Achieving financial success requires a well-marked path
Survival is the only road to riches. You should try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.
-Peter Bernstein, author of Against The Gods: The Remarkable Story of Risk.
Mitchell Barr, Client Associate
The Hiker’s Journey
The rocky earth crunches beneath your hiking boot as you plant one foot solidly in front of the other, steadily making your way up the mountain. The trail ahead is well-marked, worn by the footsteps of others who have made the same journey. Every so often a smaller trail forks in another direction, possibly created by those looking for shortcuts to reach the top of the mountain quicker.
You decide to stay on the main trail, knowing it will get you to the top in due time. The weather outside is fair. There are clouds in the sky, and a soft breeze could bring a storm over the mountain, but that’s not unusual, and often the storms blow over. As you continue trudging your way skyward, you slip here and there on some loose rocks, but you catch your fall and continue. Sometimes you stop for a breather and examine the weather. The rain is still holding off.
You are near the summit now, when suddenly the wind picks up and ominous nimbus clouds envelop the peak. In a sudden burst of energy, the sky opens up and starts dumping buckets of rain. Thunder and lightning erupt. You are so close to the summit and you don’t want to give up on reaching it. It would be easy to go back down the mountain and obey nature, knowing that you will be able to reach the summit another day soon. There is a rough trail that looks like it will get you to the mountaintop faster, and as your body grows colder, you throw on your rain jacket and give it a shot. You continue driving your legs as the earth grows muddy, intent on accomplishing your goal. On the next step, the soft ground in front of you gives way and breaks into a landslide, sending you plummeting down on your back.
Once you regain your senses, you finally decide to head back down the mountain. However, when you try to orient yourself to the main trail, you find that you are lost. Slowly you start to panic and find yourself running to whatever trail you can see, desperate to make your way back the familiar path that will get you to where you want to be. Eventually, you collapse in a heap and give up all hope, wondering if you will ever find your way and wishing you had just stayed on the beaten path.
The Investor’s Journey
The journey to a comfortable retirement and financial independence is analogous to that of the hiker, where the difference between “survival and death” is often a chain of events and decisions that may seem benign in hindsight, but combine to produce something catastrophic. Achieving financial success also requires a well-marked path of saving diligently, investing in a low cost, diversified portfolio, and staying the course to allow compound interest to work its magic.
We spend our whole lives saving for a future where we can be “retired,” which is really just being financially independent. Simply putting one foot in front of the other will eventually get you to the top of a mountain. Saving what you can consistently produces a similar result. Focusing on one small goal at a time has been shown to produce better results than pursuing unrealistic plans of grandeur. Rather than setting out to save $1 million, focus on saving a percentage of your income each month using a safe savings rate for your situation. Many accidents in the wilderness are the cause of people getting lost because they don’t plan their route. If you set a course and keep trudging forward, you will wake up one day and realize that you achieved much more than you ever imagined.
Shortcuts, like trying to pick lottery ticket investments and chasing performance, will always be tempting you on the way to the top of the financial mountain. These shortcuts appeal to your sense of urgency to summit quickly, but they often lead you away from the main path. This is especially true for diversified investors.
To be truly diversified, you have to own many different types of investments that will not and should not perform well at the same time. It is easy to capitulate and abandon diversification when the U.S. stock market rises persistently with no end in sight. But if you buy investments as they rise and sell them as they fall, that’s the exact opposite of what you should do to make money.
When people get tired in the wilderness, they are more likely to take shortcuts to reach their destination. They can even exhibit irrational behavior like leaving their supplies and resources behind to move more quickly. It’s important to keep your financial toolkit intact when you start to feel a little weary. Diversification is one of those tools, and hanging onto it is critical to getting to your destination safely.
Stay the Course
Markets experience volatility, most of which is normal. There are always storm clouds hovering, but not always a storm. Sometimes you might get scared by something you see on the news, but it usually turns out to be nothing to worry about. Some storms are terrible, though, and they are also inevitable. Many mountain climbing accidents are the result of people not planning for inclement weather or underestimating the conditions they will face on the way to the top.
What’s even worse is when the storm resembles something more like an avalanche. Financial markets are tightly coupled systems, meaning that there are a lot of interconnected parts that are dependent on each other. If one cog in the machine breaks, it can send the whole thing tumbling down. An example of this is the sand pile effect. If you flip over an hourglass, the sand will neatly pile up in a geometrically perfect pyramid, until randomly one additional grain of sand causes a mini avalanche to occur.
When the markets experience a colossal thunderstorm or an avalanche, it’s important to remain calm. Panic will only get you into trouble. When people panic, they lose rational control over their decision-making. When experts examine cases of people who get lost in the forest, the age group with the highest survival rate are those 6 and under. The most likely reason for this is because they don’t panic. If they are cold, they try to get warm. If they are hungry, they try to find food. Their brains are not developed enough to be afraid and panic.
People who panic while lost usually create a chain reaction of bad to worse decisions. Instead of evaluating their situation one step at a time, they run indiscriminately toward an unknown destination and use all of their precious energy along the way.
In the financial markets, panicked people often start trying to time the market until eventually they can’t take it anymore and sell all of their investments. Some can’t summon the courage to get back in, and they miss out on tremendous investment gains because of it. The most appropriate response is usually to listen to nature and descend the mountain as the stock market falls. Given enough time, it will continue its inexorable rise, and you will reach the summit. Staying on the beaten path may not feel adventurous, but as Peter Bernstein said, “survival is the only road to riches.”
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.