Sunday, November 6, 2011

How would you feel if you lost $1 billion?

Investors have to take many decisions: What to buy? At what price? When to buy? When to sell and at what price? How much risk is involved? What is your risk tolerance? When buying individual stocks in the stock market you can lose it all! Or you can lose a big chunk of your investment; losing 40 to 80% is not uncommon. If you own only one stock, losing it all means losing all your investment funds and you’re dead in the water until you have acquired (saved) new investment funds.

When you buy a stock index ETF, you buy an instant diversified investment portfolio. If you buy it during a bull market you may loose up 49% in the next down turn - significant but a lot less that 100%! Add to that a subsequent recovery that may result in up to 142% appreciation; i.e. making it back plus somewhat more! Obviously, it is a lot less risky to invest in a stock index ETF than in an individual stock. But then such a stock has the potential to increase 10-fold while a doubling of your ETF over a decade would be considered quite a feat.

Risk and reward! How much is your risk tolerance. You may estimate it in rational terms on a spreadsheet but when push comes to shove, you learn only about your real tolerance living through an actual market down turn. Because your risk tolerance is much more an emotional matter than that it is a matter of numerical analysis.

So ask yourself how would you feel if you lost a billion? Probably not so great; but then if you could lose a billion you’d probably be someone like Bill Gates or Warren Buffett. If you own 50 billion in stock market investments, a billion is a 2% market move. Gosh, those guys must have done that lately on a daily basis! Just imagine!

So let’s go back to our scale of investing. How would you feel about losing $40,000? Ouch! Warren Buffett drove an old car and still lives in his family home located in Omaha, Nebraska. He used to see every dollar spend in terms of future value. If your investment ROI is 10% per year then that dollar would be worth $2 in about seven years; in 14 years it would be $4 and after 28 years it would be $16 dollars. When you’re saving 1 dollar at age 20, that dollar would be worth $64 when you reach age 61. So how do you feel about spending $64 on some chewing gum or $10,000 x 64 = $640,000 on your first used car?

How do you feel about losing $40,000 at age 20 that could be worth $2.4 million when your reach freedom 61? Risk tolerance lies all in the eyes of the beholder! It is a very personal matter. It also depends on the size of your portfolio, a $40,000 loss on a $40,000 portfolio is a lot more serious than that loss on a $400,000 portfolio. Investor age is important as well.

Say you had saved $20,000 at age 20 and invested it at 10% per year in a stock market ETF with a 40 year time horizon. How much risk would you take on your next $20,000? Would you risk it all on that single start-up stock with a chance of a ten bagger? Would you go for a simple double?

If your portfolio was $20,000 at age 60; would you risk the total loss of the next $20,000 for a ten bagger chance? Less likely than if you were 20, but it still depends on who you are! Self-knowledge is essential for each investor and you are most likely to find out how risk tolerant you really are when things go wrong. So ask yourself and test yourself, how you would feel about losing $1 billion dollars. Are you a Donald Trump or a Warren Buffett?


2 comments:

  1. Great insight here every 20 year old should read. I sent it to my (20 and 22 year old) kids !

    Well written my friend !!

    Add a "for fee" section and make some money !! At least add some "Google Ad" to the right of your blog !

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  2. Hmmm, the "Google Ad" idea might be something. I'll talk about it with my son who is the real internet expert.

    ReplyDelete