Village builders

Block 8: To Buy or Not to Buy...Is That Even the Question?

Historically the market (generally meaning the S&P (Standard and Poor's) 500, a collection of 500 American-based stocks) has climbed, on average, around 10% per year. Certainly not bad! Then again, that number is an average. Some years are terrible and some years are much better. For instance, in 2008, the Financial Crisis, the market fell 37%. However, the next year it was up almost 27%. That is just to say patience pays. You can’t control the market, all you need to focus on is what you can control.

 

One thing you can control is if you decide to invest at all. If the market goes up 10% a year, that is the opportunity cost you are implicitly giving up for every dollar you are not investing.

Let us add to the argument. There is a little something called compound interest. Warren Buffett, the world’s greatest investor, uses a snowball analogy to explain it. When you roll a small snowball down a hill, more and more snow sticks to it and eventually a giant snowball is formed. Compound interest is the same. If you put $100 into a bank account with simple annual interest of 5%, you get $5 every year. But if that interest compounds, in the second year, the bank will pay you $5.25 (5% of $105). That extra 25 cents doesn’t seem like a whole lot but just like that snowball, it all adds up.

 

Apparently Einstein called compound interest the 8th wonder of the world. He probably said that because our brain has a hard time comprehending it. Our brains are really good at figuring out linear functions. 1 hour of work = $10, 2 hours of work = $20 and so on. That’s linearity. But compound interest isn’t linear. It seems like it is but it is an exponential function, meaning it is actually like a hockey-stock curve.

 

For instance, if you have $5,000 in your piggy bank (a very large ceramic pig indeed) and you save 10% of your income (the median income is $57,000) so let’s say you add $5,700 to the stock market every year, after 10 years of 10% returns, you end up with a nest-egg of $113,000. Not bad! But here’s where our brain has a hard time figuring out this whole compound interest thing. If you keep that same routine going for 35 years, you end up with…dun, dun, dun…$1.84 million. Pretty solid! More than 16x the amount after 10 years. Don’t even get me started on 50 years.

 

So the question isn’t so much, to buy stocks or not to buy stocks, that seems fairly clear. The question then becomes, what about my individual situation? You are really good at asking questions, you know that?