In Humans Are Hardwired To Suck At Investing we discussed cognitive biases that drive us to make horrible financial decisions. Everyone falls prey to them at one time or another.
These two ideas are the foundation on which we can begin to design a system to optimize our finances. Now we will give ourselves a direction.
If you haven't read Stephen Covey's "7 Habits Of Highly Effective People" I suggest you buy it immediately. It is an all time classic. In the book, Covey boils down years of research on highly successful people into 7 habits. The second one is "begin with the end in mind". For many young people, this is easier said than done.
The question "but what if I don't know where I want to end?" usually arises. I am not going to act like I have it figured out, but here is my two cents on it: having an end in mind, even if you aren't entirely sure if it is the correct one, is better than aimlessly going through life. Start off with a direction and move towards it. You may veer off in a slightly different direction over time than you thought, but it is unlikely that the direction you pick is the completely wrong one.
With investing, the same is true. The hallmark of a successful investor is one that has an end in mind and has a good grasp on what reality should look like. They plan their investments around a realistic idea that can be achieved over time.
The recipe is simple and has been around for decades. It is often that people try to derive a different way and nevertheless fail miserably. I believe having the wrong expectation of investing gets many young people into more trouble than they can handle.
The Simple Formula
Investing comes down to this simple formula:
Many people will recognize this as the compound interest formula. Anyone with knowledge of investing will know this formula by heart and could write it in their sleep. Yet most look at it as simply a tool to calculate something. In reality, it is much more than that.
We will start from the left. First, we have Future Value which is the end in which we are looking for. But in order to get a future value we first must have a Present Value. Investing is not some sort of magical, money printing scheme that will make you filthy rich overnight.
It is a process that first requires you to already HAVE some money, to begin with. That means we must first be able to SAVE money in order to be able to participate in investing in the first place. Next, we have what most people focus on which is Interest Rate. Next, we have Number Of Years. What we can take away from this is that investing comes down to how much you put in, how long you keep it there, and how much you can earn.
The Billionaire Path
Now that we understand a little more about the math of compound interest we can start to break down what a realistic goal of it is. Many people have a warped expectation of what investing can bring. We all hear different stories of a great investor who went into the market with $10,000 and came out with $10 million in 10 years.
Let's look at the math of that. In order to do that, you would need to average a 99.5% compounded rate of return every year for 10 years! That sort of return is next to impossible for just two years in a row much less 10 years. So the question becomes is how did the Warren Buffets and Ray Dalios of the world get their billions?
The answer is they were businessmen. One of the only practical ways people can amass that much money in a lifetime is by owning and running highly profitable businesses. Warren Buffet owns a holdings company and Ray Dalio runs a very successful hedge fund. People like Mark Zuckerberg and Bill Gates are all very successful businessmen.
It is very rare that people will generate vast sums of money in a relatively short period of time solely by making great investment decisions.
Many people go into the market thinking they can strike it rich off of their skill and wit. These people almost always end up blowing up at some point in their career and lose everything. Investing simply isn't the vehicle that will get you to that point. You need to create a successful business.
So What Can We Expect Then?
So if we can't amass huge fortunes and live in castles with investing then why even bother? Well, the truth is investing is how we can create a system that builds on itself over long periods of time and eventually can amass huge fortunes.
Christopher Columbus sailed over to the New World in 1492. Let's say Chris took one penny and placed it in an investment that paid 6% interest per year. And let’s say he instructed someone to take his interest payments every year and place it into a piggy bank from 1492 to 2014. At the end of 522 years, he would have a total of… 31 cents.
Now let’s say instead he left that interest in that account and let it compound over that same 522 years. At the end, he would have $162,054,713,810.29! Yes that is 162 BILLION dollars all from just one penny!
So investing is not about going into the market and making millions of dollars in a couple of years. It is about slow, steady growth of your savings over time. It is about continually saving and investing so that eventually you can become financially free.
The Math of Financial Freedom
So what is a realistic expectation? I believe a realistic goal for investing is to get what Jim Collins calls F#@k You Money. FU money is the amount of money you need invested to be able to cover your living expenses solely off of the interest that the money earns.
Essentially that you can walk up to your boss and say "F#@k you!" and walk out and only work when you want to. Some people call this financial freedom, but I like my version better.
So the question is how do we get there? Let me show you how this works mathematically. Let's say your monthly expenses are $3000 per month. A good rule of thumb to use for draw rate on your FU money is about 4% per year.
So you would need to have $900,000 invested. If you were able to save $1000 per month and able to earn 10% on your investment it would take about 22 years to save up your FU money.
Now you might think that is too long and you want to get your FU money earlier. So here are a couple of points about this calculation. First, if you can lower your monthly expenses then you can decrease the amount of FU money you need. Second, if you can save more money per month then you can reach your amount sooner. Let's take the above example. You have a total of $4000 coming in every month, $3000 for expenses and $1000 saved. Now let's say you can lower your expenses by $500 per month and save that. Now you only need $2500 per month and can save $1500 per month.
Your FU Money is now $750k and it will take you about 16 years. How could we save $500 of ongoing expenses per month? Well, most people's car payment is about $500 per month. Here again, we see that by eliminating fixed expenses, such as recurring debt payments on things, we can increase our savings and decrease our time it takes to get our FU money. I think you will find this graph very interesting:
What this shows is how long it will take for you to get your FU money based on the percentage of income in which you save and invest. It assumes a 4% draw rate and an 8% investment return. The moral of the story is the more you save and invest the less time it will take for you to be able to walk out of your job.
Summing It All Up
So how do we put this all together? First, we need to make sure we have a realistic goal in mind when it comes to our investing. We know that the major components of our plan is how much we can save, how long we can save it, and how much we can earn on it.
We also saw that investing alone is not going to make you insanely wealthy overnight. In fact, investing is a life-long process and honestly, it is usually very boring. We saw that a realistic investing goal is to become financially free and have our FU money.
That is having enough money that we can cover our monthly expenses without a need to work for a paycheck. Our money works for us. We saw that the math of the FU money favors less fixed expenses and more monthly savings. Simply put the more you save and invest the less time it takes to get that FU money. Now get to crackin’!