Expand Your Understanding of the Investment Possibilities that Exist
Most people in the western world have an overly narrow view when it comes to investing - they usually think one of those places for storing money:
Even the above list is broad - most young people today don't readily buy bonds or invest in bond funds (even though the overall bond market is bigger than the equities market). Unless you're lucky enough to have had your grandma buy you a bond, you've probably never owned one and you might not even really know how one works.
So, that leaves us with equities or cash - is there nothing else? Of course, there is something else -- most people have been doing other things with capital rather than buying equities or saving cash -- throughout history. You just have to open your eyes to the broader investing and capital allocation universe that's out here.
Of course, you shouldn't be foolish - equities (eg. stocks, mutual fund, and ETFs) and cash are better understood and offer a lot of advantages. But a person can also invest in:
getting even deeper and more complex, you can invest in things aren't aren't even assets but things that might bring a return later on. These might include:
Again, no one here is saying that you should forget the bread and butter that cash and equities offer the broad swath of the investing public - far and away these should (for most people and in most situations) make up the majority of your saving and wealth-boiling plan. However,r it's smart to lift your head up once in a while to see other possibilities and opportunities available if only to build a better and more comprehensive understanding of what capital allocation, investing, growth, return, and success really mean in your overall financial life.
The Importance of Failing at Investing - It's Almost a Prerequisite to a Successful Long-term Investing Track Record
Failure is always unpleasant but a part of life that can teach. Not all things require failure - you can be a great academic and never fail a class and you obviously don't' want to be an engineer or an architect that ever fails. However, with investing, it's a whole different game - failure early on is almost a prerequisite to a successful long-term investing track record. It's not only that failure is ok, it's almost that utter failure early on (or possibly later on, but early on is better because you usually will have less invested early on).
Financial Markets are too Difficult to Predict
This is a pretty bold statement we're making - we're saying that not only is failure ok but that failure in investing is almost a prerequisite for a good long-term investing track record. This is the case because investing -- unlike so many other professions and activities -- involves intense levels of uncertaintly and potentially chaos. The markets are uncertain and can act in chaotic ways. Additionally, when they are chaotic, they are of the more complicated second order chaos variety - this means that not only is it hard to predict financial markets but that in attempting to predict them we influence them as well. The problem is that humans have a lot of deep-seated heuristics and cognitive biases that intensely cloud our thinking and prevent us from acting in rational ways.
Cognitive Biases and Heuristics Can Lead an Investor Astray
An engineer or an actor or an architect or a college student or an academic doesn't need to fail because their professions are (1) far less uncertain in terms of predicting outcomes and (2) rely on things that are less affected by heuristics and cognitive biases. For example, a bridge builder uses principles of physics to predict the behavior of materials in various situations - not only does this prediction not involve deeply complex or chaotic systems, but it can also be tested in small-scale environments before being implemented (something that's not really possible in a world where time travel hasn't been invented yet). Here's a brief list of some heuristics and cognitive biases:
Two Main Benefits of Investment Failure
Failure in investing does one of two things (and maybe both):
A Real-Life Example of Investment Failure
As an example, I failed big time when I was about 20 years old. This was right before the Great Recession and my friend was working at Washington Mutual as a teller while going to school - the now defunct predominantly- Western bank that was purchased by Chase after it's collapse. We were young college students interested in entering the market and we had no inkling that the Great Recession might come. We bought a significant amount of WaMu stock. Then the economy tanked and the stock went down. We were pretty heavily invested in this one stock at the time. He went to his job every day and he told me no to worry - after all, how could a big bank like this with so much real estate and so much branding and so many customers collapse? It wasn't going to happen. Then, the bank failed and we lost our entire investment.
That experience taught me a lot about investing:
You can't save your way to riches if you don't have a big enough income to save just like you can't dig a big hole if your shovel is tiny. Too many people, too many financial websites, too many financial advisors, too many financial shows have for too long advocated saving with a deep lack of attention to the more important sid of the equation: INCOME.
Of course, even if you have an enormous income but still manage to spend it all, you won't build wealth. But that is not at all relevant to what we're discussing here. What we're saying is that there are simple mathematical and physical principles govern the world we live in and based on these principles there's something we know that's true:
the maximum amount you can save is your full income - this would be not possible in most cases it would require not spending anything
So, if you're earning $30,000 a year but are the most magnificent saver in the world, the most you can possibly save is $30,000 but realistically you'll be considered an ultra-saver if you manage to save $20,000 a year.
Contrast that $30,000 per year example with someone who earns $300,000 a year - clearly that individual has a much bigger shovel and has a lot more room to take advantage of saving. In effect, this person who makes $300,000 can benefit more from saving because the more he/she saves the more they can put away for building wealth up to their income. In effect, if they can spend $10,000 a year like the person in the $30,000 example, they can save a huge pile of money every year and build a lot of wealth.
People should be focused on saving, but they should equally (if not more intensely) be focused on generating more income for themselves os that they can put more money aside. This is easier said than done and that's the reason most financial resources tend to focus on saving rather than increasing income - everyone simply wants to pick the low-hanging fruit.
In Antiquity, Family and Community Provided a Safety Net in Retirement
Throughout most of human history, the idea of retirement as we know it today didn't exist. People simply worked their entire lives either hunting and gather or farming (after the Agricultural Revolution) -- if they were lucky enough to survive into adulthood -- and when they were too old to work, they relied on their families to take care of them. An old person might rely on younger siblings, children, and nieces and nephews within the family or community to take care of them. While doing this they probably still had to do some work - the idea of not working at all is a deeply modern notion and even very old people in ancient times still likely cared for children, did chores around the house, and performed other familial duties (eg. arranging marriages, representing the family to other communities, and advising younger family members).
Although life was incredibly harsh with humans having to face both natural disasters and man-made dangers in the form of banditry, war, pillaging, or abandonment, most human societies operated in a way where the elders and those who were unable to work were taken care of by family. As time moved forward and as humans settle down this was more and more true - while a hunter-gatherer tribe might leave an old person to die, a farming community would likely be able to provide for the elderly because life was calmer and a bit more stable in terms of movement and physical danger.
Obviously, no one in their right mind living in the first-world should want to go back to a hunting and gathering lifestyle and especially a farming lifestyle (as farming was likely worse than hunting and gathering for overall human well-being). However, we can't deny that the family bonds that existed in the past that effectively created an organic safety net for the elderly no longer exists today.
Safety Nets Such as Welfare Provide Retirement Security in a Changed World
As the world moved forward modernized, nations around the world began creating public, centralized welfare systems to take care of those who were too old to work and had to enter a stage of retirement or diminished income-earning capability. In the United States, during Roosevelt's New Deal during the Great Depression, the Social Security system was created - this was a system where old people who were no longer working could receive income from the government (meaning from those who were earning income). In effect, this wealth-transfer mechanism sought to replace the old traditional familial and community retirement safety nets that had long since been eroded over the centuries following the Industrial Revolution.
