October 17, 2012

Investing to be rich

If one wants to be rich, one should learn how to invest on your own…right ? that way you can compound your capital and retire rich ! Isnt that obvious ?

If I am asking this question, you can guess I don’t believe it to be the case.
I get asked this question in different shapes and forms and a typical email goes like this

Rohit – I am currently X years old and want to become financially independent in the next 10 years so that I can purse XYZ (insert a dream here). Can you suggest how to become a better investor so that I can have enough money in a decade to pursue my dream ?
What does it take to be an active investor ?
It takes a  few hours a week for a year or so to become financially literate, which involves having a reasonable understanding of various investment options such as fixed deposits, mutual funds, stocks, and insurance etc. Once you reach this level of understanding, you can with a moderate amount of effort,  identify a mix of assets which will help you earn around 12-14% return per annum (depending on the mix of debt and equity)
In effect, you can spend a few hours a month and earn 12-14% on your assets over the long term. We can call this a baseline level  of effort.
Now lets assume that you are not satisfied with the above returns and would not settle for anything less than 20%+ levels (around 10 times in the 10 years). If you wish to achieve these level of returns, then you  need to invest atleast 15+ hours a week on learning various aspects of investing and in finding new opportunities on a regular basis.
What is the return on time in case of active investing?
So what do I mean by the term – Return on time ? Let me illustrate with an example.

Let’s look at a typical case of a young professional who has a full time job. Let’s assume the following
Annual salary in year 1 = 10 lacs
Annual savings  in year 1 = 5 lacs (I know this is too high, but we are considering an optimistic scenario)

Salary increases each year by 10% and so does the savings. This individual has two options for his/ her savings. They can be financially literate and spend minimal time (a few hours a month) and earn around 12-14% per annum or spend 15 hrs or more on investing and earn a much higher return.
Lets also assume the individual works around 40 hrs each week in his / her job  (would be higher in reality)
So whats does the return on time (money earned per hour spent) look like for the person in terms of active investing ?
 Lets look at the table below
I have plotted the savings, the extra returns earned by putting in  extra hours each week (15 hrs per week) and the per hour return
A few things standout,
In the initial years when one has a small level of savings and is just starting out, the per hour ‘salary’ from investing  is way below the per hour salary from a job. The higher your education or skill, the larger the gap.

This is the best case scenario. The above picture worsens if one gets hit by a bear (a certainity in a 10 year period). The last column shows that this ratio becomes favorable only after  8-9 years

Implications of the analysis
The above analysis though silly,  lead us to a fairly important conclusion. If the only reason you want to become an active investor is to make more money, then it is not a very smart way to do it.

For starters, all the time spent in the initial years will appear to be a complete waste of time. Most of the people soon realize that the extra returns are really not worth the time.
In addition, if you start late in a bull cycle (as most individuals do), the quick and easy returns are soon lost in the subsequent bear market. In most cases, such individuals throw in the towel and move on to other pursuits in life.
Finally, the additional hours spent on investing means that one does not have time for any other pursuits like having girlfriends or other hobbies  at the prime time of their life (early to late 20s).
My personal story
The above table and discussion is not theoretical. I have personally lived it for the last 15 years. I started investing in the late 90s (around 1997). I think I was financially literate by around 1998 and around that time came across the book – The warren buffett way. I read about this person who had become the second richest person by investing in stocks and was completely mesmerized by it.
I read the biography of warren buffett (Making of an American capitalist) and his letter to sharehlolders and anything else I could find about him. It was in late 1999 , early 2000 that I finally turned to active investing.
As you can see, my timing was perfect. I made some money for around 3-4 months of 2000 and then lost all the gains by the end of year - some on paper and some of it was a permanent loss as I had put money in IT/ Internet oriented mutual funds (don’t ask what I was thinking).
The years from 2000-2003 was one long bear market, where the market slowly went down from 4000 levels to around 3000 in a period of three years. If I put the numbers in the earlier table, my ‘salary’ from investing was negative, whereas I was making a good income from my full time job.
Any rational person after three year of losing money, would have given up investing and move onto something else in life. I did not even think of it as I was extremely passionate about it and inspite of mediocre absolute returns, I was still beating the market by a large margin.
The market turned in mid 2003 and as it took off for the next 5 years, so did my portfolio.
Better way to well
As you can see from my personal experience and from the analysis, that investing is definitely not a quick or easy way to becoming rich.
Let me suggest an alternative – If you are really passionate about something or good at your full time job, focus on it and get better at it. You will have fun doing it and over a decade you will make a decent amount of money out of it. Invest the money saved, sensibly by becoming financially literate and you will realize that not only is your life more pleasant , but  that you also have enough tucked away for a rainy day.
I know this is not the conventional wisdom and we have a cottage industry of people  encouraging others to invest on their own. I would rather follow my interest/ passions and become good at it (the money usually follows then), than do something just for the sake of a little extra money.
 
