I’m hearing from a lot of people who have recently become interested in investing in individual stocks. While I’ve always been an advocate of buying individual stocks, doing so at the upper end of a market can be hazardous to financial wealth.
Avoiding annual maintenance fees charged by mutual funds and ETF’s enables investors to grow their investments much faster. Now with no commission stock transactions, the investor doesn’t even have to pay to buy or sell – a huge advantage.
Some may think a ½ to 1 ½ percent annual fee isn’t much, but unlike other transactions, the fees have a “negative” compounding effect. Each year the fees are levied on the total value (not just the gain) of the fund or ETF, which means less money is working for the investor. Add the lost compounding effect of the funds that are “fee’ed” away and it means big bucks over the long term, but that is a subject for another day.
Anyway, if someone buys stocks at the upper end of the market and the market drops, the percentage amount that has to be made to recover can be significant. This is a fine point that every investor should be familiar with.
Suppose someone invests $100 in a stock at the top of the market and the stock drops to $50. This is a 50% drop. Now to get back to $100 requires the investment to increase 100% ((100/50)-1). Paying too much and experiencing a 75% drop, requires a 300% return ((100/25)-1)!
Attached is a chart showing the percentage increase needed to get back to the original value for a variety of drop percentages should the market fall. The amount needed to get back to the starting point grows much faster with each percentage drop. This is big reason why buying at too high a price can be very hazardous to financial wealth.
The chart doesn’t use higher math, but very simple math. Start at $100 and assume different percentage drops. Now calculate how much it takes to recover to the original amount of $100.
Viscerally understanding the attached information is essential to know when investing. Paying too much at the wrong time can and does cause irreparable harm to someone’s wealth. Maybe the investor hasn’t seen an 80% drop in their experience, but a study of history shows that it is common over time. The seminal book on value investing, The Intelligent Investor, has many examples of this occurring and an 80% drop needs a 400% increase just to get back to even!
Many market participants have experienced painful drops over the history of investing. No one is immune to the vagaries of the market. Stay clear of this trap.
Be smart, be well-read and be successful.
