Compound Experience, Not Just Interest

I’m really excited to bring you the below guest post today because it comes to us from one of my blogging heroes, Tadas Viskanta of Abnormal Returns.  Tadas is one of the most knowledgeable investment writers of this generation, on or off the web.  He reads everything and he points to what matters while skipping what doesn’t.  He’s also got a brand new book out called ‘Abnormal Returns’, it’s the must-read investment tome of the summer. 

Anyway, this is a great post for investors of all experience levels, Tadas is talking about some elemental stuff here, enjoy! – JB

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Gen Y hates stocks. One recent study shows 40% of Generation Y agreed with the statement that “I will never feel comfortable investing in the stock market.” As Josh Brown at The Reformed Brokerwrites:

The Generation Yers – now in their twenties and early thirties – want absolutely nothing to do with the stock market.

In their early teens, they watched their parents get destroyed by the dot com bubble, Enron, Worldcom, and then the World Trade Center attack just to put a cherry on top…

During the brief stint that Generation Y has been conscious of the adult world and the embryonic fluid of finance that succors it, they’ve seen nothing but death and dismemberment emanate from Wall Street.

It’s hard to blame them. Who wants to invest in an asset class that for now well over a decade goes nowhere? There is nothing like a ‘lost decade for stocks’ to put a generation of potential investors off stocks. Now to add insult to injury the one deal that seemed like a no-brainer, the Facebook IPO, launches to trading problems and a 10%+ drop on its second day of trading.

Then again, Gen Y is not unique in its hatred of stocks. Individual investors hate stocks. Ever since 2008 individual investors think that the stock market has a higher chance of a crash than they ever did before. Rich guys are all about holding big slugs of cash these days. Investment strategists hate stocks and are recommending low weightings. Indeed most Americans think that gold is in fact the best investment they can buy for the long term.

One could argue that all of these are signs that we are coming closer to the end of the secular bear market we have been mired in since the start of the new millennium. Secular bear markets happen to be a great time for investors to learn the lessons of risk and return. Why? Because we see these cycles play out in a much more rapid and concentrated fashion. Secular bull markets are in contrast a tough time to gain much perspective on the true challenges of investing.

That is why it is so important that Gen Y investors take advantage of the opportunity to invest, especially in tax-advantaged accounts like 401(k) and IRAs, early on in their careers. When the tax laws are working with you, the odds are put in your favor no matter where you decide to invest. The traditional argument for saving early (and often) in one’s adult life is compound interest. Which is of course is true. That being said it is unlikely that Albert Einstein ever said compound interest was “the most powerful force in the universe.”

In my book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosophere, I write that “savings is the best investment.” By that I mean that it is far easier to generate additional savings through more conscious consumption than it is to generate additional returns, or alpha, from the financial markets. So starting early with a dedicated plan to live below your means is an important part of any comprehensive financial plan.

More importantly as a young investor you get a chance to make your novice investment mistakes while the stakes are, in actual dollar terms, relatively low. Or as said in a different context, “You only get one chance to be a beginner.” Wouldn’t you rather experience your first bear market when you are 25 and you have $5,000 in your 401(k) plan than when you are 50 and retirement is beginning to stare you in the face? The experience gained when you are young will help you when the stakes are ratcheted up later on in your career.

Therefore a more important, and relevant, concept isn’t compound interest but compound experience. By that I mean compounding experience upon experience. Taking what you learn from one experience and applying it to the next. In this context, piling lesson upon lesson helps generate much greater insights than trying to learn everything all at once and under intense pressure. Blair Livingston writing at his blog about the lessons of college life states:

The best insight into the whole process of compounding: it’s not how you finish, but how you start. How you finish is determined in part by you, but also largely by factors beyond your control – the competition, other people, etc. How you start is 100% within your control. If you start strong, layout good practices, and develop fruitful habits, you can set yourself up for a much easier journey.

These very sentiments apply perfectly to investing and saving. In retirement no one knows what kind of market conditions we will face over time. In part it depends on luck. However if you have established “good practices and fruitful habits” you will be better prepared to deal with the inevitable challenges we all experience as investors. Future retirees and near-retirees facing their first secular bear market will be at a disadvantage to those Gen Yers who embraced investing early on and who compounded not only interest, but experience along the way.

Items mentioned above:

Generation Y.  (Wikipedia)

MFS Investing Sentiment Survey.  (MFS Investment Management)

Gen Y: Post Traumatic Stock Syndrome.  (The Reformed Broker)

Facebook investors left guessing after Nasdaq glitch.  (Reuters)

Facebook drops on second day of trading.  (Bloomberg)

Individual investor sentiment nears two-year lows.  (Bespoke)

Yale School of Management Stock Market Confidence Indexes: Crash Confidence Index.  (Yale)

Is cash the new black?  (Big Picture)

Here’s the good news.  (The Reformed Broker)

Gold still Americans’ top pick among long-term investments.  (Gallup)

Invest in stocks? Forget about it.  (Big Picture)

Albert Einstein compound interest quote.  (Snopes)

You only get one chance to be a beginner.  (Signal vs. Noise)

I Wish I Had Known: don’t underestimate compounding in everything.  (Blair Livingston via @chicagosean)

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Thanks Tadas!

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