It is difficult to argue that a safety net for old people who can no longer produce income through their labor and who don't have a large enough retirement nest egg to live on is a prudent idea - it is deeply natural to humanity to take care of one another. The difference is that instead of taking care of each other locally, we started taking care of each other on a grand national scale. This creates its own problems and perverse incentives, but it fundamentally is in line with our human nature. If done in a prudent and conservative way (something that is far from guaranteed), such a retirement safety net can at once benefit the economy through stabilizing things and benefit society through creating a better and healthier moral landscape by taking care of retirees.
Retirement Saftey Nets in Jeopardy - Self-reliance is Key
However, today the Social Security system -- a system that hasn't even been around for a century -- seems to be in jeopardy (it is projected that in 2037 Social Security trust fund reserves will be exhausted and where 100% of payments will no longer be able to be made). A system designed at a time where there were few retirees living into their 60s and 70s compared to the working population is under stress in the world where Baby Boomers are aging rapidly with access to world-class health care that will allow them to live into their 80s and 90s reliably and in good numbers. Many believe this system will not be able to sustain itself. This will be further exacerbated if unemployment increases over the coming decades due tot he rise of artificial intelligence. Young people today should not rely on Social Security to be around when they are old and gray - that is now a foolish proposition.
For young people today, the idea of retirement is different than for almost all past generations. For the first time in history, neither (1) the familial/community structure that effectively provided retirement benefits for the old nor (2) the retirement benefits provided by welfare systems like Social Security is likely to be around when today's young men and women reach retirement age.
So, we're now in a world where the old family and community structure have long since been almost totally wiped out and where the retirement safety net that came in to replace that old structure is itself in peril. We are facing a troubling and dark world when it comes to retirement - we have neither one nor the other, we only have ourselves at this point. Although a fix might occur and things might turn out well, in the end, any prudent person who is under the age of 40 should discount Social Security and only rely on himself/herself to provide in old age and retirement. This requires changes - it requires a discipline that might not have existed in the last century for most of the population in term of saving. Young people must be diligent and disciplined savers and investors if they are going to be able to amass a nest egg large enough to support them through what could be decades of retirement.
This means that saving 5% or 6% in your 401k to get your employer match, putting $5000 a year into an Investment Retirement Account (IRA), or simply having a nice cash cushion in the bank is not even close to enough. Saving rates must far exceed 10% and should approach 25% if young people today are going to be able to comfortably retire. Additionally, effort and energy must be put in to invest the savings in a smart way - saving cash will not be sufficient as growth is going to be needed over time in order to build up a nest egg.
In a job you sell your time and your energy for money - you will never become rich this way because of the inherent restrictions the laws of nature and of physics place upon us all. Entrepreneurship (eg. business, ideation, innovation, etc.) has been one of the few consistent and reasonably moral paths to both moderate and extreme wealth since the industrial revolution.
Of course, other paths such as crime and political corruption have always existed as paths to wealth for those who were willing to walk on them, but we are only concerned with paths that really add value to humanity and can at least be somewhat considered morally permissible.
No matter how hard you work and no matter how many hours you work, you will be restricted to the number of hours in a day, in a week, in a month, and in a year. With a job, you are selling your time for money. Your time might be worth little or it might be extremely valuable given your human capital, but you still are selling this finite resource for money.
The richest people in your towns and cities are generally not people who have jobs. Yes, someone in your city might earn $100,000 per year or maybe $250,000 per year working as a highly-paid individuals in a big corporation, but there are also plumbers, electricians, small accountants, small lawyers, dentists, doctors, programmers/coders, restaurant owners, website owners, that earn $500,000 or $1 million (or much more) per year through their entrepreneurial ability to use their human capital in a way that is not restricted by time. In effect, these entrepreneurs are able to expand the audience for whom they create value both in time and in scope - they can reach people even when they are not working (eg. website) and they can reach many more people (possibly millions) all by themselves. In this process, the create value for a lot of people and they are themselves able to extract a portion of that value as remuneration from themselves without having to rely on an intermediary in the form of an employer.
An Absurd Example of a Great Job to Bring the Point Home
There are 8760 hours in one year. Let's say you work like a crazy person and are able to work for 1/2 of that time. This means you work for 4380 hours in a year.
That 4380, represents about 84 hours per week without taking a single week of vacation. Clearly, we have an unsustainable situation if the work you're doing is in any way physically or mentally rigorous.
So, you -- a total workaholic per the above -- are making how much money? Well, that depends on your hourly wage. According to the Bureau of Labor Statistics (BLS), the average private sector hourly wage in early 2017 is $26.19. But you're not an average person - you're making a lot more than average in our example.
According to the BLS, the highest mean hourly in the US is for anesthesiologists who make about $130 per hour - this is even higher than surgeons, lawyers, doctors, and chief executives. But even then, let's say you make even more than that.
Let's say you can make $500 per hour consistently for every one of your hours. This is a hard thing to do. Lots of people earn $500 per hour for ad-hoc work - think of a graphic designer who bills for two hours after spending two hours securing a client or a lawyer's billable hours that don't take into account time spent on client interaction or business management. Unlike most, you're able to get paid $500 per hour for your entire 84 working hours every single week of the year.
So, per the above example, you'll make $42,000 per week
This comes out to $2.18 million per year
Clearly $2 million is a very large amount of money to be earning per year, but think of the fact that even with our truly absurd example where you're working like a machine and earning an extremely high hourly wage, you will still only earn about $20 million in 10 years or $100 million in 50 years. Yes, those are a large amount of money, but they are literally nothing when compared to what some top people in business and entrepreneurship make more than $100 million in a single year. Facebook founder and CEO Mark Zuckerberg, for example, has a current net worth that would equate to earning $4 million EVERY DAY OF HIS LIFE!
Clearly, the gains Zuckerberg and other extremely rich individuals have earned are not based on income - it would be impossible to sell their time to earn such gains. Instead, they have earned money selling other things such-such as ideas that are not restricted the same way time is. The highest paid salaried people are always making less than the highest paid entrepreneurs because the world is created in such a way that time is restricted while ideas are not - with ideas you can be earning multiple streams of income every second of every day or you might have windfall gains by creating immense value for millions (or even billions of people). It's far more difficult to do this at a so-called job.
The key takeaway here isn't that it's bad to have a job. The key takeaway should be that you have to lift your head up from the current place you’re at and see things in a broader, holistic, and realistic way. By understanding the inherent restriction, a job places on your ability to earn you might be better able to spot opportunities or even better understand the world.
Entrepreneurship isn't for everyone - many people will do better at a good job in a good firm. Additionally, although the above discussion was about money, money is not the most important thing in work and shouldn't even be the reason anyone forgoes a job to start a business on their own. There must be something else besides money motivating you if you are to have a chance at being successful in any endeavor.
