“ Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
— Albert Einstein
As it turns out, Einstein was a financial planning guru just as much as he was one in theoretical physics. In another article we discussed the Cost of Costs This is a follow up or addition to discuss as well, the Cost of Loss. Retirement thinking is broken, outdated, and ineffective. I for one will never retire; the goal is to build financial capacity that allows me to “get to” do things instead of “have to.” Whether that’s international travel, volunteer work, multiple business ventures, cross-country RV trips, or whatever else you can think of. The ultimate goal of financial planning is that you “get to” control your entire schedule and that you have the money to enjoy a certain lifestyle. In other words, you “get to” live life from a place of financial certainty!
However, many lose sight of the impact that loss has on their future income and the level of certainty that they are missing out on.. We want to bring adjustment to thinking that says “Buy and Hold” is best. The one element that very few, if any of the traditional Financial Planning players talk about is time. As soon as you introduce time into the retirement equation, “Buy and Hold” no longer works. If one year before your plan is set to take effect you lose half of what you had, you are not going to “get to” live the lifestyle you want to live. You’ll be a slave to an uncertain income future.
We must break the traditional thinking around “Buy and Hold.” In the traditional model, if I’m 30 years old and accumulate $100K in traditional retirement savings - I think I have time to recover if I need to. If I suffer a loss, I’m going to continue to hold so my fund recuperates. The issue, is one of simple math - if I lose 50%, it’s going to take a 100% gain to get my loss back. That 50% loss amortized at 7% over the next 30 years is well over $1M. I’ve just lost $1M+ in future earnings simply because I didn’t recognize the opportunity cost of holding my money in an environment of uncontrollable risk. The same traditional thinking suggests that this is only a loss if I sell. Technically that is true. Remember time? At some point you have to sell to pull the income, right? Just because something is technically true does not make it practically valuable! Many people think that they have no other option; that risk is just a part of the game. Not true!
If I can get in touch with and really understand what risks actually exist and threaten my current financial makeup, and what the losses I’m experiencing actually are, then I’ll begin to make different choices.
The traditional “Buy and Hold” methodology tries to convince us that losing principle is just part of the game. That line of thinking never really counts the cost of loss. When those dollars are ear tagged for “getting to” later in life (retirement money), then losses and time are not your friend. Risk Management is simply about understanding your risk/reward ratio in relation to time. When we introduce loss into the compounding equation, we render what Einstein called the 8th Wonder of the World, compounding interest useless. Loss negates the benefits of compounding interest! Typically, when we invest, we are wise to the notion of compounding interest. When principal, the actual dollars we put to work, accrue interest, and then that total sum gains interest, and so on and so forth.
When loss is introduced into the compounding interest equation, then it is a mathematical fact that compounding interest no longer works. It’s a broken equation. You can have simple interest, but not real compounding interest.
Let’s look at a simple example. I have $100K invested, and over the next 10 years, it goes up 10%, then down 10%, then up 10%, and so on. (Insert Graphic)What is my average rate of return? This isn’t a trick question: it’s 0%.However, that doesn’t mean that I have $100K left at the end of the 10-year period. If you do the math, you’ll find that at the end of the 10 years, I’m left with $95K. That’s a Real Rate of Return of -5%. What? How can that be? If you do the same math with 50% gains and losses alternating your Real Rate of Return is -43% and you have $57K left after 10yrs or cycles. When we introduce loss into the equation it means, my money no longer grows with compounding interest, and I have the disappointment that goes with it.
This loss not only affects me in the short-term , but in the long-term as well. That $5K or $57K could have been reinvested, gaining a healthy rate of return, and growing into a larger number. I’ve lost an untold sum of money based off a “0%” average rate of return….. for the investment. As an investor I have a -5% Real Rate of Return even though the investment had an average rate of return that was 0..
What’s the lesson here? Know what your real rates of returns are as an investor. Learn how to control risk, particularly with your “get to” money. If you truly want to “get to” instead of “have to” then understanding father times role is very important. Let’s take personal responsibility for how and where our money is being invested, and ultimately learn, grow, and thrive. As it turns out, ignore-ance isn’t bliss after all. To ignore something this import will never serve you well.
“ Investors do not risk principle money and have the potential of gains. Speculators risk principle money and have the potential for gains.”
— Podcast: How to lose money
There is a big difference between speculating and investing. The best definition I have heard in a while is from a podcast entitled How to lose money. "Investors do not risk principle money and have the potential of gains. Speculators risk principle money and have the potential for gains." Invest, don’t speculate! What percentage of your hard earned money is at risk of losing the principal amount you put into it? If you don't know right off the bat, then it is time to find out. It is important to become aware of the real risks and how they impact your desired outcomes.
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