This article seeks to help college students and young professionals who are lucky enough to have extra money to invest in the stock market. I believe that the young investor should not be afraid of taking risks and making mistakes; however, there are two mistakes that should likely be avoided. The first mistake is going all in on risky plays and high maintenance investment styles. The second mistake is chasing losses.
Jonathan Burton notes that that a 25 year old who initially invests $10,000 and adds $320 per month to their retirement account with a 7% compounding rate of return will have $1,000,000 at age 65. This would be a great accomplishment; however, let's use a compound interest calculator to play with the math. An investor who did the same as above but started at 18 would have over $1.5 million at 65. Starting at 20 the investor would have $1.3 million. It is important to remember Warren Buffet's famous quote: "Someone is sitting in the shade today because someone planted a tree a long time ago."
Fellow SA contributor Henry Bee gave an overview of mistakes to avoid as a young investor. His article takes the stance that a mistake can cost a young investor hundreds of thousands of dollars over their life. I think this is a very negative view that may discourage young investors from taking risks necessary to be in the market in the first place. Bee is correct in stating that, considering time value of money, losses early in an investor's life will become amplified over time. The flip side of this perspective is that any investor is highly likely to make mistakes at the start of their foray into investing and will likely make more investing mistakes throughout their life. A young investor might as well start young, make a few mistakes while they are young, and learn from these mistakes. With mistakes come experience and the young investor can use these mistakes to become a better investor in the future. The young investor will be far ahead of another investor who waited until later in life to make the same mistakes.
This all being said, there are two mistakes that I believe a young investor should avoid.
Mistake #1: Going all in:
I keep an eye on both the "Investing" and "WallStreetBets" subreddits on reddit.com and believe that the audience for this article likely has utilized reddit as an investing resource. One prevailing theme, primarily on the WallStreetBets is "going all in." The idea behind "going all in" is placing the entirety of one's investable funds in a high risk equity or financial instrument such as VelocityShares' 3x Crude ETN (NYSEARCA:UWTI) or a volatility tracking fund such as ProShares Trust II (NYSEARCA:VIXY). By doing so, the investor has the opportunity to make tremendous gains at the risk of tremendous losses.
I have no doubt that this is working for some and I also have no doubt that there are many in these subreddits who are far more knowledgeable about investing than I am. This being said, for a majority of people, I do not believe that going all in is a wise thing to do in relation to many of the plays discussed on these forums.
If the young investor is going to make mistakes that they can learn from and use to become a better investor in the future, that investor needs to make sure they can continue to invest after the mistakes are made. Financial Samurai's article outlines common investment wisdom that stock to bond ratio should be high for younger investors and become progressively lower as an investor gets older. For example the article notes that investors 0-18 should be 100% stocks, 20 year olds should be invested 80% stocks, and so on. The young investor must remember that these formulas presume low risk investment styles.
The young investor MUST always think about the risk they are taking on and the worst case scenario of an investment play. If the young investor is not going a conventional investment route (ex: long any number of blue chip companies), they should consider not following the traditional stock to cash ratio prescribed by advisors who are assuming lower risk plays. The young investor will be thankful for implementing a more risk conscious strategy if one of these high risk plays goes south. A possible better stock to cash ratio than going all in at 100% may be 50/50 when engaging in high risk plays. John Prestbo of MarketWatch notes that an evenly balanced portfolio allows an investor to have sufficient market exposure while lowering risk.
Those who frequent the "WallStreetBets" subreddit will know that UWTI is a hot topic of discussion. Just for an example, the following charts compare UWTI's performance to Vanguard's S&P 500 ETF (NYSEARCA:VOO) over different periods of time. VOO is just meant to be an example of a possible lower risk, long term hold.
There is surely a savvy investor who made nearly as much holding UWTI over the past 3 months as someone who held VOO over the past five years. That being said, there is another investor who lost nearly ninety percent of their investment in UWTI over the past year. On the other hand, a 23 year old who put $10,000 in VOO when they were 18 now has nearly $16,000.
The hypothetical investor who utilized a more risk conscious strategy for their $10,000 by following a 50/50 stock to cash ratio when investing their in UWTI managed to earn $2150 in three months rather than $4,300. This being said, the same investor who followed the 50/50 ratio for their UWTI investment lost $4,450 over a year rather than $8,900.
Below is a comparison between the performance of VIXY and Berkshire Hathaway (NYSE:BRK.B). Berkshire is a second example of a possible good long term hold.
Clearly, the holder of VIXY lost over all three periods. Notably, over five years the holder of VIXY lost over 95% of their investment whereas the holder of Berkshire made 90%.
Beyond the investment performance aspect of "going all in", I believe that the young investor should also avoid "going all in" due to time constraints. It is easy for anyone to become overly focused and spend undue amounts of time managing their portfolio. The young investor must remember that while their investment growth is important, growth in other aspects of his or her life is also important. Even if a young investor is doing well actively trading, he or she may want to look towards a more passive investment strategy that does not take away from time needed for school, work, family, socializing / networking, etc. Looking at the VOO versus UWTI example again, the current 23 year old who began investing in VOO at 18 did not have the same stress nor did he or she have to dedicate as much time to their investment portfolio as the same investor did attempting to play UWTI for unknown gains. Surely there will be winners and losers of varying extents over time with either strategy; however, some strategies may require less stress and time for similar results.
Mistake #2: Chasing Losses:
I believe that the young investor should feel free to try different investment strategies; however, he or she should also be ready to admit defeat and change strategy if necessary. He or she should not chase their losses, or continue to attempt to make money back using a strategy that has failed in the past. As Henry Bee notes, investing should not be like gambling. There may very well be a young investor out there who is excellent at timing the market intraday, throughout the week, etc. That investor may, for example, have earned very sizable gains trading UWTI over the past 3 months. On the other hand, most investors are not successful at doing any of these things over time. The young investor should not feel bad because, in this study, monkeys' stock picks significantly outperformed hedge fund managers'. This University of Missouri study highlights why we are so bad at market timing. Essentially, people who are more risk averse get scared and sell on a dip to cut their losses, only to buy back at a high to avoid loosing out on gains. As a result, people lock in their losses rather than avoid them.
If the young investor makes a few lousy trades trying to correctly predict when to buy and sell a stock, it is perfectly fine and many others have done the same thing. This being said, that investor should be honest with themselves and reassess their timing abilities. If this self assessment returns the idea that the investor is not good at market timing, the investor should not chase losses. He or she may consider finding a solid company, proven ETF, or a mutual fund to hold long term. For example, Vanguard and State Street both offer a multitude of proven investment products that the young advisor may consider and find to be a great solution.
I hope that this article helps the young investor. I believe that if the young investor avoids going all in, both monetarily on risky plays, and time / effort wise, they stand to gain. Furthermore, I believe that the young investor who avoids chasing losses and is capable of being honest with his or her self about their investing abilities stands to gain even more. Good luck!
DISCLAIMER: This discussion is not advice to buy or sell any stock. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.
Disclosure: I am/we are long VOO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.