The only thing we're trying to portray here is that business and entrepreneurship allows you to escape from the paradigm of selling your time for money - you can escape this paradigm and go beyond the limitations of time and space on value creation that a job places on you.
Caveats and Exceptions - There are Some Jobs That Will Make You Rich
As with almost anything that's generally true, there are some caveats and exceptions. Here, the main caveat is that there are in fact a handful of people in the world who do become truly wealthy through their jobs. These people include the likes of:
Additionally, one might argue that in the above absurd example it was unfair to bring in the likes of Mark Zuckerberg - there are plenty of entrepreneurs who earn less and even more who fail and don't earn much at all. This is all true, but the point did do a comparison of high paid jobs vs highly paid entrepreneurs. In that comparison what we attempted to illustrate this that in entrepreneurship there is inherently little restrictions on earnings - earnings can be so great that they become absurd (eg. $4 million a day for every day of Zuckerberg's life) while job earnings are restricted simply by the laws of nature and the laws of physics.
You can't predict when a recession will hit, but you can be sure that a recession will come at some point. Speculation on the exact timing is a fool's proposition, but indicators exist to indicate when the overall market is overvalued and when a recession is more likely. Preparation for a recession is wise and simply ignoring overall market valuations will cause you to (1) not be ready to take advantage of investing opportunities a recession presents and (2) be potentially exposed in troubling ways due to improper diversification. The below 3 strategies are excellent ways to prepare for a recession.
1. Start Piling Away Cash for Cheap Stock Purchases When the Recession Hits
Cash is dry powder to investors and without some set aside you simply won't be able to take advantage of a recession. Cash will allow you to buy good stocks at deep discounts when the market falls during a recession.
Do you notice how the first thing we're advocating in terms of recession preparation is something that will allow you to buy more stocks instead of something that is meant to protect you? Obviously, you want to be protected in severely adverse market circumstances as an investor, but the most important thing about a recession isn't what it does to your portfolio in the short term, but the potential it has to boost your portfolio in the long term. A recession allows you to buy a lot of good quality companies at deep discounts - sometimes you see a price to earnings (P/E) ratios of indices such as the S&P 500 can drop below 10, indicating an extremely undervalued market overall.
Without having cash piled up ready to toss into good companies -- it's key that you only buy good companies -- you will miss out on potentially outsized gains due to inevitable market recoveries. The great thing about recessions is that you don't even have to pick individual stocks - something that is not recommended for novice investors or those with low-risk tolerances. Purchasing indexes (eg. S&P 500 or the Dow Jones) via broad mutual funds or ETFs will allow you to at once diversify and benefit from future recoveries. Purchasing the Dow Jones at the bottom of the 2007/2008 Great Recession would have created a 300% + return over the course of a decade without having to take on the risks of owning single stocks or having to put in the effort to pick them.
When the market seems overvalued in terms of market P/E ratios, in terms of timeframe since the last recession, or in terms of high-quality research/opinions, it might be a good idea to slightly pull back on some of the more speculative investing you're doing to put aside cash. You'll want enough cash so that you can comfortably enter positions at lows and then continue buying more and more if markets continue to drop. This abundance of cash will allow you not to think about timing the market -- something that you will not be able to do -- but will instead allow for an aggressive dollar cost averaging strategy once things start to decline until things start to turn up again.
2. Properly Diversify Your Portfolio so it Can Withstand a Recession
To make your portfolio more resilient to recession declines you'll want to diversify across:
You don't want to hold just US firm and you don't want to hold firms only in a single industry (eg. tech). Instead, you want to hold a broad portfolio of high-quality firms from around the world and from different industries. Some regions and industries will be more resilient than others and this will affect your portfolio. additionally, some firms will go bankrupt in recessions - hopefully, you don't own any such firms because you've done proper due diligence but some things are very hard to predict. You'll want to not be tied to a single industry, a single location, or a single firm when the market turns downward so that a single disastrous event will not affect more than a small portion of your portfolio and so that you can survive as an investor into the recovery.
A great way to diversify is through the use of mutual funds and ETFs, but diversification is also achievable through simply building your own high-quality stock for experienced investors - moderately experienced investors should not try this (novice investors shouldn't even think about this).
3. Buy Protective Puts on the Market (ONLY FOR ADVANCED INVESTORS)
If you don't know what a protective put is, this section is not for you at all and you should skip tot he end of the article.
If you do know what a protective put is but wouldn't be properly considered an advanced or experienced investor, you can read this section but you should not engage in this activity because it could cause a needless drain on your portfolio and a false sense of security.
If you're an advanced investor, you probably already know this strategy, but we'll remind you again. Protective puts are simply put options - they are called protective because of the context they are being used in. You can buy such protective puts on the overall market via market proxy (eg. S&P 500) in order to profit from market declines.
One way to execute such as strategy is to buy monthly out-of-the-money puts on the market proxy via a mutual fund or more likely an ETF. These should be out-of-the-money because what you're buying here is a form of insurance in case the market drops significantly - you're not trying to speculate. Out-of-the-money puts will be worthless if the market goes up or doesn't move much but will increase in value in a significant market decline. You can buy them for a reasonable term - monthly, quarterly, yearly but shorter repetitive purchases might be better because you're less exposed to the option's time decay.
If you're invested in the stock market -- be it with an individual portfolio, through an IRA, through a robot-advisor, or through a 401k -- you should know that markets will decline, economies will suffer, and your portfolio value will decrease. You can try to create a situation for yourself where you won't be exposed to the volatility of the markets, but the only real way to do this is to not be invested in equities at all - by entering the markets you're implicitly accepting a certain amount of short-term volatility that could cause you to see your portfolio drop by quite a bit. It's how you handle this drop that determines your resiliency as an investor and, in the long-run, that determines whether or not you're a successful investor.
Recessions Will Occur and Markets Will Decline
First, it's key that you understand that market will decline - you can't hide from this unless you're not invested in equities. If you only hold cash or fixed income securities (eg. bonds), you can safely ignore market prices on equities. In the case of cash, you don't care about the market either way. In the case of bonds -- although bonds can of course rise and fall in value based on credit worthiness and interest rates -you generally are more concerned with the ability of the borrower (eg. sovereign government, municipality, or firm) to pay as the agreed-upon schedule. If you hold stocks, however, you are exposed to two key factors:
Exiting the Stock Market at a Macroeconomic Downturn is One of the Greatest Mistakes an Investor Can Make
Imagine you own your house outright in 2007 and then in 2008 through 2010 the housing market starts to decline as it did in the US. Would you sell your paid-for house after seeing a drop in real estate prices of 30% or more? Clearly, that would be idiotic if you didn't need the money for something specific. Why, then, do so many investors feel so inclined to sell their stocks after a market drop? Just as with a paid-for house, you own your stocks outright unless you bought them on margin (highly unlikely for most retail investors).
