Quick note: I’ll be participating in a Huffington Post Live segment tonight at 9pm EST on the topic “Can You Afford a Baby”. If you’d like to check out my first on-camera experience and have a little fun with how awkward I look, you’ll be able to see it here: HuffPost Live: Can You Afford a Baby?
I talk a lot on here about investing. To me, it’s such an important topic because it’s one of the best ways to ensure your family’s financial security and because there are so many misconceptions about how it should be done. There’s decades of evidence showing that the best investment strategies are actually incredibly simple, but still there are always people searching for something better. That search for the mythical magic bullet, the one that gets you great returns with minimal risk, is not only a waste of time but can be incredibly harmful to your ability to build wealth.
And that is exactly why I thought Erin’s piece over at the new site Economag (check it out!) earlier this week was so important. She wrote A Love Letter to Millennials, From The Stock Market, which brought up some really important and foundational points on investing successfully. I’d like to explore some of them in a little more depth today.
You should definitely read the entire article yourself, but as a quick overview Erin came across a piece from the Wall Street Journal highlighting the fact that many young people are avoiding the stock market and instead putting their money into real estate. And not just any real estate, but multi-million dollar houses and apartments. The overall sentiment seems to be that they feel like the stock market is too risky and that real estate is a much safer investment. Erin’s plea is for these young people to recognize that nothing has delivered better long-term returns than the stock market, and that participating in those returns is a great way for people to build long-term wealth.
The strange effects of recency bias
As human beings, we have a tendency to overweight the significance of recent events. Something that happened just a couple of weeks ago feels much more likely to happen again than something that happened a few years ago, even if decades of history tells us otherwise. This effect is called the recency bias, and whether you understand its significance or not can have a profound effect on your investment success.
In deeming the stock market too risky, the young people featured in this article are exhibiting a classic case of recency bias. They started their professional lives, and likely their first real chance to invest, in the midst of the financial crisis when the stock market was tanking in what felt like a never-ending death spiral. That experience clearly spooked them, and now they’re staying away. That’s unfortunate for many reasons, chief among which is the fact that they’re completely bypassing the single biggest driver of their long-term investment returns. You can certainly avoid the stock market if you like, but it’s going to make it a lot harder to build wealth than if you instead took a history lesson, learned that there are always ups and downs, and decided to live with them for the long-term rewards.
There’s risk in every investment
On the flip side, these same people are proclaiming real estate to be a safe investment when we JUST WENT THROUGH A GODDAMN HOUSING CRISIS!!!! Seriously, I will never understand people. I have nothing against real estate as an investment and in fact am enticed by the idea of owning a rental property myself at some point in the future. But to think it’s a “safe” investment is just a little delusional. First off, if you’re simply talking about owning your own home, that is not an investment. You might save money over renting if you live there long enough, but you’re still consuming shelter, not investing your money. And there are many risks involved with rental property as well that cannot be ignored. You’re likely taking on more debt, you may have destructive tenants or no tenants at all for periods of time, there are ongoing maintenance, tax and insurance costs, you are subject to the rising or falling prospects of your neighborhood, and so on.
The point is that no matter where you’re putting your money, there is always risk. Even with “safe” investments such as savings accounts and CDs, there is the risk that the true value of your money will decline because of inflation. We tend to overweight the risks that we have personally experienced, feeling like the next investment will be safer simply because he haven’t personally felt the negative effects it can have. Rather than jumping from thing to thing based on personal experience, it’s much more prudent to understand the long-term risk and return characteristics of each type of investment and make a plan that fits your long-term needs and willingness to take on those risks.
Risk of being undiversified
When investing, diversification is your best friend. Diversification has many different forms, but at its core it’s the practice of spreading your risk across many different investments so that no single investment has the ability to lose all of your money. So you not only invest in many stocks instead of just a few, but you also spread your money across stocks, bonds, real estate, etc. It’s the single way you can decrease your investment risk without sacrificing your expected returns.
One of my big problems with real estate as an investment, especially for young people, is that it can leave you extremely undiversified. Even if you only purchase a $50,000 home, how big a percent of your net worth is that? 50%? 90%? Chances are it’s pretty high, which means you’ve just hinged most of your wealth-growing potential on the prospects of a single piece of real estate. That’s a big risk that you should think long and hard before taking.
There are two big lessons we need to learn from Erin’s story:
- There is risk in every investment. Successful investors understand the different types of risk involved in each and create a diversified investment plan that meets their individual needs.
- Don’t let recent or personal experience play too big a role in your decision-making process. There’s a lot of randomness to short-term behavior and basing your long-term decisions off that randomness can be incredibly detrimental. Instead, take some time to understand the long-term behavior of each type of investment and base your decisions off that.
Photo courtesy of Eliza