed writes in his book Succeeding:

“When you first start to study a field, it seems like you have to memorise a zillion things. You don’t. What you need is to identify the core principles — generally three to twelve of them — that govern the field. The million things you thought you had to memorise are simply various combinations of the core principles.”

Evolution tells you a lot about biology. A handful of cognitive biases explain most of psychology. Likewise, there are a few core principles that explain most of what we need to know about investing.

Here are five that come to mind.

1. Compound interest is what will make you rich. And it takes time.

Warren Buffett is a great investor, but what makes him rich is that he’s been a great investor for two thirds of a century.
Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don’t start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That’s unfortunate, and there’s no way to fix it retroactively. It’s a good reminder of how important it is to teach young people to start saving as soon as possible.

2. The single largest variable that affects returns is valuations — and you have no idea what they’ll do.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That’s really all there is to it.

The change in earnings multiples? That’s totally unknowable. Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?

If someone said, “I think most people will be in a 10% better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

3. Simple is usually better than smart.

Someone who bought a low-cost S&P/ASX All Ordinaries Index (Index: ^AXAO) (ASX: XAO) index fund in May 1993 earned a 181% return as of yesterday. That’s great! And they didn’t need to know a thing about portfolio management, technical analysis, or suffer through a single segment of “Deal or No Deal”

Meanwhile, 70% of active retail funds lost to the market over the past 5 years. according to data from S&P Dow Jones Indices.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it’s not like golf: The spectators have a pretty good chance of humbling the pros.

4. The odds of the stock market experiencing high volatility are 100%.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility.

Yet every time — every single time — there’s even a hint of volatility, the same cry is heard from the investing public: “What is going on?!”

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the US S&P 500 has returned about 6% per year, but the average difference between any year’s highest close and lowest close is 23%.

Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked financier J.P. Morgan what the market will do. “It will fluctuate,” he allegedly said. Truer words have never been spoken.

5. The industry is dominated by cranks, charlatans, and salesman.

The vast majority of financial products are sold by people whose main interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he’ll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

Everything else is cream cheese.

More expert advice from The Motley Fool

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Bruce Jackson doesn’t have an interest in any of the companies mentioned above

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