Adding a mortgage on the house makes the situation riskier and it is, therefore, more understandable that you might need to sell your house in an economic downturn (eg. income loss). However, people are still far more inclined to sell losing stock positions in a macroeconomic downturn than they are to sell their mortgaged house. This doesn't make any rational sense and it represents a fundamental flaw in the way most people approach their portfolios.
Now, if something fundamental changes - meaning one of the following:
THEN you can be justified in existing a position. In this case, you'll be exiting, not because of a macroeconomic decline, but because of a macroeconomic change to your world of the stock you're holding.
In other circumstances, however, existing a previously good position is just foolish and will lead you to underperform the market over the long term. Additionally, you'll be effectively shooting yourself in the foot - you will be purposely selling off at the worst possible time instead of holding out a bit for a far better market scenario where a more fair value can be obtained for your investing.
Play Mind Games With Yourself to Prepare for the Inevitable Market Decline
One of the greatest ways to prepare for the inevitable market collapse (if you still think that this won't happen you need to go back and diligently study investing history before you proceed any further into the markets) is not use the same tactic elite athletes use to prepare themselves for competition - mental visualizations of game day with a focus on the desired outcome and the challenges that will likely be faced.
Elite athletes focus on the win, but they also visualize and understand the pain and the suffering that game day will likely entail. Instead of being optimistically naive, they in advance fully understand how difficult game day will be, they accept that difficulty fully, and they commit to persevering in spite of it.
Applying that same theory to your investing life you might want to visualise the goals you want to achieve (eg. the return you want to obtain over time or the number you want to hit in your portfolio) but you also will want to sit down and imagine how a 10% market drop will feel, how a 25% market drop will feel, and how a 50% market drop will feel.
Typically a 10% market decline will occur once every couple of years, a 25% market decline will occur once every decade or two, and a 50% market decline will occur up to a few times in your investing life. Failing to prepare for this almost inevitable circumstance could cause you to sell at a 50% market drop - clearly a very unpleasant outcome if waiting just a few years would allow you to recover all of your gains as has been shown via a study of US stock market history.
When you're playing these mind games with yourself it's key to really visualize the scenario and get that negative feeling in your gut you would get on the morning fo the crash. You will likely not have as intense emotions as you would actually staring at your dropped portfolio, but you should definitely feel that nasty feeling in your stomach. If no feeling accompanies this exercise you're doing it wrong and you should continue doing it over time until you really get that unpleasant gut feeling.
Once you have that gut feeling, let it wash over you and don't try to make it go away as humans tend to do with all emotions. Let the feelings stay with you and explore it a bit. See what that feeling is telling you to do. Realize how your emotions are ruling over you instead of anything rational - this is dangerous because investing is very unnatural to human beings and only rationality will help you do well. Tell yourself
It's important to not underestimate the power of such mental exercises. It's easy to dismiss this and argues that imagining things during a bull market won't help you when things really go bad and you actually are sitting in front of your broker's website looking at a number that is 50% less than it was yesterday. Of course, the two things aren't the same, but the power of visualizing is far greater than meets the eye at first. A lot of mental resilience to making foolish moves can be built up using the exercise above and be doing it once a quarter will over time create a healthy mental discipline against acting like a crazy person when things really go bad int he stock market.
The stock market has proven a great investment over the last century - investing prudently and in a disciplined way in the stock market would have yielded great results in every two-decade-long period in the US. This means that no matter where you start in the last 100 years (even a day before the collapse that started the Great Depression), if you invested wisely (meaning you diversified and dollar cost averaged into the market), you would have been far better off by investing in 20 years than you would have been holding the money in cash instead.
If this is the case, why are so many people so afraid of buying stock? Here are 3 reasons why:
1. You Don't Understand What a Stock Actually Represents
If you're afraid of investing in the stock market, you might simply not understand what a stock actually represents - you literally don't know what it is. Of course, you've heard of stocks and you know they are some sort of financial instrument or products, but if pressed you probably can't give even a basic definition that would clearly define what a stock is.
If you're in this camp of people, it does make a bit of sense that you're hesitant to invest in equities and delve into the stock market. People are often (and often rightly) afraid of what they don't understand - human nature keeps us safe by making us a bit frightened of the unknown. If you don't really know about something, how can you know if it's good or bad? Just as importantly, if you don't know about something, how can you know how to deal with it in productive and effective ways? Maybe it's better to just stay away from those things you don't know?
Staying away might be a good idea for some things in life, but it's a bad idea when it comes to delving into the equities market in your financial life - by not investing in companies around the world through the purchase of shares on the stock market, you are denying your financial self and your portfolio one of the best ways regular individuals can have a piece of the global financial pie and ride the wave of global growth over the long term. Without investing in stocks, you're not going to benefit when global GDP increases - you're going to have to rely either solely on your own labor income or a bit of interest income you'll earn by letting other people use your capital. Buying shares of good firms around the world, however, will allow you to literally have an ownership state in the global economy.
So, if you don't know anything about stocks today, it's time to learn. Fortunately, you're already ahead of many others because you're here reading this on this website - you've already taken a crucial first step. Next, you'll want to pursue around Pennies and Pounds a bit more in a free-form way to just get a feel of the kind of stock-related information that is out there. Once you've got a general conception, a book or two will prove quite useful in helping you delve deeper and learn more about personal finance and the stock market. Never underestimate the importance of learning about personal finance - your financial life is a key part of your overall life and not spending any time in studying up is as foolish as not going to school but expecting to do well in the job market.
2. You've Invested in the Stock Market in the Past, but You've Been Burned and Remain Scarred
Maybe you do know about stocks. Maybe you've even ventured out into the equities market in the past. And maybe you've been burned by it. Maybe you've
If the above happened to you, it's no surprise you're hesitant to go back into the stock market. You probably feel like
Although it's understandable that you feel this way, it's totally wrong - you're wrong if getting burned in the past has fundamentally created a negative outlook of the stock market for you. You got hurt in the past not because there are fundamental flaws in the stock market or that investing in stocks is simply not for you - you got burned because you made incorrect decisions.
Investing in stocks well requires a certain amount of basic knowledge. Things such as
If you got burned in the past in the stock market you probably bought a single stock or just a handful of stocks - this is foolish unless you're a Warren Buffet and for most people proper diversification is key. If you invested in Lehman Brothers or Pets.com or any other hot stock pic, you would have gotten burned - you invested without diversification and you invested in the wrong thing.
If you're going to stock pick, then make sure you pick the right stock. is not possible for most and, therefore, stock picking should be avoided like the plague. Instead, diversification via the use of mutual funds and exchange-traded funds (ETFs) should be utilized with a few stocks here and there if you're willing to take on the risk. Additionally, a robust (but not too robust) cash position (that is separate from your emergency fund) would provide liquidity and help reduce the overall volatility of your portfolio.
