Need some inspiring story of how time in the market beats timing the market? There’s no “get rich quick”, but everyone can eventually be wealthy. All you need to do is to understand and maximize the power of compounding by maximizing your time in the market. Let’s see how!
Time in the market or timing the market?
In my previous posts, we’ve seen how the power of compounding can make or break our finances. In quick words, we should always maximize the positively compounded interest (savings and investments) while at the same time minimize the negatively compounded interest (debts, taxes, and inflation impacts).
I had a question for you at the end of the previous post,
What do you think is the more important factor in growing your money: time in the market or timing the market?
This is a classic question, so classic that it’s even too cliché to ask. But it’s surprising how many people still get it wrong. Or they may get it right but often act the opposite.
If you say time in the market outweighs timing the market, congrats! You can understand and utilize the power of compounding to advance your finances.
If you haven’t thought of or act as if time in the market as the most important factor, that’s fine. Let’s get something straightened out here to put you on the quickest path to achieve your ultimate financial goal.
The innocent bet
Elena, Carol, and Alice are best friends from childhood. They are at the same age, grew up together in the same neighborhood, went to the same schools but later took on different career paths.
At the age of 20, thanks to her first internship, Elena could take care of her essentials and managed to save $5,000. She decided to invest her hard saved money in a low-cost ETF.
In the year they hit 25, Elena united with Alice at the baby shower of Carol’s first baby. Elena told Alice about her investment and how she grew $5,000 to almost $7,200 in 5 years with an average annual return of 7.5%.
Alice, who at the time was a young bright MBA student, thought Elena was too conservative with her investment. Alice said she could do much better than the 7.5% return on investment that Elena was happy to get.
Carol was just laughing when her two best friends were betting on their winning investment strategy.
After the reunion, Elena was still investing in the same low-cost ETF that consistently gave her an average return of 7.5% a year. There were up and down years, but overall she was happy with the average return. She barely had to do anything with the growth of her portfolio and hardly remembered the bet she had with Alice. There must have been too much ice wine for Elena during their bet.
Alice, on the other hand, took her words to heart. She invested $5,000 in the high-performing individual stocks she learned to pick by herself. During the next 5 years, Alice would actively buy and sell her stocks at the timing she thought to be right, aiming at the highest return she could get. Alice had acquired tons of investment knowledge and had tremendously enjoyed a gross average annual return of 15%. This is a double of what Elena was getting with her passive investment portfolio.
Carol had her second kid at 30. Elena and Alice united again at Carol’s place. Carol asked both Alice and Elena to share how their investments were doing.
Alice proudly told her best friends about her 15% return on investment that had boosted an investment of $5,000 to just a little below $10,000 in the past 5 years after deducting buying and selling fees.
Both Carol and Elena thought the 15% annual return rate was pretty impressive. However, Elena highly doubted Alice could keep up with that in the coming years.
Elena surprised Alice by telling her that without doing anything, Elena was still getting an average 7.5% return on investment for the past 5 years. Her $5,000 had more than doubled to $10,300 in 10 years and had not incurred any maintaining fees or costs. Plus she got loads of free time and free mind to do other important things and to nurture her romantic relationship.
Mathematically, it can be proven that even before taking into consideration the buying and selling fees, a doubled return rate (aka Alice’s portfolio) still lacks behind a doubled time horizon (aka Elena’s portfolio).
Alice lost the bet with Elena this time by just a tiny bit. But she was very determined that if she kept getting the same annual return, by the next year, she would outperform the boring ETF that Elena was investing in.
Alice was too young and ambitious to realize the amount of risk she had taken to achieve that 15% return. The bull cycle was coming to an end. After giving Alice lots of excitements and high hopes, things turned sour very quickly in the next year and sent her portfolio down almost 70% while Elena lost nearly 40%. The two young girls experienced the so called financial crisis for the first time in their adulthood.
Alice grew extremely anxious and sold most of her portfolio during the downturn as a result of her active investment strategy, trying to, again, time the market. And that only proved to hurt even more. When the market recovered in the coming years, Alice could never recover the loss she cut.
Elena, on the other hand, knew she should just stick with her ETF because it tracked a broad group of assets that historically had proven to have the average return rate of 7.5%. Elena knew market turmoil and crises would come and go but she would be fine in the long run.
She also knew that was the golden chance to go full into the market. She tighten her budget to save and invest even more. Elena phoned both Alice and Carol to share the thoughts with her friends and persuade them to do the same.
