Investment Mistake Costs
Have you ever wondered what the real cost of an investment mistake is?
Few people have, it seems.
Many people appear to be more than happy to go merrily on their way, mindlessly churning their stock investment portfolios, selling the winners and buying more losers, but never taking into account how devastating the cost of investment mistakes really can be.
Young Investors And Risk
I’ve even seen some people suggest that a higher amount of risk is acceptable for young investors, because if they make a mistake, they have years ahead of them to make up for it.
I beg to differ.
While it is indeed true that barring an unfortunate early demise, young investors do have years ahead of them; I believe that young investors should carefully consider exactly how costly investment mistakes can be rather than engaging in risky behavior.
An Investment Loss
Let’s just assume that a young investor has $10,000 U.S. to invest. Through a terrible stroke of financial misfortune, he loses all of it.
How much did he lose?
Was your answer $10,000 U.S.?
One could convincingly argue that the loss in real terms is much larger than $10,000.
Investment Losses Are Larger Than They Appear
According to Timothy P. Vick, author of an interesting essay titled Finding Value In The Market, stock market losses are bigger than they at first might appear:
“Every poor investment has two costs – the near-term loss you generated and the long-term money you gave up by choosing poorly. A $10,000 loss early in your investing career costs you more than $2 million at retirement if you could have compounded the money at 20% annual rates.”
That insight is quite perceptive.
Now, as the S&P 500 only has an average annual return of 10%, I have my doubts as to whether the average investor would be able to compound his money at a 20% annual rate. It is unlikely that most investors would be able to compound their wealth at that rate as even most professional investors are unable to beat the S&P 500.
Still, even if we were to cut that annual rate of return in half, it would still have an enormous effect on retirement.
Let’s say a young investor were to invest $10,000 U.S. and compounded it at an average annual return rate of 10%. After forty-five years, that would be more than $700,000 U.S. While that is certainly a lot less than the $2 million dollars cited earlier by Timothy Vick; it would still be an enormous mistake that should be avoided at all costs.
Now that being said, Timothy Vick’s point about the devastating cost of losses early in an investment career is certainly sound. It is also a point that very few investors seem to have noticed or seriously considered. There are indeed near-term and long-term losses when investment mistakes are made.
A permanent loss of capital that instead could have compounded over a lifetime will indeed have a dramatic effect on the bottom line of an investment portfolio at retirement.
In the essay Advice to a Young Tradesman in 1748, Benjamin Franklin wrote:
“Remember that time is money. He that can earn ten shillings a day by his labour, and goes abroad, or sits idle one half of that day, though he spends but sixpence during his diversion or idleness, it ought not to be reckoned the only expence; he hath really spent or thrown away five shillings besides.”
I think it is also important to consider how long it may take a twentysomething investor to save $10,000 U.S., or likewise after a stock market loss, to once again save that amount of money to replace what was lost.
Although young investors do indeed have the advantage of time on their side, ironically, they usually have the least amount of money to invest.
Having just entered the job market, more often than not the salaries of young adults tend to be low. Especially these days, due to increases in college tuition more and more graduates are leaving school in debt.
Naturally, debt from college loans or even mismanaged credit cards would also cut into the amount of money available for saving and investment.
Nevertheless, let’s take a look at a hypothetical example of a young investor’s likely savings rate just to put the situation in perspective.
While there indeed are cases of young adults making large salaries or having lots of extra cash on hand, I think it would be safe to assume that those cases would be few rather than the norm.
After paying for daily necessities like food, rent, and insurance, if a young investor could save $500 a month, it would take him 20 months, or a little over a year and a half, to save $10,000 U.S.
Thinking about the amount of time it would take a young investor to acquire the capital needed to invest; it also seems clear that in practical terms, financial losses on the stock market are larger than they at first might appear.
Focus On The Downside
If you invest in the stock market, you will lose money. Everyone does. Especially in the beginning. The real trick is to lose the least.
One man has stood out among others in that area, Benjamin Graham, a former professor at Columbia University and the author of the book The Intelligent Investor among others.
Benjamin Graham became known as “the father of value investing” and went on to inspire many famous investors such as William Ruane, Walter Schloss, Irving Kahn, and last but certainly not least, Warren Buffett.
Having lived through the depression, Benjamin Graham emphasized the importance of investing instead of speculating. He advised his students and readers only to purchase a company’s stock when it was clearly undervalued to try and lessen the risk of losing money.
Ironically, by focusing on losing less, it has repeatedly been shown that value investors outperform investors who are focused solely on growth.
Rather than trying to go for big but risky wins, just by simply trying to make fewer mistakes and avoiding monetary losses, can lead to improved stock market returns.
The Power of Compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Anonymous
Although commonly but incorrectly attributed to Albert Einstein, the above quote does convey a powerful message. The mistaken attribution should not be used to dismiss the inherent truth contained within. Compound interest is amazing.
We’ve already seen that the power of compounding can produce astonishing results above so there is no need to illustrate it again here. Allowing money to passively compound over time also takes less effort on the behalf of the investor than actively buying and selling stocks.
Rather than take on more risk, I believe that younger investors should instead make use of their long investment timeline by letting compounding work its magic with less risky investments.
With a forty-year timeline ahead of them, there isn’t a need for any additional risk than is already inherent in the stock market. So many young people fail to realize that fact and instead pour their money into unprofitable companies that can spin a good story.
Better Personal Choices
It seems that young, testosterone-filled men, are especially susceptible to taking big risks with their money on the stock market. Although that kind of reckless behavior may perhaps become less common with maturity or… experience.
“Experience, the name men give to their mistakes.” – Oscar Wilde
When I was young, I often bought the highly volatile stock of companies that while they had an exciting technology, realistically speaking, there was little chance of success. The odds certainly were not in my favor. A massive change in consumer behavior would have been necessary to make those companies profitable.
To use a phrase that Benjamin Graham would use, I was speculating. My behavior could have perhaps even be described as gambling. I certainly would have done things differently if I knew then what I know now.
I wish I had thought more carefully cost of near-term and long-term losses, and also how long it would take to replace money squandered on the stock market. In short, I didn’t know what the real cost of an investment mistake was.
An investment loss early in life can have a devastating effect on final returns at retirement.
Focus on not losing money rather than focusing on growth. Purchase undervalued stocks.
Young investors should use time to their advantage and allow compounding to do all of the hard work.
Finding Value In The Market by Timothy P. in the book Stock Market Trading Rules. 2001. Edited by Phillip Jenks and Stephen Eckett.
Advice To A Young Tradesman. Benjamin Franklin. 1748.
What Is The Average Annual Return For The S&P 500?
86% Of Investment Managers Stunk In 2014
Value Vs. Glamour: A Long-Term Worldwide Perspective (PDF)
Time is Money. Benjamin Franklin?
Compound Interest Is Man’s Greatest Invention
Upset Investor: Ion Chiosea/Depositphotos.com
Time Is Money: Brian Jackson/Depositphotos.com
Hundred-Dollar Clock: Nikolai Sorokin/Depositphotos.com