You also might have gotten burned because you invested at the wrong time (eg. the Dot Com Bubble or in 2006/7) and then sold at the wrong time instead of waiting for the market to recover. Instead, you should have:
Instead of going in at once, a dollar cost averaging approach where you invest a bit every month or every quarter allows for less risk because instead of investing at a single time, you can take advantage of market drops by having your money purchase more stocks, mutual funds, and ETFs. Additionally, you must be disciplined enough to not sell in a market panic - this is very hard and this is what kills most investors. You need to study the history of the stock market and keep that history in mind in order to temper the craziness that will arise in your mind when you see your portfolio going down. A good investor that is invested in a strong and diversified portfolio will not sell at a panic - this investor will understand how foolish it is to liquidate positions at a market drop and will instead keep disciplined and follow through with his or her investing strategy.
3. You've Heard too Many Stock Market Horror Stories
Maybe your dad or your uncle got burned investing in stocks. Maybe a high school teacher told you about her venture into the stock market and how horribly it turned out. Maybe your grandparents' told you stories of the Great Depression and how they only hold cash and bonds. Maybe you've watched one too many news episodes during the Great Recession. Maybe you grew up in a house where there was a lot of misunderstanding and fear about the stock market.
Whatever or whoever go this fear into your head - it's not rational. Stocks have created tremendous amounts of wealth for both rich people and middle-class people over the last century. The Great Depression, the Great Recession, Black Friday, the Dot Com Bust, and all of the other horrible things that happened in the financial markets would not affect an investor that was properly diversified and dollar cost averaging (instead of going all in at once). It's normal that hearing of other people's failures when investing in stocks would make you cautious, but it doesn't have to be that way - you can easily succeed in the stock market if you take a disciplined and prudent approach. More importantly, if you're going to really build wealth and not simply rely on your own income, the stock market is one of your best bets.
Although a tax return means you've given Uncle Sam an interest-free loan over the course of the year -- something that probably isn't the best thing to do if you're a mature adult who knows how to handle money -- it can be a financial boost for many individuals and family in the early part of the year. In a sense, you've been forced to save over the year (you can think of it as forced savings account) and now you are to decide what to do with that savings.
Don't make the mistake of thinking that your tax refund is some sort of windfall or a gift from the government or some sort of unexpected gift that you didn't earn - your tax refund is literally your own hard-earned money that you've been forced to pay the government over the course of the year. Keeping this in mind, you should treat your tax refund like you should treat all of your money: with care, planning, and prudence. Below are a few key things you can do with your tax refund to improve your financial situation and add a bit of financial peace to your life.
1. Start or Increase Your Emergency Fund
This is Number 1 on our list of things to do with your tax return because for most people a strong emergency fund is the single best first step then can take to securing a better financial life.
Those that have some sort of guaranteed income might not need a rainy day fund as much as everyone else because there is far less volatility in their monthly income - for the rest of the world an emergency fund stands in between you (and your family) and financial disaster, stress, and worry should something unpleasant happen (and in this life, something unpleasant usually does happen every once in a while).
Getting your emergency fund to a solid level (typically 3 to 6 months of living expenses) is usually even more important than paying back even high-interest debt. A person with a large amount of credit card debt and nothing in the bank at all clearly is exposed to a lot of suffering if he/she loses their source of income or if an unexpected event or emergency comes up. Of course paying down the debt is very important, but without an emergency fund, there is too much exposure to even the slightest financial emergency.
Without any money, a job loss, a flat tire, a leaky roof, prolonged sickness or any other of the many things that can go wrong, will lead to a lot of pain in your life. Having even $1000 in the bank will help shield you and having a full 3 to 6 months of living expenses in the bank will give you a very pleasant calm in knowing that you've got enough stashed away to make it through most financial emergencies.
If you don't have an emergency fund, a tax refund can be used to start one at your local bank - better yet putting that money into an online savings account where it's a bit harder to reach might be a better option.
2. Pay Down High-Interest Debt
If you already have a proper emergency fund in place, the next best thing to do with your tax refund is to pay down high-interest debt. Such high-interest debt can be credit cards, personal loans, consumer lines of credit, and car loans, etc. These all qualify as bad debt in most cases - things like student loans, mortgages, and business loans (although clearly undesirable) are better because they generally carry a lower interest rate (because they are backed by either tangible assets or are not-bankruptable) and are generally taken out for thins that increase in value over time. Paying down high-interest debt will save you money on interest, will strengthen your overall financial position, and will bring some peace into your financial life.
There are two options when paying down credit card debt:
Generally, either of the above will work and actually pay down debt aggressively is more important than which of the above methods you choose. However, you can decide how to approach paying down your debts based on your own understanding of your personality - if you're the kind of person that might need a momentum boost by seeing a credit card fully paid off, then maybe focusing on the smallest balance is better for you even though it's not the best approach from a purely mathematical standpoint.
3. Take Advantage of a Bank Bonus Offer
If you've already got your debt situation under control (meaning you don't have credit card debt or other high-interest debt as described above), then you might consider using your tax refund to get even more money via a bank offer where you get a bonus for opening up a savings account.
Online banks such as Capital One 360 and even brick-and-mortar banks such as Chase often offer bonuses for opening up a new savings account. The general gist of it is that if you deposit a certain amount of new money (eg. $10,000), you get a bonus.
One offer online was for a $200 bonus for a $10,000 deposit - this equates to an almost immediate guaranteed return of 2%. To get 2% in the markets you would have to expose your money to a bit of risk. To get 2% in a guaranteed way (like you're getting with this bonus) you would likely have to lock away your money (circa 2017) for a period of at least a couple of years. Clearly, an almost immediate 2% gain is quite lucrative a low-interest rate environment and taking advantage of such an offer could give you extra boos on top of your tax refund.
4. Open an IRA
If you don't have an Investment Retirement Account (IRA) or if you're not currently contributing the maximum amount allowed, opening an IRA could be a useful way to store your tax refund and it can help lower your tax burden next year (as long as your income during the year in which you're putting the money into the IRA at least is as much as your putting in). You might want to speak to your tax professional about the best way to approach it and if this is really a good idea for you, but for most people, an IRA can help lower taxable income and, thereby, lower the overall tax burden for next year.
5. Start a College Fund for Your Children
If your financial house is in good shape, it might be time to start thinking about college for your kids (or their financial future in general). Whether college is a few years away or whether you have a newborn, saving for college is always a prudent idea and it will greatly benefit both you and your children.
A good idea is to save the money in a place where it can be used for non-college expenses. The world is rapidly changing and if your child is very young, it is not easy to predict what the academic or occupational landscape will be like in 15 years - college might be drastically different and so might college expense. Therefore, it is prudent to save in a place where your hands won't be tied in terms of how to use the money and where you won't have severe penalties if you or your child chooses to use the money for non-academic expenses (eg. starting a business, paying for a wedding, buy a house, or whatever other hopefully useful endeavor he or she chooses to embark on).
