Risk and Reward

Previously, we compared the choice between bank savings accounts paying roughly 5% interest on savings to investing in the Standard and Poors 500 index which averages approximately 10% over time.  In order to double your return rate, investing involves an element of risk.  The risk of investing versus collecting bank interest is that an investment can, in extremely rare cases lose 100% of it’s value.  By assuming this risk, a prudent investor can generally earn double the return of a bank savings account (10% versus 5%.)

If you do not wish to think much about investing, or are extremely fearful of losing your savings, then buying shares of an index fund, such as one that corresponds to the S&P 500 offers a simple solution.  Whenever the overall stock market increases in value, you will earn a corresponding return.  Bank savings accounts offer the least amount of risk, and the lowest return.  Index funds will usually double that return, but with the introduction of a moderate risk.  That risk, in the absolute worst case, is the possibility of losing your entire savings.

As a practical matter, it is highly unlikely that an index fund based on the S&P 500 would ever go to zero value.  The S&P 500 is a collection of shares of the 500 top companies, mostly based in the U.S. but also other countries in the global economy.  To reach a zero value, all 500 of those companies would have to simultaneously fail entirely.  Even during the worst depths of the great depression,  when the market lost 90% of it’s value at the absolute lowest point, it still did not go to zero.  Most investors who could afford to retain their shares of stock, saw them recover to a loss of something closer to 50%.  Eventually, even those losses were recovered, though it took several years and a World War before the markets began growing steadily again.

When I examine my own risk as an investor, I assume that the absolute worst case scenario is likely a 50% loss.  As I am not into investing for the purpose of losing money, I hope that will never happen.  Nevertheless, I plan for the future with the understanding that a loss of 50% of my portfolio could occur at any time, instantly and without a warning.

A sudden 50% loss of value is even less likely for those who invest only in the S&P 500.  It is simply unlikely the those 500 companies could all lose 50% of their value, all at the same time.  This is the value of diversification.  An investment in the S&P 500 index lowers the risk of investing losses because it is far less likely that all 500 companies would suffer a devastating loss than it would be for any one company to suffer a devastating loss by itself.

Individual companies may risk sudden failure but they also have the potential for higher return than an index fund.  An individual stock may double, triple or increase in value by a factor of ten in just a few years time.  An index fund is limited in producing those kinds of returns for the inverse reason that it is likely to never go to zero.  It is unlikely that 500 companies will ever simultaneously double or triple or increase tenfold within a 2 year period.  So it happens that diversification lowers your risk, but also lowers your potential reward.

Conventional wisdom is that investors must diversify to lessen their risk.  What the conventionally wise don’t tell you is that diversification will also probably lessen your reward.  Warren Buffett has famously said that “Diversification is a protection against ignorance.”  But he adds “It makes little sense if you know what you are doing.”

I agree with Buffett on both counts.  If you don’t wish to spend any time thinking about investing, then diversification is the right choice for you.  If, on the other hand, you enjoy researching what makes a company successful, you can achieve far more than a 10% annual return.


Your Road to Financial Independence

How to free yourself from (wage) slavery.

Legendary Investor Warren Buffett:

If you don’t find a way to make money while you sleep, you will work until you die.”

If you live in the United States or in any country with similar tax rates, then financial independence is your birthright. Many people achieve some level of financial independence in their retirement years, but there is nothing stopping anyone from becoming financially self-sufficient at any time. The amount of money you need to have to live a comfortable life is a completely personal choice. It is generally acknowledged that a modest independence can be attained and preserved with a savings of $1 Million.

If you can save $1 Million by age 65, you can afford to spend $50,000 per year for the next 20 years, by which time you would be 85. But such a simple calculation does not take into account interest that would be paid each year on the remaining balance. There is a 4% rule on retirement spending. By spending 4% of your $1 Million each year, or $40,000, you can expect your funds to last for 30 years, or until you are 95 years old.

The purpose of this website is to explain in detail how you can get your savings to $1 Million or probably much more by following a series of 3 simple steps:
1. Earn money through wages or running your own business.
2. Save a portion of your earnings.
3. Invest your savings.

Step #1 – Earning money.
The more money you earn, the faster you can achieve your goal of financial independence. You should seek the highest salary you can attain, while paying close attention to the cost of living where you are. If your expenses exceed your earnings, you will never earn enough to buy your freedom. A house that sells for $500,000 in New England or California, can be had for $100,000 in many other parts of the country. The quality of your life in where you live is a major factor in your happiness. It is certainly possible to have a satisfying life and career while still being able to save enough money to enjoy your retirement as well.

Step #2 – Saving money.
The more you save, the faster you can achieve your independence from the working world. The goal is to save as much as you can as early in life as you can. It is also true that the higher your salary is, the more you can save. It helps to have a bigger salary and it hampers your ability to save if your salary is low. You can still achieve your independence even on a minimum wage scale. But you will have to sacrifice more of what you earn to savings or work more hours. For example, you could work two jobs and live on one salary while saving 100% of the earnings from the second job.

Step #3 – Investing.
Once you have started saving money, the most enjoyable part of the 3 steps can begin, investing your savings. This is the part that people often fear most. Fearing the risk of losing their savings, many people used to place their funds in a bank savings account. On average, the prime rate for the past 100 years is close to 5%. That is the kind of rate that banks will pay you to manage your money. You could instead invest your funds in a Standard and Poors 500 index fund. Since 1926, the average annual increase in the S&P 500 is closer to 10%. An important distinction is that the S&P 500 can lose value in a given time period, whereas the interest rates paid by banks are almost always positive. There are now some banks in Europe and Japan that pay negative interest rates. Those customers actually pay interest to the bank for the privilege of holding their funds.

The choice between growing your savings at 5% bank interest or 10% in the stock market is a personal one. A practical consideration is how much time you have to work with. Most of us have about 40 working years, usually followed by 20 or more retirement years. That is a total of about 60 years that we are engaged in saving, growing and ultimately spending our money.