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Paper Gains Don’t Count In Plans

January 24, 2012 Leave a comment Go to comments

There’s a story from the dot-com bubble that we’ve probably all heard many times. Someone made a modest investment in a stock that took off. Within a couple of years the value was far more than they invested, adding hundreds of thousands of dollars to their net worth. They started spending more because they had made it. And then the stock crashed and they were left with nothing but worthless shares and big debts. It’s easy to mock this, but are we making the same mistake in our plans?

We all want to think we’re too smart to plan around investing in a company with no profits and making 10x our investment within a year. But the same model can play out in many ways. The problem in the story above is that the value of the stock at one point in time doesn’t matter if you sell it later at a much lower price. This story is just one clear example. In smaller ways this happens very frequently and it can easily sneak into our plans.

Many people make plans based on what they expect in the next few years. They might buy stocks and say “they should go up for a few more years so this is safe”. But if they keep holding those stocks while the price goes down after, there was no real gain. The price of something doesn’t matter while you own it, only when you sell it.

It gets even worse than that. If you plan to retire when your portfolio reaches a certain value you probably won’t sell it all and stick the cash in a mattress. In fact if you plan well enough to have a long retirement you will want to keep a good portion in stocks to make it last longer. But remember the value of those stocks on the day you retire means nothing unless you can sell them for the same value later.

Forget what your portfolio is worth today. What you really want to know is what each part will be worth as you sell it and that answer varies. At any given time stock prices can range from very low to very high. If you’re selling small parts over a long time you’ll get many different prices and the end result may be close to the average. But it’s always important to think about the future. What you could get today by selling your entire portfolio doesn’t matter.

I’m a young, aggressive, and well-informed investor. Many others in this situation would use an all-stock portfolio and avoid bonds. But I keep a portion in bonds because it’s not the peak that matters, it’s what you get in the end. By regularly rebalancing into bonds when the stock values get too high I can make sure some of that is kept when they come back down.

I do everything I can to avoid deciding based on how I feel about different investments. Instead I evaluate each option based on the fundamentals of all investments including how much cash it makes each year, how fast it’s growing, what could go wrong, what I can sell it for later, and when I will need the cash. If you ignore any of these it’s at your own risk and you may have a surprise later.

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  1. January 30, 2012 at 1:26 am

    It is so smart to stay diversified. When I started investing 10 or so years ago, I did an almost all stock portfolio. Boy to I ever wish I had put more in bonds!

  2. January 30, 2012 at 2:22 pm

    The last 10 years aren’t the best example of that approach 🙂 But if you go all stocks and don’t lock in the losses by selling at the wrong time that works too.

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