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  • shauchi

Math vs. Emotion

Updated: Mar 7, 2019

Most investing is driven by two emotions: fear and greed. Math, on the other hand, has no relation to emotion. Math exists. It is a tool to help us see the world. Math tells us that buying lottery ticket buys us a miniscule chance of winning. Emotion tells us that buying a lottery ticket is fun and give us a chance to fantasize.

Emotion leads to poor investment choices. Financial advisors talk about risk tolerance. They ask questions to see what kind of investments let you “sleep well at night”. What they are really trying to do is estimate how much fear drives your decision making. Their investment plans start from an “ideal” plan for maximum gain as determined by their parent company and then are ratcheted down in both gain and variability until they fall below your fear threshold. This approach makes no effort to change our behavior, However, we would all be much better off if we could eliminate fear (and greed) from our decision making.

Let us take an example of a person with $100,000 available to invest in stocks who decided to take a chance on buying Facebook. The price of FB dropped below $20 about 5 months after its IPO. In the summer or 2018 (a bit less than 6 years later), the price of FB rose above $200. In the investing world, this would be considered a home run. Fear would make you think that buying a single stock is too risky, Mutual funds can hold hundreds of stocks, so perhaps I should not have more than 1% of my money in any single stock. $1,000 invested in FB would have turned into $10,000. Congratulations.

The S&P 500 over that same period of time had a return of about 117% (with dividend reinvestment) If you had not invested in Facebook at all and just kept everything in an S&P 500 index fund, you would have ended with about $217,000. Since you had invested 1% of your money in FB instead, you ended with about $224,000. If instead, you had been willing to put 10% of your money in FB, you would have ended with about $295,000. Fear would have wasted your home run. A 1% investment would not have shortened your financial independence date by more a few months. A 10% investment could have shortened your financial independence date by years.

Of course, most stocks do not rise like Facebook. What if your stock choice had essentially remained flat over that same period of time? The 1% investment would have resulted in about $215,000. Meanwhile, the 10% investment would have resulted in about $205,000. So, picking a loser would result in financial independence being put off by 1 month (1% case) to about 6 months (10% case).

Greed (and perhaps hubris) would lead you to put all of your money into a “sure-fire winning stock”. If you had picked a stock like FB, you might already have reached financial independence. However, there were many more stocks that acted like KMI over that time. Picking a stock like that would have set back your financial independence plans by any where from 6 to 10 years.

So, what is the moral of the story? If you are willing to risk putting money into a single investment, put in enough money to make a real difference. I think this requires at least 10% of your money. On the other hand, do not put so much that it could derail your financial independence by more than 5 years or so. I think this puts a cap of at most 20% of your money.

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