If you're even a bit serious about analyzing a stock -- whether you're going to use the Capital Asset Pricing Model (CAPM) or whether you're just trying to know the stock's beta to build up some intuition -- you should calculate the beta yourself. Calculating the beta yourself is easy to do and if you either aren't able to do it or are unwilling to do it, you should probably not even be thinking about analyzing stocks at all (instead, you should stick with a far more passive strategy that involves mutual funds and ETFs).
Any serious investor and financial market participants will always calculate the beta on his or her own even if just to do a double-check against a number provided from a third-party source. However, in case you need some reasons to calculate a stock's beta on your own, here are 4 good ones:
1. Calculating a stock's beta yourself will allow all relevant information (until the day of your beta calculation) to be factored in
By calculating the beta yourself, you can literally use all the relevant data available to you through today. A third-party provider will most likely have a time lag. This time lag can be a day our two at best, but it could be almost a quarter at worst. Do you really want to have a beta that is almost 3 months stale? That is a ridiculous proposition when you can easily calculate a beta that will capture every available data point - you can calculate a beta in the evening and capture that afternoon's market volatility in your calculation.
2. You'll get to choose your own time horizon for the beta calculation
The beta you want might vary depending on your investment time horizon. For long term investors who have higher risk tolerances, daily price movements might be irrelevant. For traders or more risk-averse investors, daily price changes might be very important. When you calculate your own beta, you can choose how far back you want to go in terms of obtaining your data (eg. your market and stock prices).
Deciding how far back to go is useful, but clearly more current data is more useful than old data - there's going to be a limit to how far back you'll ant to go. Regardless, choosing how far back you want to go gives you the ability to capture data points in idiosyncratic times that you might care about (eg. an earthquake, a recession, geopolitical conflict, an election, etc.)
3. Calculating a stock's beta yourself will allow you to decide on your own interval
The more important and interesting part of calculating your own beta is the ability to choose the tie interval between data points - you can use daily market and stock prices or you can go longer and choose weekly or even monthly prices. Going longer would likely require a longer time horizon so that enough data points exist to perform soldi statistical analysis, but you're really in control when you calculate your own beta and you can decide what you care about. If you think weekly price changes are more relevant to you than daily gyrations, you can easily use that when calculating your own beta instead of having to rely on the assumptions and desires of a third-party.
4. Calculating a stock's beta will build your intuition regarding stocks, return time series, risk, and finance in general
Finally, you should calculate your own beta because it's easy to do and it will build your intuition of what beta is and what it represents. The more intuition you have, the less likely you are to make foolish investing mistakes - the more intuition you have the less likely you are to be led astray.
1. You're Taking too Little Risk
Proper finance goes far beyond the cliche risk vs. reward thinking, but there is some truth in that oversimplistic expression of financial theory - you must expose yourself to at least some risk in order to obtain returns. A portfolio that is without any risk will only earn the risk-free rate. Portfolios that aren't exposed to less risk than other, all else equal, will generally earn less than more risky portfolio.
Obviously, prudence would dictate that the proper amount of risk be taken, proper risk mitigation tactics should be used, and preferably deep value investments will be made in order to create extremely low-risk higher return investments. However, shying away from any risk or taking too little risk will usually lead to subpar returns.
Investors should examine things such as the following in order to better understand their risk tolerance:
This means that a single 30 years old earning $100,000 a year with a healthy emergency fund is likely not exposing himself or herself to enough risk if they have the vast majority of their money in CDs. They would do themselves a big service by prudently moving some money into the stock market so that far higher returns over the long run can be gained. Such a move could move the return of the portfolio from 2% to 8% - a difference that will likely mean millions of extra dollars over the course of a full investing life.
2. You Are Churning Your Portfolio Too Much
Too many investors buy and sell and buy and sell and buy and sell. They spend ridiculous amounts of mental energy, precious time, and precious money on trading fees attempting to:
Churning your portfolio will cause damage for the following reasons:
You're not a hedge fund or a trader. You don't have a supercomputer sitting near Wall St. You don't have PhDs working for you. Play the game where you have an advantage, not the game where you are deeply handicapped. Buying calmly and sitting is usually better than heavy coughing for most investors.
3. You're Trying to Pick Stocks, BUT You're a Terrible Stock Picker
Top investors such as Warren Buffet and Monish Pabrai can pick stocks - they have a true talent for it and they spend their lives doing it. What makes you think you can compete with them? Would you enter an Olympic swimming competition just because you enjoy taking laps at the local YMCA? No - that would be ridiculous. So, why do you think that you are capable of picking stocks when the cards are deeply stacked against you?
Of course, some small time investors are great at picking stocks. They are talented and lucky. If this is you, you don't really need this advice. But if you keep putting in time and energy tiring to pick the next five bagger or ten bagger only to see your portfolio trail indexes such as the Dow Jones or the S&P 500, you must ask yourself why you are wasting so much time. Why not just sit back, buy the index, and relax?
Take a hard look at your portfolio if you're in this camp and be honest with yourself. You can leave a bit of play money to mess around with, but the majority of your money might be better off in excellent mutual funds and ETFs that track both US and global indexes. These mutual funds and ETFs can be matched to your risk tolerance and time horizon and they offer market returns at almost no effort to the investor.
Systematic Risk (aka Undiversifiable Risk)
Systematic risk is a risk that cannot be diversified away - this is why it's often called diversifiable risk. That's a nice definition, but what does it really mean? Let's dig deep to understand this crucial term.
Systematic risk is a vulnerability to things that can occur at a macro or aggregate level - things that affect not only the size of a specific slice of the pie but the overall size of the entire pie. Systematic risks arise because the world is stochastic (random) in nature and as we move forward in time, things can possibly occur that will not only have micro effects (eg. affecting a city, a specific firm, a specific industry, etc.) but will affect the entire economy as a whole (eg. the entire nation or the entire globe). Stated another way, systematic risk is the risk that the overall size of the economic pie will be affected - instead of only affecting the distribution of it.
What can affect the size of the matter? That's easy to answer. Things that can affect the pie are generally events that have macro impacts:
All of these things would invariably affect everything - the overall economy would be affected. Yes, individual firms, businesses, cities, states, and counties would be affected, but they would only be affected because the entire global economy is affected and not because of their own foolishness or bad luck. Therefore, we can say that systematic risk is the kind of risk you can't really hide from - this is why it's called diversifiable risk.
