I read Dr. William Bernstein’s Kindle eBook The Ages of the Investor again. This book is worth reading and re-reading a few times.
One nugget I learned from this book that I haven’t seen emphasized quite enough in other books is the difference between investing a lump sum and investing a stream of savings over time.
There’s a big difference. I wish I had learned this difference years ago.
Traditional investment advice primarily comes from investing a lump sum: a pension fund has a pot of money to invest; money coming into and going out of the pot are small relative to the size of the pot. These investors care about the consistency in returns, thus the use of standard deviation, multi-year annualized returns, Sharpe ratio, efficient frontier, and all those good stuff.
An individual doesn’t invest that way. You start from nothing. Money comes in for many years. Then you start to withdraw for many years. An an individual investor, the more important things to me are (a) when I will accumulate enough to retire and (b) how I can make sure the money lasts a lifetime. I don’t care about standard deviation or Sharpe ratio.
If investing a big lump sum 100% in stocks is risky, it doesn’t mean it’s as risky when you are investing a stream of savings 100% in stocks, at least not in the beginning. So what if you lose 50% of your investment in the first year or in the fifth year? Your savings next year and the many years after next aren’t invested yet.
If you get a quick rebound, great, you are back to where you were before the crash. If the market stays low for years, even better. As Dr. Bernstein wrote in his book Investor’s Manifesto:
A 25-year-old who is actively saving for retirement should get down on his knees and pray for a decades-long, brutal bear market so that he can accumulate stocks cheaply.
Let those who already have a large amount of money invested worry about market crashes. Before you get there, investing 100% in stocks for retirement would be just fine.
What about risk tolerance?
Nobody likes losing money. One can learn and overcome the irrational fear though. Think about the money that you will invest in the future. Is it more or less than you invested so far? Will it buy at higher or lower prices? If the answers are more and higher, would you rather buy at lower prices now?
Once our young investors truly understand the difference between investing a lump sum and investing a stream of savings, they will stop focusing on what little they already invested and start looking ahead toward what they will invest in the future. Knowledge is power.
[Photo credit: Flickr user Anne G]