Grow your wealth - Thinking linearly can be costly

Thinking linearly can be costly

The other day, my wife and I were talking to our 16-year-old son about how to deal with people who hold strong views on certain emotive topics, especially when they have a ‘different perspective’. To be honest, he already has a constructive approach to dealing with such situations, but I pointed out that he is entering a time of his life (he is 16 years old) when his peers will start breaking free of the parental shackles and form strong opinions of their own. Over time, these opinions may well mellow as they get a more rounded perspective – although the presence of social media may make this less likely than in the ‘good ol’ days’.

This led me to think about some of the strong views I had when I was younger. As a young investor, when I was new to the finance industry, I felt strongly that equity markets were entering bubble territory. Therefore, I withheld from investing my meagre capital, waiting for a better entry point. In hindsight, this was a mistake.

While one could argue that my analysis of a bubble was right – the stock market was at that time heading towards the dot-com boom and bust - if I had invested GBP 1000 of my first pay packet into the FTSE 100 index in August 1995 and left it there for the past 27 years, that would be worth over GBP 5400 today. If I delayed 10 years (to August 2005), then the investment value would be reduced to GBP 2600. That is, for giving up just over a third of the investment time period, my investment would be worth less than half. Of course, when you express this in terms of returns, the comparison is even more stark. The returns over the two periods are 440% and 160%.

Of course, the analysis uses an arbitrary 10-year delay. Let’s say I timed my entry point ‘perfectly’, investing right at the bottom after the dot-com bubble had burst (in January 2003); the returns would have been 325%. If I had waited 12 months, presumably when it became clear that the recovery was for real, the returns would have fallen even further to 233%.

There are two key lessons here. First, nobody knows for sure what is going to happen in the future. Therefore, trying to excessively time the markets is usually not a good idea for the average investor, or even the average professional investor.

Second, is the power of compounding. Most people are conceptually aware of compounding. However, I do not think most people fully comprehend its power. I think there are two main reasons for this. First, our brains are wired to think linearly. This means that, while we understand the benefits of compounding, we underestimate the quantum of the benefit. Second, people focus too much on near-term returns, worrying about the short-term cost of entering the market too early and thus missing the long-term performance.  

Putting these together, let’s expand the analysis above. Let’s assume that I live to the ripe old age of 100 and that, going forward, the equity market return will be 5% a year. If I had invested GBP 1000 when I started work in 1994, this 1000 would be worth almost 89,000 when I turn 100. If I had invested at the post-bubble low, this sum would be just under 65,000, and if I invested 12 months later, it would be just over 50,000. While the difference in wealth levels today look relatively insignificant, the impact over longer time horizons is huge.

So, what does this mean for an investor? I understand that dealing with uncertainty is the hardest thing we all face. However, deal with it we must. I have shared with you the potential costs of delaying. Here, I have only covered one asset class and one forward-looking scenario, and this is a simplification. Uncertainty is high right now. However, markets are already on sale. Could the sale become even deeper? Absolutely. But do you want to bet your financial future on it? Perhaps not. Therefore, it is critical that you have an investment plan in place as this helps you keep in mind the long-term benefits of compounding rather than getting buffeted by day-to day news flow.

(Steve Brice is Chief Investment Officer at Standard Chartered Bank’s Wealth Management unit.)