Imagine a person or a firm tries to diversify away risks and protect themselves from all of the possible negative things that could occur. Say they make sure spread their money into different places, get income from different sources, be prudent about capital purchases and how they are financed, and investing in a vast variety of things (things such as precious metals, stocks, bonds, real estate, private equity, etc.). all to these things would clearly protect whoever is doing them - a drop in gold wouldn't affect them, nor would the drying up of a certain source of income, and nor would the bankruptcy of an individual firm. The person or firm engaging in the above actions would be so diversified that they would hardly feel the effects of a small catastrophe. However, they are still totally exposed to the risks we described above - a major war, a comment, an alien invasion, or deep geopolitical troubles would impact them regardless because everything they own would lose value. They would be affected not because of the loss of a single slice, but because the entire pie would now be smaller than before.
Imagine a probability distribution - the x-axis represents wealth and the y-axis represents the number of people who have that amount of wealth. The area under the curve would be the total wealth in the society in effect. You're unsure of where you'll end up - maybe in the middle but you hope to end up on the far right. Systematic risk is the risk that you'll be affected no matter where you are - it's the risk that the entire distribution will get smaller (that the overall area under the curve will be smaller).
Unsystematic Risk (aka Diversifiable Risk)
Unlike systematic risk, unsystematic risk is a specific type of risk that is present only at a micro level. This type of risk can be that:
All of the above risks are obviously severe (and will obviously be unpleasant to those experiencing their realization), but they only affect a small number of firms and a small number of people. A person who owns no gold, hasn't invested in that stock, or didn't buy that bond won't care about any of the above risks - they'll be totally fine no matter any of the above potential scenarios. The risks, therefore, are not systematic in nature but are rightly called unsystematic or specific risks.
These risks are also called diversifiable risks. We stated above that you can't diversify away systematic risks - no matter what you do you're exposed to those large-scale risks that could make the entire pie smaller (that would affect the overall amount of resources instead fo just affecting the place in the distribution). You can, however, diversify away unsystematic risk - you diversify in investing, for example, by:
You will always be exposed to systematic risks, but you don't have to be exposed to unsystematic risk at all - you can simply diversify it away. By not diversifying, however, you are exposed to both systematic and unsystematic risk - not only are you exposed to the macro systematic risks, but you're also exposed to the risk of the particular investment you're holding.
Out of the many questions a new investor can ask, this question is by far a ridiculous one:
How much is the stock?
This question wouldn't be so ridiculous if it wasn't followed by statements to the effect of:
These and similar statements, when combined with the first statement above, evince a fundamental misunderstanding of what it means to buy a share or a stock. A person who can ask such a question with a straight face and who proceeds to enter the equities market despite his or her lack of knowledge is asking for trouble - they'll likely end up losing over time until they get a better grasp of finance and the financial markets.
The reason the person who asks the above question is deluded is because they don't seem to understand that in purchasing a stock, you are purchasing a piece of a company - in purchasing a stock, you literally become the owner (along with many other owners) of a real business. The price of the stock, therefore, should be somewhat related to the business - specifically, it should be related to the cash flows the business produces.
A seasoned and knowledge investor may ask the same question -- he or she might ask how much a stock costs of course -- but the seasoned investor will only do so at the end of a thought process and analysis that will allow him or her to put the price in its appropriate context. The seasoned investor won't just look at the price and arbitrarily decide whether it's cheap or expensive based on how much the stock costs relative to other goods in the market - he or she will think about how much the stock costs relative to the profits of the firm (and/or the momentum of the price if he or she is a technical investor).
The seasoned investor won't care if he or she can only purchase a single share of the stock at it's current price because he or she will understand that the price of the stock is determined by how the firm is divided - if you divide up the firm into more shares each stock (which will now represent a smaller piece of the firm) will be worth less. The seasoned investor instead focuses on the profits (or cash flows) that each stock represents - in a simple sense he or she is focused on how profitable the entire firm is.
A seasoned investor thinks of buying a single share of a stock as equivalent to buying the entire firm - they are one and the same with the only difference being the percentage of the firm that is owned.
Knowing the above, what sort of questions might a seasoned investor ask? He or she might ask something to the effect of:
A fundamental principle of investing is that rates of return are key - but most people don't really understand their profound importance. Of course, most savers and investors know that the rate of interest they get on their savings or the rate of return they get on their investments matters a lot, but they are too easily willing to give up valuable return to things such as:
It's important to note that not all of the above fees are bad - you're paying these for a reason. For example, you want the mutual fund to hire a good money manager - this person will need to be compensated well. You clearly understand that administrative fees are going to exist for mutual funds and ETFs. Trading fees obviously are required so that the brokerage is paid for the service they provide you - this is a small price to pay for being able to enter and exit positions with ease.
However, you still don't want to overpay. You will not want your mutual fund or ETF to spend excessively on hiring poor-performing managers, spring money on lots of useless advertising, or running thing so inefficiently that the administrative fees are too high relative to similar funds. You'll obviously want to shop around to find a reputable and high-quality broker, but not one that charges excessive fees relative to what's available on the market. You'll also want to be disciplined and not constantly enter or exit positions so you don't accumulate excessive trading fees that will eat away at your capital. Common sense will dictate that even if the fees are reasonable in principle, they could be unreasonable in practice (meaning in amount).
To illustrate this point well, let's use an example. Examples are often an excellent way to illustrate importance finance principles in ways that are easy to understand - a theory is good but seeing numbers and graphs often allows people to really visualize the concepts being presented and gives the motivation to use the new knowledge they gained.
Let's start with $10,000 in our example and let's invest that money at different rates of return - the return rates will be from 0% to 8% in intervals of 2%. First, we'll break down the possible rates and understand where you might obtain them:
Now, let's see how $10,000 will grow at each of the above rates of return by taking a look at the graph below. From looking at the graph we can see that the 0% return stays constant throughout with all of the non-zero returns separating from it more and more over time. We can also see that each 2% increase does not bring a proportional increase in the final amount - the increase itself increases over time. 2
The 8% portfolio brings the initial $10,000 to almost $500,000 but the 6% doesn't even reach $200,000. We can say how important even a small increase in return can make over the long term. That 2% difference is sadly something too many investors ignore. It makes sense given the human mind's propensities that a person wouldn't be able to totally and intuitively grasp the importance of even a 0.25% difference in return, but through education, we can see that the small differences end up with very big differences in results.
How can a 2% difference result in a greater than 50% difference in the final portfolio value? This doesn't seem to make too much sense at first glances - the 2% difference is only 1/4 of 8%, so shouldn't it result in a 25% difference? The maths of finance don't work this way - this is an incorrect way of thinking through it. The way it works is that the 2% you forgot on the first year doesn't stop there - that 2% you would have gained is no longer able to be around in the second year to earn additional return. For example, by forgoing 2% on the $10,000 investment, you forgo $200 in your first year, BUT it doesn't end there - in the second year that $200 would have been working for you t earn a return. The same is true in the third year, the fourth year, and so on. In effect, the person who invests at 8% is able to not only bring along that extra amount every year but to also keep that amount invested and earning. In effect, changes in investment returns compound over time. This is the underlying principal as to why small differences in return can have tremendous impacts in final portfolio value.
