The case for getting into equities young

This post is primarily in response to a Asan Ideas for Wealth discussion on Jim Otar’s “Unveiling The Retirement Myth” where one of the points he makes is basically arguing for a more conservative, less equity oriented approach for young people due to behavioural risk aspects. I do not agree with the author’s premise, believing that the opposite approach is a better one for the reasons stated below:

Asymmetric Payoffs

The most obvious reasoning for investing early is the compounding argument. Since the mathematics of it have been discussed repeatedly and in detail, I won’t go into it here. However do note that a portfolio invested early benefits from an asymmetric payoff as in: if you get lucky and stumble upon a bull market / exceptional fund / stocks you might end up with several times the capital you started with.

If not, your capital base is relatively small at this stage and you have your human capital (earning power through work) to fall back on, which ought to increase in time. A prolonged bear market in the early years will also allow you to put money to work in building positions at attractive valuations (who doesn’t love a good sale?) and benefit from both capital appreciation down the line and often abnormal dividend yields in the near term. It is in my mind a win-win scenario.

Start-up analogy

Consider the case of an early stage company trying to make inroads into an industry while simultaneously fine-tuning its business model. Its founders are likely to experiment with new ideas in terms of product design, positioning, branding, target segments etc. Some of these ideas may turn out to be tremendous successes, and some of them might fail spectacularly. However this is an invaluable learning experience for the company at an early stage. They learn how to manage venture capitalist expectations, customer feedback, limited resources etc. They learn capital allocation from making smaller acquisitions with less money at stake. It is an invaluable business education that should be learned earlier than later, because the consequences of failure are smaller, knowledge compounds with time and an increased willingness to innovate at an early stage.

Learning how to invest is similar in many ways.  Capital & asset allocation, assessing industry dynamics and business economics, position sizing, valuation, risk identification and control, learning from and applying various disciplines like finance, economics, psychology are all necessary skills and tend to be picked up over a period of time. It is also a good time to understand your own psychology, risk-taking ability and develop a style of investing that works for you.

Additionally, as Warren Buffett once said “I am a better investor because I am a businessman and a better businessman because I am an investor”, reinforcing the idea that business and investing skills are not mutually exclusive. Not only will you become better at investing over time through knowledge gained both directly and vicariously, but you will also be a better employee / manager / businessman and person through all the reading and thinking involved.

Stress Inoculation

One of the concepts talked about in Malcolm Gladwell’s “Blink” is how the human body’s sensory range has an optimal range of arousal in which the body performs optimally, which corresponds to a heart rate of around 115 and 145 beats per minute. This is the range that top athletes report being in the “zone” in, entering a state of extreme focus where outside distractions are shut off and time seems to flow at a slower rate.

However, what happens when the stress / pressure gets too extreme and the heart rate spikes above 175 bpm? The human body overreacts: complex motor skills shut down, the fore-brain which is responsible for higher cognitive function begins to give way to the mid-brain. Animal instinct takes over, loss of depth perception, tunnel vision and loss of focus occurs.

In order to cope with this, police and military forces are put through rigorous and stressful simulated environments that closely mimic the real experience of combat. This is known as stress inoculation, and allows them to operate effectively in situations where a civilian would freeze up or panic.

Similarly, unless an investor is acclimatized over time to the stress that comes with market volatility and portfolio declines, he or she is unlikely to be able to make decisions in a rational and dispassionate manner. The only way to do this is to start early and invest through periods of declines. If you frequently see smaller declines, then 10% and 20%, and perhaps even a 30-50% decline will not seem so bad in contrast. Over time, the end result is getting so inured to volatility and the prospect of your net worth fluctuating that it hardly registers at an emotional level so as to be able to assess the situation tactically and seek opportunity through the lens of risk / reward instead, much like a trained officer sizing up a battlefield.

Skin in the game

The Babylonian Code of Hammurabi had a rule that if a house constructed by an architect collapsed and killed it’s owner, the architect was put to death. The architect this had a very strong incentive to learn his trade well and understand risk. The idea of management owning a significant amount of shares in the business they are running is along the same lines, because their incentives are aligned with that of other shareholders in creating wealth while their own net-worth is at risk if they do not.

If an investor wants to learn how to invest well and have a long and successful tryst with the capital markets, sufficient skin in the game is necessary i.e a sizable amount of the portfolio must be in equity. The declines ought to hurt otherwise harsh yet essential lessons will not be hammered into the brain. When a sufficient amount of own capital is at risk, the incentive to learn effectively and stay focused on the task at hand is greatly increased. No amount of paper-trading, theorizing and modeling will substitute for this aspect.

Conclusion

I am not making a case for being blindly bullish and rushing out and dumping your networth into equity, this post should not be considered as such. I also understand the point that people may be scared off by a bad experience early, and I do not believe that everyone will stay the course or agree with this. However as Charlie Munger once pointed out  “if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament”

The market may be an expensive place to figure out whether you do have the requisite qualities, but the tuition is paid in percentage terms, so better to get a sense for this early when you have less to lose.

 

Advertisements

2 thoughts on “The case for getting into equities young

  1. After seeing a paper loss of 60% in my portfolio ( it was an ocean of red at that time) , no correction or bear market till date has scared me off from stopping investing in equities every month 🙂

Please share your valuable thoughts

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s