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The compounding effect of excessive risk

The compounding effect of excessive risk

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Filed on 29. Aug, 2012 in Contributors

By Ben Esget
Contributing Writer 

One of my good friends recently told me he and a buddy have been attempting day trading.

I was shocked. I think of this friend as very conservative; he works as an engineer, lives below his means, and has never been concerned with trying to get rich quick. Knowing full well how low his odds of success are, I asked what percentage of his portfolio he was trading with.

To my dismay, it was most.

After some discussion I convinced him that such a strategy is incredibly risky. I explained that he’s competing with the best and brightest people in the world with nearly unlimited budgets to deploy, and highlighted research explaining how lower turnover is correlated with higher returns. Finally, he asked a question that was very difficult to answer: If he wanted to continue experimenting with day trading, how much should he set aside to do this with?

After some contemplation, I have decided the best answer is zero.

It’s often thought when someone is young they can afford to take risks because they have time to make up losses. Instead, I would offer risky ventures should only be taken with money that is outside of a retirement strategy, because even modest losses early on will destroy your compounding ability down the road.   Time is literally money.

Let’s say my friend speculated with 10 percent of his portfolio. On a $20,000 portfolio this would mean he is risking $2,000. But he risks a much greater loss than $2,000.

My friend is roughly 30 years old. Lets assume he wants to retire at the age of 65, and his portfolio will generate a very healthy 10 percent for the next 35 years. If he compounds his entire account at 10 percent for this period of time, his account would grow to $562,048. But if he risks only 10 percent (initial $2,000) at age 30 and loses it all, he effectively cuts out the value gained from his 35th year of compounding.

This reduces his final retirement amount to $505,843, and results in a loss of $56,204 (see graph).

Investing is all about taking risks—specifically, trying to take controlled, smart risks.

Capitalism functions on the backbone of people putting capital at risk. Famed investor Peter Thiel was the first investor in Facebook, and his willingness to take a large risk with $500,000 has not only been rewarding to him but to society in the form of increased GDP and job creation.

With icons such as Peter Thiel and Warren Buffett touted in the news media, it is easy to see why average investors want to try their hand in the speculation game. Speculation should be confined to funds that are not paramount to your retirement.

My firm’s research shows that investors habitually take too much risk, and most do not differentiate between core retirement assets and non-core retirement assets.  If you are considering taking more risk to increase your returns we recommend:

-Weighing the risk reward very carefully.

-Limiting the funds in this investment to non-core retirement funds.

-Keep your core-retirement funds in liquid, straightforward investments, ideally in a tax-deferred account

-Don’t rush in. Give it a week or two to settle in your mind. Contemplate if it’s too good to be true and identify the drivers of returns and risk

My advice to my friend: Follow the above parameters—and for speculation, only use funds you can afford to lose. Risk is great, but keeping it tempered in retirement funds is most advisable.

Note: The information in this paper should not be construed as investment advice. Everyone’s goals and investment portfolios are unique. Please contact a financial advisor or an accountant for your particular needs.

Ben Esget is the president of WealthMark LLC, an investment firm in Bellingham. His columns appear on BBJToday.com every other Wednesday. Esget also created the finance blog Outsider-Trading.com, in an effort to level the playing field between Wall Street and Main Street. Contact him at 360-734-1323 or ben@wealthmarkllc.com. 

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