We aren't going deep into the maths here, but you can reference a 2013 article titled "The Arithmetic of Investment Expenses" by William F. Sharpe. The article is accessible to most readers and the title should give you a hint at the complexity of the maths - it's not very complex to calculate nad understand the impact of fees on final returns.
Next, we'll present another graph - this time with the same $10,000 initial investment but now we'll look at a broader spectrum of return rates (0% to 18%).
As we did above, let's take a look at how each of the additional returns can be achieved:
As you can see from the graph, the initial investment returns we plotted on the first graph are made to look minuscule here. Although most investors shouldn't expect to obtain returns over 14% over the long term, this graph clearly represents how important every percentage point is to the final portfolio value.
Finally, to really bring this home, let's go over one more example - this time let's look at two men. One is Benjamin and one is Gerald. Both Benjamin and Gerald invest $10,000 on the birth of their first child - this could be a college fund or a sort of "start of life" fund so that their progeny is financially stable. Clearly, both Benjamin and Gerald are intelligent, prudent, and caring individuals and parents - most people don't do such things. Another thing that's clear is that their children are quite lucky - they have dad's who care enough to put away some money for them at their birth. Both Benjamin and Gerald have $10,000 ready for this investment - they are quite similar in this and many respects. But, let's now see how they're different?
The strange thing is that Benjamin and Gerald are far more similar than different - in the thing that matter (caring, prudence, planning ahead, etc.), they are clearly quite similar. Their differences, as we'll see shortly, will be quite small and trivial if it wasn't for the outcome those differences would lead to.
Benjamin takes his $10,000 and invests it in a fund over the course of one year in a series of 24 purchases, once every month. He shops around for a good brokerage - the makes sure they're reputable and reliable but keeps an eye on trade pricing too. Benjamin chooses a long-term growth fund but looks at expense ratios, loads, and the quality of management in order to make sure that he's choosing the best fund for his strategy.
Gerald takes his $10,000 and invests it in 60 purchases because he is attempting to time the market. Gerald doesn't shop around for a brokerage and chooses the first one he finds. Gerald doesn't shop around for a fund, but instead takes a recommendation from his friend or family member - this fund has the same strategy as Benjamin's fund but isn't managed as well, has a load, and has a higher expense ratio.
Both Benjamin and Gerald leave the money in their account after the first year and never touch it again - they pass it down to their children who also are wise enough to leave it alone and let it grow.
Take a look at the tables above to see the actual numbers Benjamin and Gerald are dealing with. In effect, Benjamin and Gerald end up with different starting amounts and different return rates (9.75% vs. 7.25) due to their different choices. These small differences made in the first year have tremendous impacts on the final portfolio values after 50 years. While Benjamin's portfolio is valued at over $1 million in 50 years, Gerald's is valued at only a bit above $300,000 - this is approximately a 70% difference. This 70% was a result of about a $600 difference in initial investment and a 2.5% difference in return. Most people would probably ignore these differences, but they are clearly extremely important.
If you're interested in further reading, below is a paper titled "The Arithmetic of Investment Expenses" by William F. Sharpe - a paper published by the same William Sharpe who created the famous Sharpe Ratio on how fees and expenses can impact the terminal value of a portfolio.
Compound interest is something we all know about, but not something we fully grasp. Sure, most people in the developed world in 2017 know what compound interest is and what that it's a pretty powerful thing, but few know exactly how powerful it is. There's a rumor that Einstein said something to the effect of "compound interest is the greatest force in the universe." If that's true, he was a smart man.
So, how can we approach a better understanding of compound interest? There seem to be two possible approaches here:
It seems that both are important, bu that the examples always are better in getting the ball rolling. Some examples are so astonishing that students of finance and financial theory are in awe both at the power of compound interest nad the previous disrespect for it. Here is one such example for your entertainment and pleasure.
Let's imagine 3 scenarios:
So, we've got 3 scenarios here, with each person separated by two main differences:
So, we know what's different, but what is the same? We have a few things that are the same for the people in all 3 scenarios:
So, we now have what we need - we have 3 babies born on the same day in the same hospital to different families. Let's take a look at how things turn out for them over the course of their lives.
We first notice that the baby in the Ideal scenario starts accumulating wealth - although not very much. In the first year, $1200 is saved. By Year 10, however, almost $20,00 has been accumulated thanks to the 10% growth. Another 10 years goes by and by Year 20 the Ideal baby has accumulated almost $69,000 - a very significant sum especially given the fact that the parents have only saved/invested $24,000 over the course of those 20 years.
Now, let's move to Year 25 - the Optimistic baby is now and adult and is joining the pack here. Unlike the Ideal adult who now has a lot of cash at Year 25 (about $118,000), the Optimistic baby has nothing. However, the Optimistic baby is saving 10x what the Ideal baby is saving - that's $1200 a year vs. $12,000 a year!
So, let's observe these two over time. At Year 30, the Ideal adult has roughly double the amount the Optimistic adult has (that's about $197,000 vs. $93,000). This might seem not astounding unless you realize that the Ideal adult has only saved/invested $36,000 over the course of his or her life while the Optimistic baby has already (over the course of just 5 years) invested $60,000.
Continuing through to Year 50, where the Typical adult finally joins us, we see an interesting situation - the Ideal and Optimistic adults have roughly caught up with each other. Each has about $1.3 million, BUT the astounding part is only revealed when we think about how much each has saved/invested over the course of their lives:
Now, we've got everyone in the game - the Ideal, the Optimistic, and the Typical adults. Let's follow through until 65 - they have 15 more years to save and growth their wealth.
Catching up with all of them at 65, what do we see? We see a few interesting things, but first, let's start with the numbers:
BUT, let's again sit in awe of the power of compounding by taking a look at how much each saved/invested:
So, we see that they're all very wealthy, but they've achieved their wealth in very different ways. While the Ideal person barely saved anything throughout their life, the Typical person saved a ton. Digging deeper, we can see that the Ideal person actually saved less in their entire 65 years than the Typical person saved in one single year. This is truly astounding and provides excellent evidence at the amazing power of compounding.
We can see that time matters a lot. In fact, this example clearly shows that in many cases, time matters more than money. The one who started first finished ahead of everyone and barely had to save anything. The Idel person could have earned $40,000 their entire lives with no raises at all but would still have more money at 65 than the Typical person who had to earn enough from 50 to 65 to be able to put away $120,000 per year (that's very hard considering that savings comes after expenses and after-tax for the most part). The Typical person would probably have to earn at least $400,000 per year to be able to reasonably save that much money - even at that level of income saving $120,000 per year would feel like an incredible sacrifice.
Take a look at the table below for a rundown of all the numbers. You'll see the age of our group on the left along with the savings rates and rates of returns at the top.