Carol, a 31-year-old mom of two, had not even thought of investing her tiny savings. It wasn’t easy to save when she had an average job paying an average salary while her family was fast growing plus everyday expenses were shooting high in the recent years. But she was convinced by Elena that chances like this wouldn’t come so often, so she decided to invest the first $5,000. That was basically all the savings she got.
Carol knew she could never go back to 10 years ago to have Elena’s age when Elena first invested. She knew she could not take advantage of a longer time horizon, which is the critical factor in compounding.
All Carol could do was to contribute more: more capital and more frequently. She made a plan with her husband to save and invest an extra $500 each month, then increased this amount to $750 and $1,000 and even more as they managed to cut living costs and their salaries grew in time.
The happy ending
All three friends now comfortably live off their sizable portfolios. They sometimes made investment mistakes but quickly learned from the mistakes. Their investment strategies are different but on one thing they all agree: the power of compounding is undeniable and time is the most critical factor of compounding.
It’s simply math:
Doubled time horizon outperforms doubled initial contribution and doubled return rate.
In other words, when to start investing (or time in the market) can overweigh how much you initially invest and how much return rate you earn. The three friends always make ultra sure that their children would be fully aware of how precious the young age can be in the preparation for their future wealth.
What can we learn from the tale of three friends
Although I wish I could be Elena, I’m more like Carol in the story. For several personal reasons including financial hardship and lack of awareness, I didn’t start investing until the age of 31. That is probably more than one third of my life.
Unlike Carol, I don’t have kids and big financial obligations, so I can save to invest 50% of my after tax income every month. But gosh… I always wish I could go back in time to educate my younger self about money and investment.
Many Baby Boomer (ages 55-73), Gen X (ages 39-54), and Millennial (ages 23-38) haven’t even ever thought of savings, let alone investment. Time is limited. We can’t live forever to invest and enjoy compounding.
If you haven’t invested, the time to start, regardless of your age, is RIGHT NOW!
If you’ve already invested, the time to increase the amount and frequency of your contribution is RIGHT NOW!
Are you ready to join the path of millionaires?
Everyone, and I must emphasize, everyone, even with an insignificant income, can eventually become wealthy and live a comfortable life. All it takes is to invest with great discipline as early as you can, as much as you can.
Whenever you feel more financially comfortable, increase your additional contributions either by the amount or frequency. Don’t increase your expected return by taking on more risk.
A good benchmark investment return is about 8% by the S&P 500 index. (Depending on the number of years over which the average is calculated, the rate may vary.) Do you know that only less than 5% active fund managers could outperform this benchmark year after year in the past 15 years?
Unless you’re an investment guru and confident in your own ability to time the market and constantly beat the market (like Alice thought she could), we all should stick to an expected investment return of no more than 8%.
There’s no such a thing as “get rich quick”. Sustainable wealth requires a clear plan, enduring patience, and serious discipline. But everyone can do it! We don’t have to make a lot of money or win the lottery to become rich. All we need to do is to understand and maximize the power of compounding by maximizing our time in the market.
Key takeaways from my “Power of Compounding” series
Enough of storytelling and future painting. Let’s get into some real actions!
Minimize negative compounded impacts
– Pay off ALL bad debts with higher interest than your expected investment return. Make it a pressing non-negotiable priority.
– Inflation is unavoidable and beyond our control. Unfortunately, inflation rate usually beats savings interest rate. If you’re looking to beat inflation, investing is your only choice.
– If you are savings or investing, use tax advantage accounts to avoid or delay paying tax. Canadians should always optimize their contributions and investment allocations inside TFSA and RRSP to minimize the tax incurred from capital gains, dividends, and interest payments. Money saved from not paying tax (in the legal way of course) will continue to bring more compounded money for you in the long run.
Maximize your time in the market and contribution
– Time in the market is more important than timing the market. While you’re in total control of when and how much you can invest, you can’t predict when and how much the market will go up or down. Your easy stress-free option is average cost investing: investing small amounts regularly. Buy into the broad economy and hold your investment for as long as you can.
– Compounding time is powerful but limited. Every human only has a finite number of heartbeats. If you want to grow your money beyond what your remaining lifetime can do, your only option is to contribute more, right now, as much as you can. Remember to take advantage of your employer matching program if applicable. Also, if your big fat year-end bonus or tax return is coming, don’t spend it and let it compound.
Action call: clear all consumer debts and bad debts, then start investing, and increase the contribution to your investment!
Maximize your time in the market. Don’t waste any of your heartbeats.