One of the questions Jason Hartman likes to ask young people is: What do you plan to be doing in five years? The reason is because when you are young, it is easy to become distracted by day-to-day events, and hard to keep your focus on longer-term goals. When school becomes boring and monotonous, it is important to visualize the future that will be realized if we are successful in our education and training. When working through a difficult project, it is useful to think about the longer-term prospects for our career. This places the current difficulties in context as a ‘blip’ in the bigger picture.
Unfortunately, many of us stop thinking in terms of a five-year plan once we move into a “grown up” career. This leads to becoming bogged-down in the daily ritual of work and life. The future feels far away, and our present concerns begin to crowd out our thoughts of future investments or achievements. As we move further down our current path, it becomes increasingly difficult to shift focus to a new paradigm that may offer even greater rewards.
It is critically important to consistently create a 5-year goal for your career that articulates the key milestones that you seek to achieve. The type of plan that we create will be highly influenced by where we are in our personal investing career. We like to think of this as the “Entry Point” for your 5-year plan. There are three entry points in particular that carry significantly different priorities. These entry points are the new investor, the growing investor, and the short path to retirement.
The New Investor
- As a new investor, one of the most important things to do is take action. However, there is another very important thing to consider for people who are just beginning their investing career. This factor is that early returns have a tremendous impact on long-term compounded wealth. In this way, capturing a higher rate of return will make a huge difference in your long-term investing career.
- In the nearby chart, two investors are illustrated. The first earns a 20% rate of return for the first five years of their investing career through shrewd analysis and intelligent decisions. Afterward, they reduce their risk and earn a 10% rate of return for the remainder of their 30 year investing career. The second investor captures a steady 10% for their entire 30-year investing career.
- By the time 30 years have gone by, the first investor has earned 54% more than the second investor, even though he earned the exact same rate of return for years 6 through 30. By earning a higher return at the beginning of his career when a higher amount of risk can be taken, the new investor can set himself up for long-term success.
- A particular advantage that new investors hold is that they can cherry-pick the most attractive deals for investing their capital. It is well known that the best deals in both stock and real estate investing tend to be small and localized. This makes it difficult for large investment funds to capture the exceptional gains since they have a large amount of capital to deploy, and it is simply too much work to seek out and close a high volume of small deals.
- Beginning investors have the opportunity to find deals that larger scale investors ignore. If these deals are used to generate a higher rate of return for the beginning years of an investors career, then it can be highly favorable for long-term wealth building.
The Growing Investor
- The growing investor finds himself in a slightly different situation from the beginning investor. As you gain momentum in your investing career, it becomes increasingly important to build stability into your portfolio.
- The importance of stability comes from the fact that it allows you to compound your investments at a steadier pace. By compounding more steadily, it allows the investor to avoid the destructive effect of major contractions.
- This principal is demonstrated by a hypothetical example of four investors with four different strategies. The first investor earns a steady 10% rate of return with no fluctuation. The second investor earns an 11% average rate of return with regular small losses, and less regular large gains. The third investor realizes a 12% average rate of return with large swings between gains and losses, while the fourth investor earns a 13% average rate of return with even bigger swings between gains and losses.
- The strength of the steady investor is that their wealth continues to grow while the returns of other investors gyrate wildly. In our example, the steady investor earns the most compounded wealth at the end of 30 years. However, even in cases where the volatile investor earns a higher compounded rate of return, there is significant risk to the strategy.
- Nobody knows when the time will come that they need to pull money out of their investments for some event such as medical expenses, children’s education, or any of the other things that tend to come up as we go throughout our lives. When our investment capital is highly volatile, a badly timed expense can cripple our wealth building. This is one of the key reasons why stability is important for growing investors.
The Short Path to Retirement
- As investors near retirement, the importance of stability becomes critical in nature. The reason for this is because losses reduce our base of investment capital, and the reduced capital must generate a rate of return that exceeds the total loss in order to break even. We separate the levels of loss and recovery for investors into three designations: the green zone, the yellow zone, and the red zone.
- The Green Zone occurs when your investment portfolio incurs a loss in the range of zero to negative 20%. This represents a bad year, but is relatively easy to offset because the percentage that must be gained is not significantly disconnected from the percentage that was lost.
- The Yellow Zone occurs when your investment portfolio incurs a loss in the negative 30% to negative 60% range. This represents a major hit to your wealth that will require a very long recovery time. Investors nearing retirement cannot well afford to absorb many years in the yellow zone, since it requires very high future returns in order for the losses to be recovered.
- The Red Zone occurs when your investment portfolio incurs a loss between negative 70% and negative 99%. This is a critical impact to your wealth that is frequently impossible to fully offset. For example, if your portfolio loses 90% of its value, the remaining capital must grow by 900% to simply break even with where it previously was. For investors nearing retirement, it is absolutely critical to avoid any years in the Red Zone.
As we have seen, the entry point for your investing career will have a dramatic impact on the type of investments you pursue, and the relative value of returns vs. stability. As you are constructing your five-year plan, begin by taking an honest assessment of your point of entry, and determine to what degree you need to prioritize stability vs. earning higher returns.
In the next part of this series, we will discuss constructing your detailed five year plan, building a holistic portfolio of investments, and discussing the characteristics of different investments that can be used to populate your portfolio. The five year plan is important for people at all stages of their investing career. Not only does it help us to build a blueprint for making our financial decisions, but it serves as a blueprint for thinking critically about the rest of the decisions that we make in our lives.
* Action Item: Take an honest inventory of where you are in your investing career, and evaluate it against the different entry point stages. This assessment will place you in an advantageous position to determine what actions should be taken to position your portfolio for long-term success.
The Jason Hartman Team
