Although technology mostly took over the job of keeping track of nitty-gritty numbers in business, some feel that the good ole brain is the best way to keep track of the details. But it is very possible to be losing money by trusting the gut rather than running the numbers. Here are some ways of how investment math mistakes may lose you money.
Compounding is amazingly rewarding
Imagine you somehow saved the life of Jeff Bezos, the richest man in the world, and in his geeky manner, he offers you a choice of two rewards: either you get $1 million today or 30 days in which each day earns you double the cash of the previous day’s payout starting with just a cent. So, day one’s payout is a penny, day two’s payout doubles to 2 pennies, day three doubles again to 4 pennies, and so on for 30 days. Which would you choose? While most would likely grab the million dollars without a second thought, thanks to the magic of compound interest, the “double cash” reward totals $10,737,418 at month’s end! Even after people learn how compound interest works (Invest $100 at 10% compounding interest: year one’s earned interest is just $10 [$100 x 10% = $10], but year two’s interest is $11 [$110 x 10% = $11]), it’s still hard for the human brain to fathom how numbers grow or shrink exponentially over lengths of time. Investing is based on compounding, and even very successful businesspeople often mess up their investment math.
The house was a nice investment…
Although simple arithmetic in business may seem intuitive, the more confusing investment math can lead astray and potentially cost money. I had a client, Shloimy, who used his head for investing, rather than running numbers or hiring financial analysts to make decisions. He liked buying houses in frum areas with his extra cash; after all, his parents’ $1.2 million house had been purchased in 1960 for just $50,000. His confidence in the fantastic returns of investing in houses based on his parents’ experience is mistaken. Turning $45,000 into $1.2 million is very nice, but when you consider the 59 years it took, the compounded annual price growth was just 5.8%. While the house had some rental income (or the value of the family living there, which is the same thing), there was also a very significant cost in taxes and upkeep. This house was a really solid investment for Shloimy’s parents, but without running the numbers and comparing it to other available investment options, it’s not easily clear just how solid.
But stocks earned eight times as much
The actual numbers of stock mutual funds, will probably surprise you too. If you invest Shloimy’s $45,000 into a fully diversified stock portfolio and left it there for the same 59 years, its value would have grown to $10.3 million by 2019 (9.8%)! Note that although the compounding growth rate of stocks was less than double that of the house (9.8% vs 5.8%), the total accumulation in mutual funds was over eight times that of the house! This nonintuitive difference is another example of the complexity of compounding mathematics. While there are other compelling benefits to invest in a house versus stocks (desire for home ownership, avoiding stock market risks, tax and leverage benefits of real estate), it is not a simple financial comparison.
Hedge fund’s 15% turns into 6%
Running the numbers hedge funds would also probably lead you to a different perspective on its attractiveness. Most of these funds come with fees and incur taxes which eat up substantial portions of their growth.
The bottom line is: without a careful calculation of their compounding arithmetic, investors will take on more risk for less reward. While any investment “tool” —real estate, stocks, bonds, hedge funds, etc. —can do very well, using them without running the numbers carefully is a bad idea.