Account value vs account balance
“Success is found on the other side of fear.” – Unknown
Over the past few weeks I’ve had a number of individual meetings with people whose level of confidence and experience when it came to investing was quite low. I found it interesting that, even though their ages and backgrounds were quite different, they shared a number of common fears and misconceptions which had made them hesitant when it came to selecting investments within their group retirement plan. This hesitation meant that either they had delayed joining the plan because they didn’t know what to write in the “investment selection” portion of the application form, or they had simply left the section blank and had subsequently been invested in whatever the plan default fund happened to be.
Related article: Making investment decisions using behavioral finance
It’s not unusual for people to be nervous about making investment decisions. We don’t teachour kids anything about investing in school and the financial services industry has done a good job of making people feel as though they need a degree in finance in order to manage their own money and of course there’s always the small print in any investment profilewarning us that “investments can go down as well as up”.
History has shown us that stock markets move in cycles and that there are more up years than down years but as anyone who has invested in mutual fund knows, the value of your investments can drop, sometimes significantly, depending on how you’re invested.
Related article: Stock market historical data
This isn’t necessarily the big disaster that people perceive it to be though and, if you can overcome psychology with logic and the occasional shift of perspective, it can be extremely profitable.
Account value is not the same as account balance
One common “mis-perception” that people have when it comes to their investment accounts is that they view the balance in the same way as they view the balance of their chequing account which can lead to a lot of unnecessary worry and stress. Let me explain…
If the balance of your chequing account is $10,000 this means that you physically have $10,000 in your account. If the balance of your chequing account drops to $7,000 this means that $3,000 has to have left your account and the only way to increase the balance is to add more money.
By comparison, if the balance of your investment account is $10,000 that doesn’t mean that there is physically $10,000 cash inside your account, it means that the value of whatever you hold in your investment account is $10,000. That value will only be converted into physical cash at the point where you sell your investment.
When you invest in a mutual fund you are buying pieces or “units” of that fund and the value of those units will vary from day to day. It can be hard to see those mythical “units” as something tangible so let’s imagine for a second that the investments you hold in your account are actually purple baseballs.
On the day you decide to invest in those purple baseballs, they are valued at $10 each. You exchange a $100 bill for 10 purple baseballs and so the value of your account is $100. If the value of purple baseballs increases to $20, the value of your account will increase to $200 but you will only have doubled your money if you actually sell the baseballs for $20 each.
Similarly, if you decide to hold on to the baseballs and then the value of baseballs drops to $5, you will only have lost money if you sell your purple baseballs for $5 each. If you hold on to them until their value increases to $10 you’ll be back to even and if their value continues to increase you have the potential to make even more money when you sell them.
This is the main reason why investing in mutual funds is often a long term rather than a short term investment. The idea is to ride through the ups and downs of the market until you arrive at a point where it makes sense to sell your investment and either use the money to invest in something different or leave it in cash.
Buy low sell high
For many people, the downturns in the value of their investments are their least favourite part of the investment rollercoaster. It’s easy to be happy with our decision to invest in an aggressive fund when the markets are strong and we’re seeing high returns but it’s a totally different story when the markets are volatile and our investment has dropped significantly in value.
If we can put aside our emotions for a second and remember that a) we only lose money when we sell and that b) the only way to make money in investing is to “buy low and sell high” then it makes it a little easier to see how a market downturn might be an opportunity to lay the foundation for some strong wealth building in the future…
Related article: The secret on how to buy low, sell high
If we go back to the purple baseball analogy and imagine for a second that we bought the 10 baseballs for $10 each and now their value is $5 each. We know that we only lose money if we sell the balls for $5 each and so we need to hold on to them until the purple baseball market recovers but what happens if, while the value of purple baseballs is low, we decide to buy 10 more balls? Now, when the value of baseballs goes back up to $10, our original investment is back to its original value but the10 baseballs we bought in the down market for $5 each have all doubled in value.
While there’s no sure-fire way of timing the markets to make sure we’re always investing when the value is lowest and selling when the value is highest, we do know that investing on a regular basis (weekly, semi monthly or monthly) allows us to take advantage of the ups and downs of the market that occur.
Related article: The Power of Dollar Cost Averaging
This is one of the many reasons that investing in a group plan via payroll deductions or setting up a regular pre-authorized payment from your bank account to a personal plan is a good idea.