Investors usually focus too much on portfolio strategy, and not enough on their spending behaviour and investment discipline. This could jeopardise their long-term financial wellbeing.
It’s not the big stuff, but rather the innocuous daily choices that really impact your savings.
Consider not just your financial capacity to take risks, but also your emotional ability to stomach short term losses.
Having a contingency and emergency fund helps in staying invested through market turmoil.
Compounding works when you earn decent returns, on average, and stay invested over the long run
What could Sylvia Bloom, a legal secretary, Ronald Read, a gas station attendant, and Grace Groner, a secretary at Abbott Laboratories, have in common? Turns out, all three of them amassed fortunes upwards $7 million each in their lifetimes. While luck and individual circumstance should not be discounted, these improbable stories of investment success offer a compelling insight into wealth creation: frugality and long term investment discipline outperform even the most sophisticated financial instruments. Let’s break this down and explore further.
Wealth is what you haven’t spent
Wealth is what you haven’t spent; the vehicle upgrade postponed, the iPhone not purchased, or the expensive dinner shelved for another weekend. At Clarified, we consistently see our customers underestimate their own spending, often by more than 50%. Usually it’s not the big stuff, but rather the innocuous daily choices that really leak the bucket. Simply being aware and keeping track of your expenses goes a long way helping you contain your lifestyle spending.
Take calculated risk, and account for your emotions
Holding on to more cash than necessary, or letting your savings languish in a bank account is without doubt damaging. However, taking risks without accounting for your risk tolerance is detrimental as well. Before creating investment portfolios at Clarified, we look not just at the financial capacity of the customer to take risks, but also at the emotional ability to stomach short term declines in portfolio value. In fact, this additional room for error is the often the difference between a steady, long-term portfolio, and one that churns with every business cycle.
Nothing sums up the importance of factoring in your emotions while making investment decisions better than this quote by Harry M. Markowitz, Nobel Prize in Economic Sciences, and co-author of Modern Portfolio Theory, “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualised my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimise my future regret. So I split my contributions 50/50 between bonds and equities.”
Stay the course
Linear thinking is intuitive, exponential thinking is not. As a result, we consistently under appreciate the power of compounding. High returns, realized infrequently, do almost nothing for long-term wealth creation; compounding does not work in the absence of continuity. The correct approach is to aim for decent returns, on average, over the long run; that is when compounding works its magic.
Finally, we must remember that in investing, volatility is inevitable and normal. Having a buffer, and accounting for your risk tolerance is necessary precisely because this helps you stay invested through periods of market volatility. It also helps to create a separate fund for contingencies and emergencies, so you don’t have to access your investments to meet short term needs.
Published on: September 5, 2018