When it comes to investing, really, who doesn’t love a good deal? We are all well aware that if you want to get to early financial independence, you must amass a good amount of wealth in a relatively short-period of time.
What’s the best way of accumulating wealth?
Most freedom fighters like to focus on consistent cash flow. Some like appreciation. Regardless of the route you take, though, everyone will experience a good degree of bumps and bruises along the way.
That’s just how markets work.
Every asset class is cyclical so turbulence along the way to early FI is to be expected.
The key to navigating through these tricky waters, I believe, is to convert some of that same turbulence into opportunity; focus a portion of the offensive gameplan on buying up the most undervalued assets at any given time.
On the surface, a 50% drop is a 50% drop… It doesn’t matter what heights you started from. If you have $10,000 invested into a stock and it gets cut in half, you’re left with $5,000. Similarly, if you are invested in a $500,000 residence and it falls to $250,000 due to a market crash, nominally speaking, you’re out the same amount of percentage points as the stock investor.
After all, 50% is 50%.
In either case, both freedom fighters are probably not going to be too happy with those end results!
But it can become all too easy to generalize nominal values as being reflective of true value, or the risks involved with the underlying asset under consideration…
Again, let’s use another example to illustrate this point.
Let’s say we have two stocks, Stock A and Stock B. For all intents and purposes, let’s assume everything about these two investments are EXACTLY the same (industry, revenue, profits, debt, share structure, etc.).
The share price of each stock proceeds to witness the following decline:
In both cases, Stock A and Stock B are starting from the same nominal value of $10.00. If Speculator A purchased Stock A in 2015 at $10.00 and continued holding until after the 50% haircut in 2016, the underlying asset would now only be worth $5.00.
Similarly, if Speculator B purchased Stock B in 2011 at $10.00 and held it while it was at $5.00 in 2012, the results would be identical as in the first scenario, a 50% drop (provided we froze time at this point and didn’t let the remainder of this story play out)…
But what if Speculator C came along in late 2015 and picked up shares of Stock B while it was trading for $0.625? If we map out the final data point, we will see that this speculator will have no better luck than the others, as Stock B will proceed to slump to $0.3125 in 2016, an identical 50% reduction as in the other cases.
So, again, 50% = 50%, right?
Well, not really…
Although in each particular moment when the stock is down 50%, all three speculators will experience the same EXACT pain (assuming the same initial capital investment was made for each specualtor), the final verdict will most likely be vastly different for all parties.
When it comes to speculating, it’s especially important to consider valuations (current, historical, and to a degree projected future).
For instance, what if Stock A was vastly overvalued in 2015? A drop from $10.00 to $5.00 might have simply been a reversion back to the mean… If that is indeed the case, then you can imagine how tough a time Speculator A might have in holding onto the stock; not in hopes of making a profit, but just trying to get back to break even on the investment!
The same logic would apply for Speculator B.
But for Speculator C, the story could be completely different. If a reversion to the mean for Stock B is also $5.00, then being able to pick up shares at $0.625 must be considered a fortunate gift! “An opportunity of a lifetime”, as is often stated… provided the asset being purchased is of high quality and not junk, of course…
Yes, in the short-term, Speculator C experiences no better luck, and also has to stomach the same unpleasant 50% drop, down to $0.3125. In fact, the stock could even decline further and get slashed 50% yet again before it finally recovers!
That’s of course the risk you take with any speculation, but again, that’s why a speculator needs to rely on valuations; it serves as both your roadmap and compass…
How else would you have any idea of where you are, or where you might be headed next?
For this speculation to work out, Speculator C might need an iron stomach (and a ton of patience) to get through the volatility, but in the quest for early FI, there really is no better way to turbocharge progress than to speculate on deep value propositions.
In the case of Speculator C, at $0.625, a reversion back to the mean would require an 8x increase just to get back to $5.00.
Deep value investing, or the coiled spring approach, can produce massive total returns, but there are NO guarantees, of course… To execute this strategy successfully, a speculator must choose asset classes (investments) that have a better than reasonable chance of not only returning back to their previous means, but to overshoot to the upside.
What type of investments are we talking about? Well, in 2009-2013, housing was the name of the game… In 2015 (and presumably over the next few years moving forward), it looks like commodities are and will continue to remain in disfavor…
As a freedom fighter, quite frankly, I don’t discriminate… I’ve learned to accept whatever the market hates with great glee.
Don’t look a gift horse in the mouth…
Currently, my commodities speculations are down about 15%… Now, I have no way of knowing where I currently reside on the Stock B spectrum of discrete values… My own guess would be that I am currently trading at least in the $1.25 range, possibly lower…
$1.25 back to $5.00 represents a 4x jump, or 300% return…
Do I believe we’ll get there?
Yes, in due time… which helps explain how I can accept these “devastating” paper losses in stride.
After all, as outlined above, not all drops are created equally. And as I’ve mentioned before in the past, I like to get into speculations AFTER they’ve already been chopped in half numerous times (similar to Speculator C)…
Falling from a skyscraper can be devastating… but rolling off a mattress (with no bedframe) onto the floor?
That shouldn’t hurt too bad…