In case you wondering about the life I had outside work and investing early on …I am not going to disclose than on my blog and get in trouble with my wife J

19 comments:

mkd said...

Hi Rohit,

Once again, excellent points and thoughts which have been laid out very well.

In anything we do, its the passion and interest which matters a lot. So although direct investing might mean more returns but may not be everyone's cup of tea. Not because of capability but rather because of interest and passion.

Persistence is key in this game, and despite bull or bear runs, despite good picks or bad picks, despite making superlative returns or not, the ability to learn something new everyday and enjoy it while learning will help us excel at it.

Once we excel at it, returns will just be a consequence along the journey.

Anonymous said...

This is why the blog is so nice, really liked the last few golden words..thanks.

Anonymous said...

Excellent write up.. good confidence booster for newcomers in investment field. I was wondering that this would have been true for a investor in last 10-15yrs in any of the assets like real estate, gold and equity.

Abhi said...

I believe if one spend a good 5-8 years of his life unearthing deals, studying markets and analyzing balance sheet and if you have a passion for it and honestly asses your mistakes one reaches a point where next 15-20 years becomes much more easier spotting and opportunity. Basically what I am trying to say is you know what a opportunities not to consider and hence not waste a your time and therefore becoming efficient. And therefore you should get more return on your time.
I feel much this way as I have personally seen that happen to me. I am not saying one becomes a master , but fairly confident in your ability to asses a investment call with lesser data and greater probability of being right (and one can never be 100 % right).

Stable Investor said...

A really wow post Rohit :-)
We really like the concept of hourly income from investments idea.

Anonymous said...

A very practical article. Many people get swayed during a bull run and unnecessarily loose money and confidence. I have seen people dump their jobs and repent later.

A practical way is to use the Investment/Job and see if it makes sense to switch or not.

Even if this ratio may be favorable, one may may want to hold to his/her job if passionate about it. After all money is just a means to and end.

Anil Kumar Tulsiram said...

Excellent, simply love your idea of salary per hour of investing. I have always believed that DIRECT INVESTMENT IN STOCKS is only for people who can devote substantial amount of time to investment, for others MFs are best (again one needs basis understanding here, else will be cheated by financial advisors).

Just out of curiosity, how do you manage your full time job and investment activity. Any tips on time management.

Rohit Chauhan said...

Hi mkd
agree with you and its not just investing as you said, its true for any meaningful pursuit in life.

it is the passion and persistence more than talent which makes the difference. most of us will not be warren buffetts, but can get much better over time if we have the interest in the craft

rgds
rohit

Rohit Chauhan said...

hi anon
it is true for any type of investor and for all asset classes, some more than other

if an asset class makes 10% versus other makes 20% then you will make more in absolute terms in a higher returns asset class

rgds
rohit

Rohit Chauhan said...

Hi abhi
exactly my point ...key point being ' if one spends 5-8 years' how many can do that without much to show for unless you like doing it ?

its almost the same time one needs to complete graduation and post grad (even more). you are assured a degree and usually a decent job at the end of it (notwithstanding the pretty girls in the class).

in comparison investing is a solitary acitivity ...not many people will commit themselves to 8 years of it

rgds
rohit

Rohit Chauhan said...

