I still remember it like it was yesterday: The day the secret of wealth-building was revealed to me.
There are many paths to riches, but as a poor kid growing up in Oklahoma, I wasn’t sure how to get there. However, after seeing my grandparents toil all their lives and retire on nothing but Social Security, I knew I had to find a way.
The secret was revealed in my 9th grade algebra class. My teacher showed us the power of compounding. It was the first time I had ever seen this magic. And I knew in an instant that I had the key to wealth.
The Formula of Wealth
I interpreted the formula as “Time plus compounding = wealth.” The math isn’t that difficult. I am a long-range thinker with patience. Retirement was on my mind at the age of 18. I calculated that to be a millionaire by the time I retired, I only needed to save about $35 a week at an annual return of 8%. That is a lower annual return than the long-term return of the S&P 500.
I knew I could do that. In fact, I knew I could save much more than that. I also thought I could earn a higher return than that, so I could reach my million dollar goal much sooner.
I did do much better than that in the early years, and I was far ahead of the timeline I had set by the time I was 30. But then I ran into a buzz saw that made me realize that my wealth formula was missing a term. In addition to time and compounding, you have to avoid big mistakes.
My First Big Mistake
I made one during the dot-com bubble. I had been investing on margin for a while. It really helps accelerate the path to wealth. At least, it does in a bull market.
I increased my leverage every chance I got. I thought I understood the risks, but I didn’t. When the dot-com bubble burst, it decimated my portfolio. I lost years of gains. The problem with investing on margin was revealed as the market was plunging. I had a long time horizon, and I was ready to ride out any volatility.
However, when you are heavily margined and the market crashes, the margin calls start to come. Then your positions get sold out from under you. There is no riding through volatility when your positions have been sold.
After that experience I revised my wealth formula to “Time plus compounding minus crucial mistakes = wealth.” And, having learned that hard lesson, I started to climb that mountain once again.
Don’t Take Risks You Can’t Afford
This is how I convey that lesson to people today. It doesn’t matter what the upside is if you can’t afford the downside. Let’s say it took you a long time to accrue $100,000. Then someone offers you a bet. You flip a coin, and if it’s heads you get a million dollars. If it’s tails, you lose your $100,000. Would you take that bet?
You shouldn’t, because you can’t afford that downside if it took you years to reach $100,000. Compounding will help get to you to a million, but not if you lose everything. (On the other hand, if you can easily replace $100,000, then that’s an attractive risk/reward.)
It all comes down to not taking risks you can’t afford. What are some of those risks?
Failure to diversify is a big one. I have a friend who works for a technology company that recently went public. He received stock options that are suddenly worth a lot of money. But his wealth is all tied up in a company that might not make it.
I told him he is running a big gamble. Yes, he “might” continue to ride that share price higher and higher, but if he loses it all he might not ever find the path back. I advised him to substantially diversify that investment.
There is a well-known story of a secretary who worked for Enron who put all her retirement savings into Enron stock. At one point she had accumulated $3 million of Enron stock. She never diversified, and when Enron imploded she went from being a millionaire to unemployed with no retirement savings.
A second big risk factor is leverage, which I learned the hard way. Leverage shouldn’t be taken lightly. It can completely wipe out your portfolio in a market that is crashing. You can be right 90% of the time, but leverage can wipe out all those gains you made when you were right.
Finally, don’t invest heavily in speculative stocks. It’s OK, and even fun, to have a small portion of your portfolio invested in high-flyers. But don’t overdo it, because those can quickly crash your portfolio.
Slow and steady wins the race consistently. But you will get there a lot faster if you avoid the big mistakes during the race.
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