Hi anon
you are right ...i have used the same approach. always kept my day job as i learnt investing. that way my family was always taken care of.

it is also less pressure from wife and others when you are doing this on the side and can do it at your own pace. full time investors are under pressure to make money sooner as they have to support themselves

rgds
rohit

Rohit Chauhan said...

Hi anil

true ...inpsite of the bad name ...MF are better than other options. ofcourse one needs to find the decent (not necessarily the best options)

on finding time ...well i have a patient and understanding wife who tolerates my interests and gives me the time and space to follow it - as they say behind a man ...is a women ...i have two - mom and wife

rgds
rohit

Anonymous said...

Hi Rohit,
Excellent post, on a lighter note if you are in IT you have option to finish up your work in 6 hours and then spend remaining 2 hrs reading some stuff you love (market) pretending as if you r doing something important work :-)

Anonymous said...

Nice one!

Mokhtar said...

Very well put! Specially the comparison with your own life story in the market.

I could only think of this after reading your article.Investing is simple but it we people/industry who make it seem complicated.

Cheers

Dhwanil said...

Hi Rohit,

I think you have articulated the problem extremely well. However, I would like to point out here that this model may be a good guide for someone who has just started earning and building wealth from zero. But in my opinion, result will be quite different if one has taken a disciplined approach in initial years and have saved money to compound for 10-15 years at decent average rate (13-14%) to build a sizable corpus (now sizable corpus is a relative term with direct corelation to current salary of investor)while not becoming full time active investor. Once this corpus reaches a critical threshold limit, the effect of compounding will far outweigh the salary increase one may get over a period of time due to differential in rate of return versus average annual increase in salary that one would normally expect.

Hence if one is seriously considering active investing as full time activity, one has to start early, save decent proportion of income and earn average/above average returns on saved money to reach critical scale. Once this critical/threshold scale is reached, one can decide to become active full time investor. Even in this scenario, I see a possibility of cash flow mismatch from income from investment returns and meeting with monthly expenses.

Best Regards
Dhwanil Desai

Rohit Chauhan said...

Hi anon
nice tip :)

hi mokhtar
thanks for the comment

hi dhwanil
agree partly with your comment. yes one can work full time and make 13-14% of slightly above average returns during the this time. once the corpus reaches a certain level, then the investment income is high enough

the issue is that at that time, if one wants to be a fulltime investor, then the skills have to be good enough, which means that you should have spent the last 10+ years working hard and learning how to invest. so in a way we are in a chicken and egg situation

in summary, one will need 8-10 years to save and get the required skills where the investment income will become big enough that one can do it full time. till then, one needs to pay the dues

rgds
rohit

Ginto Tharaniyil Mathew said...

Hi Rohit,

Excellent post.

This answers several topical questions such as;

a) should I quit my job now and become an active investor (the frequency of this question is directly proportional to the index levels :) )
b) how do I quantify the cost/benefit ratio of an active investment pursuit
c) how long does it take for the active investing pursuit to match/overtake the other regular income source
d) how big should the investment corpus be to match/exceed current returns from primary source of income

It is hard to argue with the numbers. You have just showed that some problems can be analyzed better by looking at them quantitatively.

Your journey is a huge inspiration for me (as for many others in your huge fan base I am sure). I draw courage from your posts to stick with the game and to be brutally honest with self.

I can vouch from my own experience over the past 15 years that the baseline return expectations and the time it takes to learn literacy and proficiency in the investment language are indeed the amounts your quote above.

Also it really does help to have an alternate engagement in which you can immerse yourself in in periods of utter agony or crazy euphoria in the market.

Regards
Ginto

Bhavik Kakkad said...

Hi Rohit,

Thanks for sharing this post. Your post very well articulates the key messages and gives a lot of pointers to think about to anyone keen on pursuing the craft - either full time or alongside the current job.

Once again, thanks for sharing!

Bhavik